Macro-Economic and Industry

Analysis
 Macro-Economic and Industry Analysis: Fundamental analysis-EIC
Frame Work, Global Economy, Domestic Economy, Business Cycles,
Industry Analysis. Company Analysis- Financial Statement Analysis, Ratio
Analysis. Technical Analysis – Concept, Theories- Dow Theory, Eliot wave
theory. Charts-Types, Trend and Trend Reversal Patterns. Mathematical
Indicators – Moving averages, ROC, RSI, and Market Indicators. (Problems
in company analysis & Technical analysis) Market Efficiency and Behavioral
Finance: Random walk and Efficient Market Hypothesis, Forms of Market
Efficiency, Empirical test for different forms of market efficiency.
Behavioral Finance Interpretation, Biases and critiques. (Theory only)
 Macro-Economic and Industry Analysis

• To determine the intrinsic value of the equity share, the security analyst
must forecast the earnings and dividends expected from the stock and
choose a discount rate which reflects the riskiness of the stock. This is
what is involved in fundamental analysis, perhaps the most popular
method used by investment professionals.
• Researchers have found that stock price changes can be attributed to the
following factors:
– Economy wide factors: 30-35 percent
– Industry factors: 15 to 20 percent
– Other factors: 15 to 25 percent
• Based on the above evidence, a commonly advocated procedure of
fundamental analysis involve a three step examination, which calls for:
– Understanding the macro economic environment and developments
– Analyzing the prospects of the industry to which the firm belongs
– Analysing the projected performance of the company and the intrinsic value of its
shares.
 Macro-Economic Analysis

The macro economy is the overall economic environment in which all firms
operate. The key variables commonly used to describe the state of the macro economy
are:
a) Growth rate of GDP: GDP is a measure of the total production of final goods and
services in the economy during a specified period usually a year. The current GDP rate
is hovering around 7 to 8 percent. Firm estimates the of GDP growth rate are available
with the time lag of one to two years or so, the preliminary estimates are made from
time to tome by various bodies like CIME, NCAER and the RBI. The higher the growth
rate of GDP, other things being equal, the more favourable it for the stock market.
b) Industry growth rate: The GDP growth rate represents the average of the growth rates
of the three principal sectors of the economy, viz. the services sector, Industrial sector,
and the agricultural sector.
Publically listed companies play a major role in the industrial sector but only a
minor role in the services sector and the agricultural sector. Hence stock market
analysts focus more on industrial sector. The higher the growth rate of the industrial
sector, other things being equal, the more favourable it is for stock market.
C) Agriculture and monsoons: Agriculture accounts for about a quarter of the Indian
economy and has important linkages, directly and indirectly, with industry. Hence, the
increase or decrease of agricultural production has a significant bearing on industrial
production and corporate governance.
d) Savings and investments: The demand for corporate securities has an
important bearing on stock price movements. So, investment analysts should
know what is the level of investment in the economy and what proportion of
that investment is directed towards the capital market. Other things being
equal, the higher the level of savings and investment and the greater the
allocation of the same to equities, the more favourable it is for the stock
market.
e) Government budget and deficit: The central budget prepared annually
provides information on revenues, expenditures and deficits. In India
revenue come form the taxes. The excess of governmental expenditures over
governmental revenues represents the deficit. Investment analysts examine
the budget to assess how it is likely to impact the stock market.
f) Price level and inflation: The effect of inflation on the corporate sector tends
to be uneven. While certain industries may benefit, others tends to suffer.
Industries that enjoy a strong market for their products and which do not
come under the purview of price control may benefit. On the other hand,
industries that have week market and which come under the purview of
price control tend to loose
g) Interest rates: Interest rates vary with maturity, default risk, inflation rate,
productivity of capital, special features and so on. A rise in the interest rates
depresses corporate profitability and also leads to an increase in the
discount rate applied by equity investors, both of which have adverse impact
on stock prices. On the other hand, a fall in the interest rates improves
corporate profitability and also leads to a decline in the interest rate applied
to equity investors, both of which have a favourable impact on stock prices.
h) Balance of payment, forex reserves and exchange rate: The balance of
payments deficit is equal to: Balance of trade deficit (imports minus
exports)+ Balance of invisibles like tourism and interest rates (payment on
account of invisibles minus receipts on account of invisibles)+ Balance on
account of capital account (repayment on account of loans minus receipt of
loans).
A balance of payments deficit depletes the forex reserves of the country
and has an adverse impact on the exchange rate; on the other hand a
balance of payments surplus augments the forex reserves of the country
and has a favourable impact on the exchange rate.
i) Infrastructural facilities and arrangements: Infrastructural facilities and
arrangements significantly influence industrial performance. More
importantly adequate and regular supply of electric power, well developed
transportation and communication system, assured supply of basic raw
materials like steel, coal, petroleum products and cement.
a) Sentiments: The sentiments of consumers and businessman can have an
important bearing on economic performance. Higher consumer confidence
leads to higher expenditure which boost the business confidence which
gets translated into greater business investment that has a stimulating
effect on the economy.
 Industry Analysis

