1612 NOTES FOR SEMESTER EXAM 2

Technical analysis
intro

Explains and forecasts price movements based on past price behavious

Markets are dominated at certain times by a mass psychology and over time there wil be a
regular pattern in share price movements
Share price pattern: a graph overtime of movements in a share price or market index
o It assumes that historic patters will re emerge in full
o Therefore being able to predict future prices
Analysts take either technical approach or fundamental approach
o Combination of both provides a better forecast
Fundemental: reasonable forecasting trach record until the share market moves
above or below the norm
When past the norm, analysts will use technical forecasting
Timing can change forecasting strategy
Limitation of fundamental analysis, forecasting on the fundementals can suggest that the
market is overvalues and is due for a correction but cannot predict timing of the downturn
o Therefore adjustments must be made
Technical analysis include
o Moving averages
o Charting

Moving averages

Price series: a graph of historic share price or market index movements over time
Moving average model: a graph of a series of average prices constructed over time
Designed to reveal a trend more clearly in a price series
Calculating an average 5 day MA
o Adding the data together and then dividing the value by 5
o on day 6, day 1 price is dropped and the day 6 is brought in
o the sum of the current set of 5 daily prices is still divided by 5, however, giving the five
day MA on day 6
o this proves is repeated
Following rules apply to be able to get benefits from the MA technique

Buy when the actual price series cuts the MA from below- especially if the MA has been

flat or is in a gentle decline

Buy when the MA series is rising strongly and the price series cuts or touches the MA
from above, but then moved back above the MA after only a few observations

Sell when the MA flattens or declines after a steady rise, and the price series cuts the

ma from above
Sell when the MA series is in decline and the price series cuts or touches the MA from
below, but then moves back beneath the MA after only a few observations

Daily constructed MA usually use 10 or 30 day periods

o 10 day periods pick up short term changes in trend
o 30 day period picks up medium term trend changes
Analysts generally use a combination of MA series in order to general their buy/se;; signals
rather than a single MA series
Weighted MA
o Most recent prices are the most valuable information on what the market perceives the
value of the shares to be
o Each piece of the raw price data is given a weighting and the lastest price is given the
higher weighting than historical prices
o To calculate the latest price, we must delete the earliest price within the series(usually
day 1) then recalculate the weighted values starting from the next day

Charting

Trend lines
o Uptrend line
Connection between the lower points of a rising price series
o Downtrend line
Connection of the higher points of a falling price ereis
o Return line
A line drawn parallel to a trend line to create a trend channel
o Characterisation of trend lines
The longer a trend line has been in force, and the more times its has been
tested, therefore higher validity
If a trend line is of long standing and has withstoof 3 or 4 tests and then an
indecisive break is experiences, this penetration can be ignored and the orginal
trend retained
Intra- day trades that break through established trend lines are considered to be
unimportant, however if the breakout is on high trading volumes, it may signal a
weakening trend
Failure to reach the return line in a well-established trend indicates
deterioration in the trend
Once a trend is broken on the downside, process fall from it, and then often
makes a return move towards the line

o
Support and resistance lines
o Dotted lines are drawn across the chart at historic support and resistance levels
o Support lines: lower price levels where an increase in demand halts a price fall
o Resistance lines: higher price levels where an increase in supply halts a price rise

o
o

Represents periods of conflucts between buyers and sellers, with the price being
bounced between the two lines
o Indicators of a breakout
Rectangles tend to be characterized by reducing volumes, except for a few days
before the breakout, where there are strong increases in the volumes of trade
in the shares
If the last bottom does not touch the support level, beginning the formation of
an ascending triangle, and if the prices then rise rapidly on increasing volumes,
it is likely that there will be a topside breakout
If the tops fail to reach resistance levels, begening of the formation of a
descending traiangle, therefore a downside breakout
Continuation patterns
o The previous patterns are called continuation patterns
o 2 main continuations
Triangles
Pennants and flags
o Continuation patter: sideways share trading that does not normally signal a change in
trend
o Triangles
Symmetrical triangles

A series of price fluctuations with each top and bottom smaller than its
predecessor
No safe prediction of a breakout
Ascending triangles
Usually form in an uptrend and characterized by ascenging bottoms and
horizontal tops
Descending triangles
Downward trend and are characterized by decreasing tops and
horizontal bottoms

