Part II : Asset Building Through Equity

Part  II :   Asset  Building  Through  Equity

CHAPTER 11: MARKET  MOVERS    

THE  FORCE  FROM  BEHIND

Our deeds determine us,

As much as we determine our deeds.

                                 – George Eliot

Introduction:     

As we have discussed earlier there are many persons operating in the market who will qualify the category of Market Movers. But all of them can be classified into three major categories.

1. Classification based on Attitude

2. Classification based on Behavior

3. Classification based on Approach

1. Classification based on Attitude   

Two kinds of Investors

                                       A. Herd Instinct

                                       B. Contrarian thinking

A. Herd Instinct      

Herd behavior describes how individuals in a group can act together without any reason or planned direction. The term pertains to the behavior of animals in herds. Human conduct during activities such as stock market bubbles and crashes resembles this herd instinct.

Large stock market trends often begin and end with periods of frenzied buying (bubbles) or selling (crashes). Many observers call these episodes as clear examples of herding behavior that is irrational and driven by emotions — greed in the bubbles, fear in the crashes. Individual investors join the crowd of others in a rush to get in or out of the market.

Following the herd, however, is not a correct approach for good investment performance. And yet so many do it. That's why they are called herds.

B. Contrarian Thinking 

“No one is thinking if everyone is thinking alike.”

                                             Porter B. Williamson

“Do not follow the herd”

The greatest contrarian thinkers in the evolutionary history of earth are the Amphibians – but for whom we, the humans, might not have existed today. Instead of remaining in an aquatic environment like majority of their counterparts in the Paleozoic Era, they are the one who explored the land in the pre- historic past and became precursors of major land vertebrate groups.

            A contrarian thinker is ‘one who takes a contrary view or action, who makes decisions that contradict prevailing wisdom’.

When others are rushing to buy, they are selling. At moments of panic and rushed selling, our contrarian friend is busily buying, and often at greatly reduced bargain prices. While contrarian tendencies are obvious in the financial and investment communities, they are more difficult to discern in the everyday world of entrepreneurship and independent business.  Still, the contrarians are out there, and more often than not, their companies are thriving.

It requires a lot of mental strength to be a contrarian. In stock market it will definitely help you to make wise investment decisions in the long run.

2. Classification based on Behavior

BULL

If a person is optimistic and believes that stocks will go up, then that person is called a "bull" and is said to have a "bullish outlook". Bulls are optimistic about the upward movement of stock prices and are primarily buyers. A bull market is when everything in the economy is good, people are finding jobs, gross domestic product (GDP) is growing, and stocks are rising.

BEAR

If a person is pessimistic, believing that stocks are going to drop, then the person is called a "bear" and said to have a "bearish outlook". Bears believe that the stock prices are going to fall and are primarily sellers. A bear market is when the economy is bad, recession is looming and stock prices are falling.

Note:

There are also PIG’s in the market. Pigs are high-risk investors looking for the one big score in a short period of time. Pigs buy on hot tips and invest in companies without putting in the required effort to learn about these investments. They get impatient, greedy, and emotional about their investments, and they are drawn to high-risk securities Professional traders love the pigs, as it is often from their losses that the bulls and bears reap their profits.

Make sure you don't get into the market before you are ready. Be conservative and never invest in anything you do not understand. Before you invest in the market without the right knowledge, think about this old stock market saying:

"Bulls make money, bears make money, but pigs just get slaughtered!"

3. Classification based on Approach

Based on their approach on investments, the market participants can be classified into three categories. They are A. Fundamentalists B. Technical analyst and C. Technimentalist.

A. Fundamentalists

A fundamentalist is the one who makes his investment decisions based on fundamental analysis.

Fundamental analysis is a technique that attempts to determine a security’s value by focusing on underlying factors that affect a company's actual business and its future prospects.

You can perform fundamental analysis on industries or the economy as a whole.

On a broader scope, the term simply refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements.

Fundamental analysis serves to answer the following questions

v  Is the company’s revenue growing?

v  Is it actually making a profit?

v  Is it in a strong-enough position to beat out its  

                                                Competitors in the future? 

v  Is it able to repay its debts?

v  Is management trying to "cook the books”?

B. Technical analyst

Technical analysts believe in market forces rather than the intrinsic value of the company.

Technical analysis assumes that market psychology influences trading in a way that enables predicting when a stock will rise or fall.  For that reason, many technical analysts are also market timers, who  believe that technical analysis can be applied just as easily to the market as a whole as to an individual stock.