• The objective of industry analysis is to assess the prospects of various

industrial groupings. Admittedly, it is almost impossible to forecast exactly
which industrial groupings will appreciate the most. Yet careful analysis
can suggest which industries have a brighter future than others and which
industries are plagued with problems that are likely to persist for a while.
• Concerned with the basics of industry analysis, this section is divided into
three parts:
– Industry life cycle analysis
– Study of the structure and characteristics of an industry
– Profit potential of industries.
 Industry life cycle analysis

Many industrial economists believe that the development of almost every

industry may be analyzed in terms of the life cycle with four well defined
stages:
a) Pioneering Stage
b) Rapid growth stage
c) Maturity and stabilization stage
d) Decline stage

• Give industry analysis prior attention in your investment selection process.

• Display caution during Pioneering stage- this stage has an appeal primarily for
speculations.
• Rapid quickly and expand your commitments during the rapid growth stage.
• Moderate your investment during maturity stage.
• Sensibly disinvest when the signals of the decline are evident.
Structure & Characteristics of an Industry
1. Structure of the industry and nature of competition: the numbers of firms,
licensing policy, entry barriers, pricing policies, competition from foreign
firms, comparison of the products in the industry with substitute etc.
2. Nature and prospects of demand: major customers and their requirements,
key determinants, degree of cyclicality of demand, expected growth rate.
3. Cost efficiency and profitability: Proportion of the key cost elements,
namely raw materials, labour, utilities and fuel, turnover of inventory,
receivables, control over prices of outputs and inputs, gross profitability,
operating profits, net profits, etc.
4. Technology & Research: degree of technological stability, important
technological changes, proportion of sales growth attributable to new
product.
Profit Potential of Industries: Porter model
1. Threat to new entrants
2. Rivalry among the existing firms
3. Pressure from substitute products
4. Bargaining power of buyers
5. Bargaining power of suppliers
 Technical Analysis

• It involves a study of market generated data like prices and volumes to

determine the future direction of price movement.
• The basic premises underlying technical analysis are as follows:
– Market prices are determined by the interaction of supply and
demand forces.
– Supply and demand is influenced by a variety of factors, both rational
and irrational. These include fundamental as well as psychological
factors.
– Barring minor deviations, stock prices tend to move in fairly persistent
trends.
– Shift in demand and supply bring about changes in trends.
– Irrespective of why they occur, shifts in demand and supply can be
detected with the helps of charts and market action.
– Because of the persistence of trends and patters, analysis of past
market data can be used to predict price behaviour.
 Differences between Technical and Fundamental Analysis

• Technical analysis mainly seeks to predict short term price movement,

whereas fundamental analysis tries to establish long term values.
• The focus of technical analysis is mainly on internal market data,
particularly price and volume data. The focus of fundamental analysis is on
fundamental factors relating to economy, the industry and the firm.
• Technical analysis appeals mostly to short term traders, whereas
fundamental analysis appeals primarily to long term investors.
 Charting techniques

Technical analysts use a variety of charting techniques. The most

popular ones seem to be the Dow theory, bar and line charts, the point
and figure chart, the moving average line and the relative strength line.