Pennants and flags

Usually form in fast moving markets
Both tend to form rapidly
Usually occur after very sharp increases in price on high volumes
Reffered as the pole
During the formation, trading volumes will fall and then increase suddenly to
take prices sharply lower than highly respectively
Presuming that breakout of prices will most often be to a height equl to the
height of the pole that preceeded the pennant or flag
Can also develop in a failing market

Reversal patterns
Head and shoulders patterns are one of the most reliable patterns
Simple head and shoulder patterns consist of 3 successive rallies and
reactions
The second rally and reaction reaches a higher point than the rallies on
either side
The left shoulder forms on an expanding volume strongly rally towards
the end of an upward trend
The head forms on a strong rally which carries the price higher than that
for the left shoulder and followed by a reaction that sees prices moving
back to the vicinity of the previous low
The right shoulder represents the conclusion o the pattern, marked by
reduced volumes indicating price weakness
Completion of the patter occurs when there is a breakthrough the
neckline ( formed by a line drawn across the lows of the left and right
shoulder)
Following this the prices often move back to the price of the head
Elliott wave theory
The existence of distinctive wave patterns that characterize share
market price
Try to obtain early warning signals relating to likely movements in share
prices
Technical analysis have little validity, if sufficient number of markets participants employ
technical analysis to guide their actions and impacts on share prices at various times

Electronic

Program trading
o Buy and sell orders, typically in large amounts that are automatically triggered by
computer based programs in response to movements in share price
High frequency trading
o Application of high speed supercomputers that are controlled by algorithms that analyse
data, indentify investment opportunities and influence stock order flows and therefore
share prices in the market

Place thousands of buy/sell orders in seconds to take advantage of big offer

spreads

Flash trading
o Certain privileged institutional investors typically HFT firms, receive information from
stock exchange of incoming stock orders a fraction of a second before information is
sent to the trading systems
By gaining flash information before other participants, the HFT firm is able to
match the best big or offer in the system and pick up the incoming order
o Violated the principle of market fairness
Dark pools
o Trading system with an exchange that allows certain institutional investers to conduct
large transactions without immediate disclosure to the market
o Participants place an indication of interest to buy or sell a quantityof securities at a set
price to be determined at a nominated time during the trading day
o The price at which the trade is settled will not reflect the impact of the large trade
News analytics
o Algorithmic based strategy
o Financial institutions and traders scan large amounts of textual information
(newspapers,internet sites) and will determine whether the commentary has a larger or
number of positive or negative statements
o If a computer detects relatively large amounts of positive commentary about a
company, buy orders will be excecuted
Program trading, HFT, flash trading, dark pools and news analytics all have impacts on share
prices and therefore need to be considered when conducting analysis to forecast movement in
share prices

The random walk, efficient market and behavioral finance hypothesis

Random Walk Hypothesis

Each observation in a time or price series such as share prices in independent of the previous
observation
Path of a series of share prices is random and unpredictable
Does not describe the movement of a share price, historical data does not contain valuable
information to predict future price movements
Each share is assumed to have intrinsic value that is based on investors expectations about the
present value of the firms future net cash flows
Forecast is based on the latest information vailable and relevant ot eh companys current statee
and future prospects
Most likely information received will not have a particular trend and movements of share prices
will be random
Share prices react to new information coming into the market and therefore you will need to
consider how quickly the information is absorbed and reflected on the share prices

The efficient market hypothesis

Derived from the random walk hypothesis

If markets are eddicient, it should not be possible for an investor to make abnormal profits
through having superior information to that of the rest of the market
Denies that there is a chance of making superior profits from employing the techniques of
technical analysis as these techniques rely on the assumption that past price patterns will repeat
themselves
Employing fundamental analysis to share valuation will not yield superior results for one
investor over another
o All information required in either approach should be available to all market participants
Has been tested on three levels
o With each level making different assumptions about the degrees of information
efficiency
o The least stringent test of the hypothesis is weak form efficiency: successive changes in
the share price are independent of one another, therefore investors cannot make
superior profits through determining the shares trading behavior on the basis of
historic data
o Semi-strong form efficiency: all publicly available information regarding a company is
fully reflected in the price of a share. Therefore investors cannot make superior profits
using publicly avaibale information because it is already reflected in the share price.
Analysts who identify mispriced information using fundamental analysis
approached will not be successful
Issues will timing and how quickly the market participants aree able to absorb
information
Interpretation of information may be different with analysts due to different
outcomes and interpretation
o Strong form efficiency: all information, including that which is publicly acailable and
through private reseach will be reflected fully in the market price of a share
Specialist analysts and insiders of a company who have new information cannot
earn greater profits than those who do not have access

