Chapter 7

Forecasting Share
Price Movements

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-1
Slides prepared by Anthony Stanger
 Learning Objectives
• Evaluate and apply bottom-up and top-down
approaches to fundamental analysis
• Describe and apply technical analysis techniques
• Examine the role of program trading
• Explain the theoretical concepts and implications
of the random walk and efficient market
hypotheses when forecasting share price
movements

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-2
Slides prepared by Anthony Stanger
 Chapter Organisation
7.1 Fundamental Analysis: Top-down Approach
7.2 Fundamental Analysis: Bottom-up Approach
7.3 Technical Analysis
7.4 Program Trading
7.5 Random Walk and Efficient Market Hypotheses
7.6 Summary

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-3
Slides prepared by Anthony Stanger
 7.1 Fundamental Analysis: Top-down
Approach
• Share price is determined by supply and demand
of a company’s shares
• Expectation of bad company performance causes
investors to sell their shares, increasing supply
and reducing the price
• Expectation of good company performance
increases demand and leads to an increase in
share price

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-4
Slides prepared by Anthony Stanger
 7.1 Fundamental Analysis: Top-down
Approach (cont.)
• What causes the shifts in demand and supply of a
company’s securities on the secondary market?
• Three approaches to answering this question
– Fundamental analysis: top-down
– Fundamental analysis: bottom-up
– Technical analysis

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-5
Slides prepared by Anthony Stanger
 7.1 Fundamental Analysis: Top-down
Approach (cont.)
• Fundamental analysis
– Considers macro and micro factors that impact upon cash
flows and future share prices of various industry sectors
and firms
 Macro factors include interest rates, economic growth,
business investment
 Micro factors are firm-specific and relate to management’s
impact on company performance

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-6
Slides prepared by Anthony Stanger
 7.1 Fundamental Analysis: Top-down
Approach (cont.)
• Top-down approach considers macro factors
– Economic growth of international economies
– Exchange rates
– Interest rates
– Domestic economy
 Growth rate
 Balance of payments
 Inflation
 Wage and productivity growth
 Government responses to changes in the above factors

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-7
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 Top-down approach—international
economies
• The higher the growth rate in the rest of the world,
the greater the demand for Australian exports
• Sectors benefitting from international growth
determined by source of the growth
• Growth can be driven by
– Increased consumer demand
– Increased business investment in equipment

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-8
Slides prepared by Anthony Stanger
 Top-down approach—rate of growth of an
economy
• Generally, greater domestic growth leads to
increased profitability of firms
• But high growth can lead to any of the following
factors, which can reduce firm profitability
– Deterioration in balance of payments
– Increase in inflationary pressures
– Pressure on wages
– Depreciation of the exchange rate
– Rise in interest rates

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-9
Slides prepared by Anthony Stanger
 Top-down approach—exchange rates
• Affect the domestic currency profit of exporters that
quote their products in foreign currency prices
– A strengthening Australian dollar (AUD) makes these
firms worse off because the AUD value of their exports is
less
• Exchange rates also affect firms indirectly
– e.g. devaluation of currency increases cost of imports,
thereby increasing inflation

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-10
Slides prepared by Anthony Stanger
 Top-down approach—domestic economy
Interest rates
• Have both a direct and indirect impact on a firm’s
value
– Direct effect on profitability
 Represents the cost of debt finance for borrowers and the
return for finance providers
– Indirect effect on profitability
 Rise in interest rates may indicate a slowing of economic
activity
 Future reduction in profitability

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-11
Slides prepared by Anthony Stanger
 Top-down approach—domestic economy
(cont.)
Current account of balance of payments
• If current account is in deficit (i.e. total international
payments exceed total international receipts) then
– Some export income is diverted to service debt
– Need to borrow foreign currency to service debt
• Indirect effect on firms’ profitability
– Government may increase interest rates to slow
economic growth and control the debt

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-12
Slides prepared by Anthony Stanger
 Top-down approach—domestic economy
(cont.)
Inflationary pressures
• Effect of inflation on firm’s real profit
• Tax treatment of inflation
– Makes historical-based depreciation allowances
inappropriate
– Combined with higher replacement costs leads to an
overstatement of after-tax profit
• Inventory
– ‘Inflated’ selling price of inventory creates an illusion of
inventory profits