Dow Theory
Dow developed this theory to explain the movement of the indices of Dow
Jones Averages. He developed the theory on the basis of certain
hypothesis.
1. The first hypothesis is that, no individual buyer can influence the major
trend in the market. However an individual investor can affect the daily
price movement by buying or selling huge quantum of particular scrip.
2. The market discount everything. The Pokhran blast affected the share
market for a short while and the market returned back to normalcy.
3. This theory is not infallible. It is not a tool to beat the market but
provides a way to understand it better.
 According to Dow theory the trend is divided into primary, intermediate
and short term trend. The primary trend may be broad upward or downward
movement that may last for a year or two. The intermediate trend are
corrective movements, which may last for three weeks to three months. The
primary trend may be interrupted by the intermediate trend. The short term
refers to the day to day price movement. It is also known as oscillations or
fluctuations. These three types of trends are compared to tide, waves and
ripples of the sea.
• Trend is the direction of movement. The share price can either increase fall or
remain flat. The three direction of the share price movements are called as
rising, falling and flat trend. The share price do not fall or rise in a straight line
every rise or fall in price experiences a counter move.
• The trend lines are straight line drawn connecting either the tops and
bottom of the share price movement to draw a trend line.

• The rise and fall in the share prices cannot go on forever. The share price
movement may reverse its direction. Before the change of direction,
certain pattern in price movement emerges. The change in the direction of
the trend is shawn by the violation of the trend line from above; it is
violation of trend line and signals the possibility of fall in price. Like wise if
the scrip pierces the trend line from below , this signals the rise in price.
 Indicators

• Volume of trade: volume expands with the bull market and narrows down
in the bear market. Large rise in price or large fall in price leads to large
increase in volume.
• Breadth of the market: it is a method often used to study the advances
and declines that have occurred in the stock market. Advances mean the
number of shares whose prices have increased from the previous day’s
trading. Decline indicates the number of shares whose prices have fallen
from the previous day trading.
• Short sales: Short sales refers to selling of shares that are not owned. The
bears are the short sellers who sell now in the hope of purchasing at a
lower pric in the future to make profits.
• Odd lot trading: Shares sold in smaller lots fewer than 100 are called odd
lot. Such buyers and sellers are called odd lotters. The increase in the odd
lot purchases results in an increase in the index. Relatively more selling
leads to fall in the index.
 Moving Average analysis

• A moving average is calculated by taking into account the most recent n

observations. The word moving means that the body of data moves ahead
to include the recent observation. It is the five day moving average, on the
sixth day the body of data moves to include the sixth day observation
eliminating the first day’s observation. In moving average closing price of
the stock is used.
• To identify trends, technical analysts use moving average analysis: a 200
day moving average of daily prices (or alternatively, 30 week moving
average of weekly prices) may be used to identify a long term trend; a 60
day moving average of daily prices may be used to discern an intermediate
term trend; a 10 day moving average of daily prices may be used to detect
a short term trend.
 Moving Average Analysis
Sum of five most recent closing
trading day Closing price prices Moving Average
1 25
2 26
3 25.5
4 24.5
5 26 127 25.4
6 26 128 25.6
7 26.5 128.5 25.7
8 26.5 129.5 25.9
9 26 131 26.2
10 27 132 26.4

Chart Title
Series1 Series2

27
26.5 26.5 26.4
26.2
26 26 26 25.9 26
25.6 25.7
25.5 25.4
25
24.5

1 2 3 4 5 6 7 8 9 10
 Buy Signal Sell Signal

Stock price line rises through the moving Stock price lines falls through the moving
average line when the graph of the average line when the graph of the
moving average line is flattening out. moving average line is flattening out.

Stock price line falls below the moving Stock price line rises above the moving
average line which is rising. average line which is falling.

Stock price line, which is above the Stock market line which is below the
moving average line, falls but begins to moving average line, rises but begins to
rise again before reaching the moving fall again before reaching the moving
average line. average line.
 Relative Strength Index

• Relative strength Index was developed by Wells Wilder. It is an oscillator used

to identify the inherent technical strength and weakness of a particular scrip
or market. RSI can be calculated for scrip by adopting the following formula.
RS= 100-[100/1+ Rs]
Rs= Average gain per day/Average loss per day
• The RSI can be calculated for any number of days depending on the wish of
the technical analyst and the time frame of trading adopted in a particular
stock market. RSI is calculated for 5,7,9 and 14 days. If the time period taken
for calculation is more, the possibility of getting wrong signal is reduced.
• Reactionary or sustained rise or fall in the price of the scrip is foretold by the
RSI.
• The broad rule is, if the RSI crosses seventy three max be downturn and it is
time to sell. If the RSI falls thirty it is time to pick up the scrip.
 Rate of Change