Behavioral finance hypothesis

Identify and recognize the importance of cognitive factors that may shape investors behavior
and lead to a divergence between actual share prices and those that would be expected to
prevail in an efficient market
Having a better understand of the financial markets may be obtained by studying the
psychology of investors
Dissatisfaction with the traditional models of decision making and the apparent incongruity of
equilibrium theory with the volatility observe to the characterized the markets
A survey of behavioural finance: identifies 2 main tenets of behavioural theory
o First is that rational investors may not necessarily correct the mistakes of irrational
investors

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o

o
o

Although investors may make mistakes and the market inefficiencies created by
them will not be corrected by rational investors, even if rational investors
recognize an opportunity because there are limits to arbitrage
Strategies need to be put into place to correct some markets
inefficiency or may be too risky or costly
May also be very costly to maintain, therefore no incentive for rational
investors to correct
The limits to arbitrage concept is a challenge to the orthodox
neoclassical equilibrium model and a defence of the rationale of the
behavioural finance theory
The second tenet of behavioural finance theory is that investors decisions diverge from
those that would be consistent with the efficient market hypotheses in ways that can
be explained and predicted on the basis of cognitive psychology
The orthodox model or rational choice that is challenged by the discovery of
these decision making baises
An individual makes a choice from his or her available opportunity in
order to maximise utility
Risk and uncertainty
Outcomes are risky when there is a chance that the actual outcome
may be different from the expected
Risk and uncertainty describes how an individual cannot simply pick the
opportunity with an outcome that may bring their maximum utility
The expected utility is the sum of the utility of each possible outcome
weighed by its probability of occurrence
Expertimental economics: a branch of economics that attempts to explore the
operation of economic theory under controlled conditions
Prospect theory: an alternative model of choice under rist
Assessing different risky opportunities or prospects on the basis or prospect
value
Cummulative prospect theory: an updated version of prospect theory that revolves a
number of theoretical and practical problems identified by critics of the original version
Important decision-making biases that have been identified are:
People are confident and overestimate the accuracy of their investment
decision and underestimate their potential for erre
People are averse to losses
People exhibit framing bias
People exhibit representativeness
People display cognitive dissonance
People make decisions with a reference point in mind

Investors in the share market

Share Market Investment

Investors must construct an investment portfolio to meet particular investment preferences

A primary preference swill be the return on the portfolio
Returns may be in the form of dividends or capital gains/losses made
The board of directors of a company may be income to sharerholders in the form of a dividend
usually paid bi yearly
Investors need to consider the tacation implications of income versus capital growth as well as
liquidity requirements
Shares on a stock market can be listed as systematic risk or unsystematic risk which have
impacts on the general share prices in the market
o Systematic ris: exposure that affect the price of the majority of shares listed on a stock
exchange
Examples include: changes in interest rates, changed in exchange rates,
centration or expantion in economic activity, introduction of new legislation,
political stability, changes in market confidence and perception
o Unsystematic risk: exposure that specifically impacts on the share price of a particular
corporation
Example: the resignation of an executive manager, change in future performace
forecasts, a possibility of a merger, the failure of technology or communication
system, dissent with the board of directors, rumours or evidence of financial
difficulty
Investors can diversify away a large proportion of the unsystematic risk
o Diversified investment portfolio: an investment portfolio that includes a wide range of
securities and assets
o Can minimise risk exposure associated with investing in a single share
o Having to invest in man categories of shared
Main risk exposure is systematic risk
o Rewarded for level of systematic risk that is evident in portfolio
o Measured by beta-coeficient
The amount of systematic risk that is present in a particular share relative to an
average share listed on a stock exchange
Investors must also decisde on whether to take an active or passive investment approach
o Active investment approach: a portfolio structure based on share analysis, new
information and risk/return preeferences
Buy/sell shares based on new information received In the market using
fundamental and technical analysis
o Passive investment: building an investment portfolio based on shared incorporated in a
share market index