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-13
Slides prepared by Anthony Stanger
 Top-down approach—domestic economy
(cont.)
Wages growth
• Increase in wages growth raises the amount of
business profit used for salaries
• This will impact most heavily on those firms that
are highly labour intensive

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-14
Slides prepared by Anthony Stanger
 Chapter Organisation
7.1 Fundamental Analysis: Top-down Approach
7.2 Fundamental Analysis: Bottom-up Approach
7.3 Technical Analysis
7.4 Program Trading
7.5 Random Walk and Efficient Market Hypotheses
7.6 Summary

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-15
Slides prepared by Anthony Stanger
 7.2 Fundamental Analysis: Bottom-up
Approach
• Following identification of the best economies and
industry sectors for investment using the top-down
approach, the bottom-up approach can be used to
identify the best companies within these
• Bottom-up approach considers micro factors using
ratios and other measures of a firm’s financial
characteristics and performance

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-16
Slides prepared by Anthony Stanger
 7.2 Fundamental Analysis: Bottom-up
Approach (cont.)
• Considers factors like the following
– Accounting ratios that assess a company’s capital
structure, liquidity, debt servicing, profitability, share price
and risk (see Chapter 6), observing the trend and making
comparisons with firms in the same industry
– Additional information on key management changes,
corporate governance and strategic direction

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-17
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 7.2 Fundamental Analysis: Bottom-up
Approach (cont.)

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-18
Slides prepared by Anthony Stanger
 Chapter Organisation
7.1 Fundamental Analysis: Top-down Approach
7.2 Fundamental Analysis: Bottom-up Approach
7.3 Technical Analysis
7.4 Program Trading
7.5 Random Walk and Efficient Market
Hypotheses
7.6 Summary

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-19
Slides prepared by Anthony Stanger
 7.3 Technical Analysis
• Explains and forecasts share price movements
based on past price behaviour
• Assumes markets are dominated at certain times
by a mass psychology, from which regular patterns
emerge
• Two main forecasting models
– Moving averages (MA)
– Charting

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-20
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 Moving Averages (MA) Models
• Smooth out a series facilitating the identification of
trends in the series

• Calculation of MA
– Assuming a five-day moving average, the MA is
calculated by taking the average of the price series for
the preceding five days

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-21
Slides prepared by Anthony Stanger
 Moving Averages (MA) Models (cont.)
• Trading rules
– Buy when the price series cuts the MA from below
– Buy when the MA series is rising strongly and the price
series cuts or touches the MA from above for only a few
observations
– Sell when the MA flattens or declines and the price series
cuts MA from above
– Sell when the MA is in decline and the price series cuts or
touches the MA from below for only a few observations

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-22
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 Moving Averages (MA) Models (cont.)
• Typically for daily price series both 10-day (short-
term) and 30-day (medium-term) moving averages
are calculated

• Weighted MA
– The most recent information is given the greatest weight

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-23
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 Charting
• Investigating patterns in price charts

• Several techniques
– Trend lines
– Support and resistance lines
– Continuation patterns
– Reversal patterns

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-24
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 Charting (cont.)
Trend lines
• Trends are regular movements in share prices
• Two types of trends
– Uptrend line—connecting the lower points of rising price
series
– Downtrend line—connecting the higher points of falling
price series
 Return line—line drawn parallel to a trend line to create a
trend channel
• Critical issue is to determine when the trend line is
going to change

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-25
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 Charting (cont.)
Support and resistance lines
• Support levels—where there is sufficient demand
to halt further price falls
• Resistance levels—where there is sufficient supply
to halt further price increases
• ‘Strong’ levels—historical support and resistance
• ‘Weak’ levels—support and resistance based on
more recent activity

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-26
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 Charting (cont.)
Continuation patterns
• Sideways share trading that does not normally
signal a change in a trend
• Two types
– Triangles—composed of a series of price fluctuations,
each smaller than its predecessor
 Symmetrical triangle (no change in trend); ascending
triangle (uptrend); descending triangle (downtrend)
– Pennants and flags—formed during a sharp rise in prices
(‘the pole’); trading volume then reduces and then
increases suddenly to take prices sharply higher