Technical analysts believe that they can accurately predict the future price of a stock by looking at its historical prices and other trading variables.

A method of evaluating securities by relying on the assumption that market data, such as price or  volume charts and open interest  can help predict future (usually short-term) market trends. Unlike fundamental analysis, the intrinsic value of the security is not considered.

One of the main tenets of technical analysis is that stocks move in trends. Another is that a trend will continue until an equal or greater opposing force acts on the stock. An unexpected change in earnings, the loss of a large contract or any number of countless reasons could be a force significant enough to change investor sentiment. Betting on a trend reversal is far riskier than betting that it will continue.

C. Technimentalist

These persons belong to a Hybrid category – a combination of both Fundamentalists and Technical analysts.

The technimentalist, understands that there are fundamentals but that the market's reactions depend on the emotions of fear and greed. The technimentalist also realizes that the individual will never have access to all the facts to react before the market reacts. Nor can he or she predict future market sentiment or the price swings that it causes. For this reason, the technimentalist understands that stock price is the best indicator of all. Covering the bases, fundamental analysis tells this hybrid investor what to buy or sell, and technical analysis tells when to buy or sell.

The Discipline of Technimental Analysis

No one would argue against doing your homework on a company before investing. But technimentalists believe an examination of the trend is more important than getting tied up on past performance numbers.

1. Are corporate revenues declining, stable or increasing?

2. How effectively is the company competing?

3. Is it gaining market share or losing it?

4. Is the company experiencing growth and is that growth from top-line expansion (selling more product on increasing margins) or bottom-line cuts (laying off workers, cutting expenses or selling assets)?

5. Examining the activity of corporate insiders

If insiders such as directors and executives or institutions are selling their stock like there is no tomorrow, it is for a reason:

They may believe that the stock is overpriced or they may be responding to other deep-rooted problems.

Why should you buy stock in the company if those closely associated with it are selling large blocks of it?

On the other hand, if insiders suddenly start to buy or are increasing holdings, it could indicate that corporate fortunes are improving or a promising new technology or product is having a positive effect on the bottom line.

Conclusion:

While investors with any experience would never buy a stock without researching the fundamentals of the company, many will completely ignore the technicals. But relying solely on fundamentals to buy or sell ignores two major market forces: the emotions of fear and greed.

By studying the fundamentals - such as the direction of revenues, margins, insider sales and other key factors-you can determine what stocks to buy or sell. But by following the technicals such as direction and trend of the stock chart to monitor sentiment and by waiting for all to agree, you can determine exactly when to make your move.

Fundamentalists are longer-term investors while technicians are generally short to medium-term traders. In the eyes of each, the other could not be more wrong.

                            

Dr.Felisleo

13.2.2011

Part II : Asset Building Through Equity

Part  II :   Asset  Building  Through  Equity

CHAPTER 10: DOW THEORY     

                                               

Chance favours the prepared mind.    

                                                LOUIS PASTEUR

INTRODUCTION:

Charles Dow is commonly referred as the granddaddy of technical analysis, Dow Theory was formulated from a series of Wall Street Journal editorials authored by Charles H. Dow from 1900 until the time of his death in 1902. These editorials reflected Dow’s beliefs on how the stock market behaved and how the market could be used to measure the health of the business environment.

Due to his death, Dow never published his complete theory on the markets, but several followers and associates have published works that have expanded on those editorials. Some of the most important contributions to Dow Theory were William P. Hamilton's "The Stock Market Barometer" (1922), Robert Rhea's "The Dow Theory" (1932), E. George Schaefer's "How I Helped More Than 10,000 Investors to Profit in Stocks" (1960) and Richard Russell's "The Dow Theory Today" (1961).

Charles Dow, however, never wrote a book and never used the term “Dow Theory”. It was A.J.Nelson, a close friend of Charles Dow who formalised the theory for economic forecasting and dubbed it the Dow Theory. As on date, whatever is generally being accepted as technical analysis has its roots in the Dow Theory.

Dow first used his theory to create the Dow Jones Industrial Index in 1884 and the Dow Jones Rail Index (now Transportation Index), which were originally compiled by Dow for The Wall Street Journal. Dow created these indexes because he felt they were an accurate reflection of the business conditions within the economy as they covered two major economic segments: industrial and rail (transportation). While these indices have changed over the last 100 years, the theory still applies to current market indices.