Share market indec is a grouping of shares listed on a stock exchange that shows
changes in the overall prices of those shares day by day
Index funds aquire shares so that a portfolio replicates a specific share market
index
Investors should be aware of the risk and return characteristics of each share investment and its
relationship with the total investment portfolio
o The expected return of a portfolio is the weighted average of the expected returns of
each share
o Portfolio variance or risk is the variability of the portfolios returns over time
Result of the variance of each individual investment contained within the
portfolio and the covariance and correlation between the pairs of securities
within the portfolio
Covariance and correlation meausres that way two share prices move in relation
to each other
Investors must consider asset allocation within the share portfolio
o Risk vs return
o Investment time horizon
o Income vs capital growth
o Domestic and international share investments
Investors may apply a strategic asset allovation approach: a portfolio structure to meet an
investors personal preferences
Investors may acopt tactical asset allocation: a portfolio structure to take account of a dynamic
investment environment

Buying and selling shares

Investors should consider a whole range of issures in the share investment decision process.
These consideration includes:
o Liquidity: how easily shares can be converted to cash
o Risk: including variance, standard deviation, beta, volatility
o Integrity: of the company, management and share market
o Charges: transaction costs such as fees on managed funds or brokerage on disrect
transaction through a stockbroker
o Return: the type of return expected- dividends, capital growth
o Capital growth: factors that will affect the level of growth- inflation, interest rates,
economic and business cycles
o Accessibility: the depth and liquidity of the promari market and secondary market
o Flexibility: portfolio restructuring, active investment, passive investmtent
o Taxation: income tax, capital gain tax, dividen imputation tax
o Social security: effect of investment on the income test and asset test associated with
social security benefits
There are 2 types of approaches in buying and selling shares through the stock exchange
o Direct investment
An investor buys and sells shares directly through a stockbroker

Investor selects company in which to invest and place an order with a

stockbroker to buy or sell specific shares
The broker will place that order into the stock exchange through electronic
strategy system
The system will prioritise by price and time, match the corresponding buy and
sell orders and then execute trade
The broker will send a contract note to the buying or seller confirming their
transaction and advising the stock traded, number of shares, the date of the
trade, the price, transaction cost and total amount due
The stock exchange will electronically transfer ownership of the shares to the
buyer and forward financial settlement for the transaction to the seller
Discount broker: accepts buy or sell orders from clients but provides no advice
or recommendations to the client in relation to the investment alternatives or
opportunites
Full service advisory broker: executes buy and sell orders but also provides
other services to clients including investment advice
Buying and selling shares on the instruction of the client
Providing investment advice on sercurities listed on the stock exchange
Giving advice on other investment opportunities such as cash
management
Making recommendations and establishing and monitoring personal
finance plans for clients
Preparing retirement plans for clients
Conduct investment research, forecasting and disseminating
information to clients
Discount fee is lower than full service fee
Indirect investment
Investing through a fund manager in a unit trust or managed funds
Most common form in shares occurs when aninfvestor purchases units in a unit
trust or managed funds
The trustee of the fund will allocate part of the accumulated pool of the unds to
professional fund managers
Fund managers will invest the funds in asset classes permitted under the terms
of the trust deed of the fun

Taxation

Capital gains occue when the value of the share or share prices increase
There is a required taxation on total annual dividends recieced and realised capital fains
Taxation of investment returns varied from country to country in relation to
o Taxation of dividend income
o Taxation of capital gains
o Rate of tax
o Treatment of capital losses
Personal income tax rates in Australia

o
System of double taxation
o Companies paid tax on profits before a proportion of after tax profit was then
distributed to share holders in the form of dividend payments
o Second tac was also payable by shareholders on the dividends received
Tax was levied at the shareholders marginal rate of tax (the percentage of
income tax paid progressively increase relatice to the amount of income earned)
o Occurs in many countries today
Dividend imputation system
o Encourages investments and growth in share market

Company tac rate of 30%, therefore $30 tax paid by the company is available for
allocation to shareholders as a franking credit
Assume 100% of profits are distributed as dividenets to shareholders
Assume personal marginal income tac rate of 37% and 2% medicare levy