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-27
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 Charting (cont.)
Reversal patterns
• Occur after a major market move
• Result in a ‘head and shoulders’ pattern
– Three successive rallies and reactions, the second rally
being stronger than the first and third rallies
 Left shoulder—formed by volume-strong rally on uptrend,
followed by reduced-volume reaction
 Head—second rally increases price before reaction moves
price back to previous low
 Right shoulder—final rally marked by reduced volume
indicating price weakness

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-28
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 Charting (cont.)
Elliott wave theory
• The existence of distinctive wave patterns that
characterise share-market cycles
• Key proposition is that a bull market consists of
three major waves upwards, followed by two major
down-legs, resulting in a reversion of share prices
to about 60% of the peak

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-29
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 7.3 Technical Analysis (cont.)
• Validity of technical analysis
– Even where techniques have no apparent underlying
validity, if they are followed by enough participants they
may impact share price behaviour at times
– More likely to forecast successfully when share prices
move out of a range explained by economic and financial
fundamentals

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-30
Slides prepared by Anthony Stanger
 Chapter Organisation
7.1 Fundamental Analysis: Top-down Approach
7.2 Fundamental Analysis: Bottom-up Approach
7.3 Technical Analysis
7.4 Program Trading
7.5 Random Walk and Efficient Market Hypotheses
7.6 Summary

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-31
Slides prepared by Anthony Stanger
 7.4 Program Trading
• Refers to buy and sell strategies generated by
computer programs
• Programs range between
– Simple buy/sell orders based on moving averages
– Complex monitoring of both derivatives and share
markets for the purpose of hedging a share portfolio
• Program trading increases the speed at which
prices change

Copyright  2007 McGraw-Hill Australia Pty Ltd

PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-32
Slides prepared by Anthony Stanger
 Chapter Organisation
7.1 Fundamental Analysis: Top-down Approach
7.2 Fundamental Analysis: Bottom-up Approach
7.3 Technical Analysis
7.4 Program Trading
7.5 Random Walk and Efficient Market Hypotheses
7.6 Summary

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-33
Slides prepared by Anthony Stanger
 7.5 Random Walk and Efficient Market
Hypotheses
• Two theories on security values and changes in
price
• Random walk
– Share price is assumed to be formed by investor’s
expectations of future cash flows, i.e. intrinsic value
– Price will change in response to new information; since
information arrives in a random fashion, stock prices
adjust in an unpredictable fashion

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-34
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 7.5 Random Walk and Efficient Market
Hypotheses (cont.)
• Random walk (cont.)
– Each observation in the (price) series is assumed to be
independent of the previous price
– There is an equal probability that the next price will move
up, down or remain unchanged

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-35
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 7.5 Random Walk and Efficient Market
Hypotheses (cont.)
• Efficient market hypothesis (EMH)
– EMH proposes that markets are information-efficient if
prices adjust immediately to new information
– It is not possible for an investor to make abnormal profits
through superior information

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-36
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 7.5 Random Walk and Efficient Market
Hypotheses (cont.)
• Efficient market hypothesis (EMH) (cont.)
– Three forms
 Weak form—historic price data reflected in share price
 Semi-strong form—all publicly available information is
reflected in share price
 Strong form—public and private information is fully reflected
in share price

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-37
Slides prepared by Anthony Stanger
 Chapter Organisation
7.1 Fundamental Analysis: Top-down Approach
7.2 Fundamental Analysis: Bottom-up Approach
7.3 Technical Analysis
7.4 Program Trading
7.5 Random Walk and Efficient Market Hypotheses
7.6 Summary

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-38
Slides prepared by Anthony Stanger
 7.7 Summary
• Demand and supply determines the price of
shares
• Demand and supply of shares is determined by
expectations about future
– Company performance
 Fundamental analysis
• Top-down approach
• Bottom-up approach
– Share price movement
 Technical analysis
• Moving averages models
• Charting

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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-39
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 7.7 Summary (cont.)
• Program trading involves buy and sell orders
generated by computer programs
• Random walk hypothesis—the price of a share is
independent of its previous price
• Efficient market hypothesis—prices adjust
immediately to new information

Copyright  2007 McGraw-Hill Australia Pty Ltd

PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney 7-40
Slides prepared by Anthony Stanger