Dow, who developed this theory to explain the movement of the indices, relied exclusively on closing prices and did not use the high-low-close (bar charts). However, the theory is also applicable to individual scrips. Also, he made certain assumption, which has been referred to as the hypothesis of the theory.

Much of what we know today as technical analysis has its roots in Dow’s work. For this reason, all traders using technical analysis should get to know the six basic tenets of Dow Theory. Let’s explore them.

THE CONCEPT:

1. Markets have three trends

2. Trends have three phases

3. The stock market discounts all news

4. Stock market averages must confirm each other

5. Trends are confirmed by volume

6. Trends exist until definitive signals prove that they have ended

1. Markets have three Trends

The markets can be divided into three trends:

1. Primary Trend

2. Secondary Trend

3. Tertiary Trend / Minor Trend

The Primary Trend can be a rising or falling market. The primary trend should last for more than a year and can endure for many years.

Secondary Trends can be found within the primary trend. They represent correction phases. Their duration is usually three weeks to three months. These reactions are often 1/3 to 2/3 of the secondary movement of the previous trends.

Short-term movements are Tertiary Trends, or minor trends or daily fluctuations, a period that can persist upto three weeks. Secondary trends consist of a series of minor trends.

 According the Dow Theory, short-term price movements can be influenced by higher order volumes. However, the primary and secondary trends are not influenced by the short-term price movements. For this reason, Tertiary Trends are unimportant and do not need special attention.

The minor trend or daily fluctuations are quite deceptive and tend to correct the overbought and oversold conditions that are created by the secondary reactions. It would be best to ignore this type of daily fluctuations and concentrate on the intermediate and the main trend of the market. This minor trend tends to retrace the rise or fall during the intermediate trend by 33-66%.

Bullish Move

According to Dow, if the indices exhibit the formation of higher bottoms and higher tops, the trend would be said to be bullish and as long as this phenomenon of higher bottom and higher top continues, the trend continues to rise.

Bearish Move

If on the other hand, the indices start to exhibit the formation of lower tops and lower bottoms, the trend would be said to have turned bearish. Also, as long as the indices register lower tops and lower bottoms, the trend continues to be bearish.

Action Required

 A buy and hold approach should be adopted in a rising or bullish market and a sell or move out approach should be adopted in the bear or falling markets.

2. Primary Trends have three Phases

The primary trend can be divided into three phases:

1. Accumulation Phase

In the first phase (Accumulation Phase) shares will be bought by informed investors who expect an economic recovery and anticipate a long-term growth. During this phase, most of the “other investors” stand opposed to equities.

 In the accumulation phase, investors begin to build up stocks.

2. Participation Phase

The Participation Phase is characterized by rising corporate profits and better economic conditions. More and more Investors buy shares.

3. Distribution Phase

In the third phase, the Distribution Phase, shares are sold. The distribution phase is marked by record profits of the companies. The masses feel confident to participate in equities. Investors always buy more shares and believe that the prices keep rising.

 In this phase, informed investors sell, because they expect an economic slowdown.

It is important that the three phases can be applied only to the primary trend

THREE TYPES OF MARKET MOVEMENTS 

Markets fluctuate in more than one time frame at the same time:

Dow compared the three types of market fluctuations/movements to the tide, waves and ripples of the sea. If one were to stand on the sea and observe the tide, one would notice that during high tide, each successive wave makes further inroads onto the shore and the net effect would be a gain on the sea-shore. Now, if the tide were to turn, one would notice that each wave moves further into the sea and the net result of the waves (forward and backward) would be a loss on the sea-shore.

The market has three well defined movements which fit into each other.

1. (Ripple).

 The first is the daily variation due to local causes and the balance of buying and selling at that particular time. 

2. (Wave).

 The secondary movement covers a period ranging from days to weeks, averaging probably between six to eight weeks  

3. (Tide).

  The third move is the great swing covering anything from months to years, averaging between 6 to 48 months.  

NOTE:

Primary Trends

Bull markets are broad upward movements of the market that may last several years, interrupted by secondary reactions.

Bear markets are long declines interrupted by secondary rallies.

These movements are referred to as the primary trend.

SECONDARY MOVEMENTS

Secondary movements normally retrace one third to two thirds of the primary trend.

POINTS TO PONDER

Daily fluctuations

Daily fluctuations are important for short-term trading, but are unimportant in analysis of broad market

Large Corrections

A large correction occurs when price falls below the previous low (during a bull trend) or where price rises above the previous high (in a bear trend).

CHANGE OF TREND

Only accept large corrections as trend changes in the primary trend:

 A bull trend starts when price rallies above the previous high.