Dividends on which the company has already paid company tax are referred to as
franked dividends ( dividends paid to shareholders that have a franking credit attached,
that is derived from company tax paid)
For personal taxation purposes, the franked dividend received by the shareholder is
grossed up (the total of the franked dividend plus the franking credit included in a
shareholders taxable income) by the franking credit and the total amount is included in
the assessable income

the amount of company tax paid and transferred to a shareholder with

a franked divided
o A shareholder whose marginal tax rate is lower than the company tax rate will pay no
tax on the dividend received and the excess franking credit can be applied against other
assessable income
o If the shared holder whose marginal tax rate is higher than the company tax rate than
the shareholder will receive a cash tax refund
o Only applies to Australian company tax paid
Tax payable on capital gains realised from buying or selling shared
o Vaired over time
o Without considering retrospective arrangements, the current system required 50% of
capital gains to be included as assessable income
o Capital losses may be used to off set capital gains

Financial performance indicators

Capital structure

Capital represents the funds available to a company for its business purposes
Capital structure: proportion of company assets financed by debt and equity
Measure by debt to equity ratio
Proprietorship or shareholders interest ratio which is the ratio of shareholders funds to total
assets
o Indicator of long term financial viability and stability of the firm
o Companies with a higher ratio of equity to other forms of finance are less dependent on
external finding and this have a lower level of financial risk, also stronger position to
grow the business as they hold necessary equity to support an expansion
Higher level of debt financing relative to the proportion of equity provided by
the shareholders of a firm, the greater the level of risk associated with future
profitability
The higher level of risk derived from the nature of debt, interest payments on
debt and principle repayments must be made when they fall
If revenues from business operations fall, the company may struggle to pay debt

Liquidity

A company must ensure that is has access to sufficient cash to be able to meet its current
commitments and take advantage of future business opportunities
o Indicated by levels of liquidity
Being able to meed short term financial obligations and thus continue trading
Current ratio is used to measure liquidity:
o
o
o

Current assets: cash, financial investments, accounts recievable and stocks/inventories

Current liabilities: accounts payable and short term debt commitments sich as a bank
overdraft, bills drawn and commercial paper issues
Liquid ratio
o
o

Provides more realistic view of a companys liquidity position

By excluding inventory from the assets is that the liquidation of inventory may
be quite difficult to acieve if the company is experiencing a liquidity crisis
Overdrafts are deducted from current liabilities because an overdraft facility
with a bank is typically an ongoing financial arrangement and is less likely to be
required to be repaid
Company with higher liquidity or current ratio is in a healthier position than one with lower
ratios
o too much liquidity is not a good performance indicator as there is a cost in maintaining
high levels of liquidity, the retun on received liquid assets are generally lower
ratios will vary considerably between firms in different sectos
o due to the varying operating practices
o Therefore liquidity should be compared between companies of the same sector
Accepted current ratio should be around 1.5, implying that a company hass sufficient liquid
assets to cover its current liability and a half times, making a buffer for unexpected situations
Liquid ratio should be around 0.7 to 0.8

Debt servicing

One ratio used to measure a firms solvency is the debt to gross char-flow ratio
o Compares the amount of debt outstanding with the firms gross cash flow
Gross cash flow is the net profit after tax plus non cash charges including
depreciation (the amount by which the value of an asset is written does in an
accounting period)
o Provides indication of the number of years required for the cash flow to repay the total
debt of the company
Companies usally retain a level of debt because ass one debt issue matured, it is usually
refinanced
o Can be very expensive when credit conditions in capital markets are tight
Another measure of servie debt is the interest cover ratio

o
o
o

Number of times the business finance lease and interest charges are covered by the
earnings before lease charges, interest and tax

A minmum interest cover ratio of 2 times, this means that a rise in interest rates will
not result in an undue negative situation for the company
If less than 1, means that the company will experience an operating loss before income
tax and a negative cover ratio indicates loss situation even before interest expenses are
deducted

Profitability

Earnings before interest and tax ratio allows for comparisons to be made between companies
with different capital structures
o
o
o
o

The profits of a firm before allowing for interest expenses and tax payments
A variation of this ratio is to exclude short term funding
Eliminates the effect of seasonal fluctuation in the amount of shot term debt employed
by some companies

o
Another measure of profitability is return on equity

o
Earnings per share considered by shareholders
o Measures the earnings that are attributed to each ordinary share after abnormal items

Share price

Price of ordinary shares in a company listed on a stock exchange represents the opinion on
investors ass to the present value of the furutre net cash flow to be generated by the company
Higher demand= higher share price
Price to earnings ratio: market price of a companys shares/ earnings per share