• ROC measures the rate of change between current price and the price ‘n’
number of days in the past.
• ROC helps to find out the overbought and oversold position in scrip. It is
also useful in identifying the trend reversal.
• Closing price issued to calculate the ROC. Calculation of 12 week or 12
months is so popular.
• Suppose the price of AB company’s share is Rs. 12 and price twelve days
ago was Rs. 10 then the ROC is obtained by using: 12/10*100= 120%.
• In the second method the % variation between the current price and the
price twelve days in the past is calculated.
 Charting Patterns

• Charts are the valuable and easier tools in the technical

analysis. The graphical presentation of the data helps in the
investors to find out the trend of the price without any
difficulty. The Charts also have the following uses:
– Sports the current trend for the buying and selling.
– Indicates the probable future action of the market by projection.
– Shows the past historic movements.
– Indicates the important areas of the support and resistance.
Points & Figure Charts
• To predict the extent and direction of the price movement of a particular
stock or the stock market indices uses point and figure charts.
• The PF charts are of one dimensional and there is indication of time and
volume. The price changes in relations to previous prices are shown. The
chart can be drawn in the ruled paper.
• Bar Charts: it is the simplest and the most commonly used tools. To build a
bar a dot is entered to represent the highest price at which the stock is
traded on that day, week or month. Then another dot is entered to
represent the lowest price on that particular date. A line is drawn to
connect both the points a horizontal nub is drawn to mark the closing
prices.
• It is used to indicate the price movements. The line chart is simplification
of bar chart. Here a line is drawn to connect the successive closing dots.
• Double top and bottom: This type of formation signals the end of one
trend and the beginning of another. If the double top is formed when a
stock price rises to certain level, falls rapidly again rises to the same
heights or more and turn down. The double top may indicate the onset of
the bear market.
• In a double bottom, the price of the stock falls to a certain level and
increase with diminishing activity. Then it falls again to the same or to a
lower price and turn up to a higher level. It is a sign for bull market.
• Head and shoulders: this pattern is easy to identify and the signal
generated by this pattern is considered to be reliable. In this pattern there
are three rallies resembling the left shoulder, a head and a right shoulder.
A neckline is drawn connecting the lows of the tops. When the stock price
cuts the neckline from above, it signals the bear market.
 'Candlestick'

A candlestick is a type of price chart that displays the high, low,

open and closing prices of a security for a specific period. It
originated from Japanese rice merchants and traders to track
market prices and daily momentum hundreds of years before
becoming popularized in the United States. The wide part of the
candlestick is called the "real body" and tells investors whether the
closing price was higher or lower than the opening price (black/red
if the stock closed lower, white/green if the stock closed higher).
• The candlestick's shadows show the day's high and low and how they
compare to the open and close. A candlestick's shape varies based on the
relationship between the day's high, low, opening and closing prices.
• Candlesticks reflect the impact of investor sentiment on security prices and
are used by technical analysts to determine when to enter and exit trades.
Candlestick charting is based on a technique developed in Japan in the
1700s for tracking the price of rice. Candlesticks are a suitable technique for
trading any liquid financial asset such as stocks, foreign exchange and
futures.
 Random Walk Hypothesis

• The theory that stock price changes have the same distribution and are
independent of each other, so the past movement or trend of a stock price
or market cannot be used to predict its future movement.
• In short random walk says that that stocks take a random and
unpredictable path.
• There is an equal chance that a stock’s price will either rise or fall from
current levels.
• The theory gained popularity in 1973 when Bourton Malkiel wrote “ A
Random walk Down Wall Street”, a book that is now regarded an
investment classic.
 Efficient Market Hypothesis
• The Efficient Market Hypothesis (EMH) is an investment theory whereby
share prices reflect all information and market price is an unbiased opinion of
its intrinsic value.
• Theoretically, neither technical nor fundamental analysis can produce risk-
adjusted excess returns, or alpha, consistently and only inside information
can result in outsized risk-adjusted returns.
• According to the EMH, stocks always trade at their fair value on stock
exchanges, making it impossible for investors to either purchase undervalued
stocks or sell stocks for inflated prices.
Foundation of market efficiency:
• Investor Rationality: if all investors are rational, stock prices will adjust
rationally to the flow of new information.
• Independent deviation from rationality: As long as the deviation from
rationality is independent and uncontrolled, errors tends to cancel out and
the market price will still be an unbiased estimate of intrinsic value.
• Effective Arbitrage: rational professionals will exploit mispricing of securities
caused by the behaviour of irrational amateurs .
 Forms of efficient Market Hypothesis
The Three Basic Forms of the EMH