 A bull trend ends when price declines below the previous low.

 A bear trend starts at the end of a bull trend (and vice versa).

Hypothesis of Dow Theory:

1. The first hypothesis states that ‘the primary trend cannot be manipulated’. The primary trend has been defined as a broad upward or downward movement that is commonly known as the bull or bear market and lasts for over a year or a number of years. No single individual or group of individuals can exert influence on the major trend of the market. Manipulation is, however, possible in the day-to-day movement and to a lesser degree, on the intermediate term movement. Here, the intermediate term movement has been defined as the price movement that lasts from over two to three weeks on an equal number of months.

2. The second hypothesis states that the ‘averages discount everything’. This is one of the basic assumptions on which technical analysis rests. As per this hypothesis the market discounts the hopes, fears, muscle power, insider information, et al. In fact, according to Dow, natural calamities like earthquakes, fires, etc also get quickly discounted in the market price.

3. As per the third hypothesis, ‘the theory is not infallible’. It is not a tool to beat the market, but a way to understand it better. Also, Dow does not give the time frame or the likely price targets; he just talks of the broad upward and downward movement, which according to him is the most important message for the investors.

3. The Stock Market is discounting all Informations

Each share price reflects all informations that are known about an investment. As soon as new informations are available, the price immediately reacts to this news.

Equity indices reflect all the informations which are known to all stocks. They represent an aggregated sum of all information.

In this respect the ‘Dow Theory agrees with the hypothesis of market efficiency’.

4. Stock Market Indices must confirm each other

During the period when Charles Dow gained knowledge, the U.S. was a growing industrial nation. Urban centres and production centres were far apart. Factories had to transport their goods to urban centers, typically by railroad. The first Dow-Indices were an Industry Index and Transport Index.

According to Charles Dow, a rising Industry Index was not sustainable as long as the Transport Index did not also rise. The idea behind it was the following: If the producers reported rising profits, then they have produced more. If they produced more, they had transported their goods to the customers. Consequently, an investor has to notice the Industrial Index as well as the Transport Index. Both Indices should be in the same direction. A divergence is to be evaluated as a warning sign.

5. Trends are confirmed by the Volume

Dow laid great emphasis on volume. According to him, volume should expand along the main trend. This means that if the main trend is bullish, the volume should increase with the rise in prices and fall during the intermediate reactions. If one were to find that the volume falls during the rise and rises during the reactions, then the bull market or the main bullish trend becomes suspect.

6. Trends exist until clear signals signify an end

Recent market developments may move in the opposite direction of the Primary Trend. With the help of trend lines and indicators, an investor can identify if a price movement is a short-term movement or the beginning of a new primary trend.

Dow Theory: Current Relevance

There is little doubt that Dow Theory is of major importance in the history of technical analysis. Many of its tenets and ideas are the basis of much of what we know today. Aspects of Dow Theory are also incorporated into other theories, such as Elliott Wave theory.

One of the bigger problems with the theory is that followers can miss out on large gains due to the conservative nature of a trend-reversal signal. A signal is confirmed when there is an end to successive highs (uptrend) or lows (downtrend). However, what often happens is that by the time the market has shown a clear sign of reversal, the market has already generated a large gain or loss.

Also of importance in Dow Theory is the idea of emotions in the marketplace, which remains a characteristic of market trends. Charles Dow and Dow Theory helped investors improve their understanding of the markets so that they could make better investments and achieve investment success.

Recommended Reading:

                           Technical Analysis of Stock Trends

                                                       By Robert D. Edwards, John Magee

 

Dow Theory And The Great Depression

"On the late Charles H. Dow's well-known method of reading the stock market movement from the Dow Jones Averages, the twenty railroad stocks on Wednesday October 23 confirmed a bearish indication given by the industrials two days before. Together the averages gave the signal for a bear market in stocks after a major bull market with the unprecedented duration of almost six years..."

With his words, William Peter Hamilton (1867-1929), had written the Obituary for the most speculative period in American history, the end signaled by a Dow Theory confirmation.

Conclusion

The Dow Theory is concerned with just the trend of the market and has no forecasting value as regards the duration or the likely price targets for the peak or bottom of the bull and bear market

Even today, the theory finds application in the stock market. In fact, this is one theory that has stood the test of time rather remarkably.

Dow Theory represents the beginning of technical analysis. Understanding this theory should lead you to a better understanding of technical analysis and of an analyst's view of how markets work.

Dr.Felisleo

23.1.2011