The efficient market hypothesis assumes that markets are efficient. However, the
efficient market hypothesis (EMH) can be categorized into three basic levels:

1. Weak-Form EMH: The weak-form EMH implies that the market is efficient, reflecting all
market information. This hypothesis assumes that the rates of return on the market
should be independent; past rates of return have no effect on future rates. Given this
assumption, rules such as the ones traders use to buy or sell a stock, are invalid.
2. Semi-Strong EMH: (market and non market information) The semi-strong form EMH
implies that the market is efficient, reflecting all publicly available information. This
hypothesis assumes that stocks adjust quickly to absorb new information. The semi-
strong form EMH also incorporates the weak-form hypothesis. Given the assumption that
stock prices reflect all new available information and investors purchase stocks after this
information is released, an investor cannot benefit over and above the market by trading
on new information.
3. Strong-Form EMH : The strong-form EMH implies that the market is efficient. it reflects
all information both public and private, building and incorporating the weak-form EMH
and the semi-strong form EMH. Given the assumption that stock prices reflect all
information (public as well as private) no investor would be able to profit above the
average investor even if he was given new information.
 Weak Form Tests

The tests of the weak form of the EMH can be categorized as:
• Statistical Tests for Independence - In our discussion on the weak-form EMH, the
weak-form EMH assumes that the rates of return on the market are independent.
Given that assumption, the tests used to examine the weak form of the EMH test
for the independence are the autocorrelation tests (returns are not significantly
correlated over time) and runs tests (stock price changes are independent over
time).
• Trading Tests - Another point we discussed regarding the weak-form EMH is that
past returns are not indicative of future results, therefore, the rules that traders
follow are invalid. An example of a trading test would be the filter rule, which
shows that after transaction costs, an investor cannot earn an abnormal return.

Semi-strong Form Tests

Given that the semi-strong form implies that the market is reflective of all publicly
available information, the tests of the semi-strong form of the EMH are as follows:
• Event Tests - The semi-strong form assumes that the market is reflective of all
publicly available information. An event test analyzes the security both before and
after an event, such as earnings. The idea behind the event test is that an investor
will not be able to reap an above average return by trading on an event.
• Regression/Time Series Tests - Remember that a time series forecasts returns
based historical data. As a result, an investor should not be able to achieve an
abnormal return using this method.
Strong-Form Tests

Given that the strong-form implies that the market is reflective of all information,
both public and private, the tests for the strong-form center around groups of
investors with excess information. These investors are as follows:
– Insiders - Insiders to a company, such as senior managers, have access to
inside information. SEC regulations forbid insiders for using this information to
achieve abnormal returns.
– Exchange Specialists - An exchange specialist recalls runs on the orders for a
specific equity. It has been found however, that exchange specialists can
achieve above average returns with this specific order information.
– Analysts - The equity analyst has been an interesting test. It analyzes whether
an analyst's opinion can help an investor achieve above average returns.
Analysts do typically cause movements in the equities they focus on.
– Institutional money managers - Institutional money managers, working for
mutual funds, pensions and other types of institutional accounts, have been
found to have typically not perform above the overall market benchmark on a
consistent basis.
 Behavioural Finance

• The branch of economics which is concerned with this emotion and

psychology paradox is called behavioral finance. This relatively new field
seeks to combine behavioral and cognitive psychological theory with
conventional economic theory in order to propose explanations as to why
people might make irrational financial decisions.

Biases in Behavioural Finance:

• Overconfidence
• Optimistic Biases
• Confirmation Biases
• Illusion of Understanding