Unit 3 WM

Explain different approaches to Security Analysis – Fundamental

Analysis, Technical Analysis, and Efficient Market Hypothesis (EMH).

Security analysis involves evaluating financial instruments (stocks, bonds, etc.) to assess their value and
make investment decisions. There are three main approaches to security analysis: Fundamental
Analysis, Technical Analysis, and the Efficient Market Hypothesis (EMH).

1. Fundamental Analysis

Fundamental analysis focuses on evaluating the intrinsic value of a security by examining economic,
financial, and qualitative factors. It involves looking at company-specific factors (like financial
statements), industry trends, and macroeconomic factors that might affect the security’s value.

Key Components:
Financial Statements: Analysis of income statements, balance sheets, and cash flow
statements to understand a company’s profitability, financial health, and cash flow.
Valuation Ratios: Key ratios such as P/E (Price-to-Earnings), P/B (Price-to-Book), and
EV/EBITDA to assess whether a stock is undervalued or overvalued.
Economic and Industry Analysis: Examining the macroeconomic environment (GDP,
inflation, interest rates) and industry-specific factors (competition, regulation, demand-supply
dynamics).
Qualitative Factors: Assessing management quality, competitive advantages, and business
strategy.
Goal: To determine the "true" or intrinsic value of a security. If the current price is below this
intrinsic value, the security may be considered undervalued, making it a good investment
opportunity.
Example: An investor might analyze a tech company’s financials, growth prospects, and
competitive position to decide if the stock is a good buy.

2. Technical Analysis

Technical analysis focuses on the study of past market data, primarily price and volume, to forecast
future price movements. Unlike fundamental analysis, technical analysts do not focus on the intrinsic
value of a security but rather on price trends and patterns.

Key Concepts:
Price Trends and Patterns: Analyzing chart patterns (head and shoulders, double
tops/bottoms) and trendlines to predict future price movements.
Indicators and Oscillators: Tools like Moving Averages, Relative Strength Index (RSI), and
MACD (Moving Average Convergence Divergence) help identify potential buy and sell signals
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 based on historical data.
Volume Analysis: Studying volume changes to confirm the strength of a price trend. A price
movement accompanied by high volume is considered more significant than a movement on
low volume.
Market Sentiment: Using price behavior to gauge market psychology and sentiment, often
through concepts like support and resistance levels.
Goal: To identify patterns that signal potential price movements. Technical analysis assumes that
all relevant information is already reflected in the price, and trends tend to repeat over time.

Example: An investor might use a moving average crossover strategy, where they buy when the
short-term moving average crosses above the long-term moving average and sell when it crosses
below.

3. Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis (EMH) is a theory that suggests that financial markets are
"informationally efficient." According to EMH, asset prices fully reflect all available information at any
given time, meaning that securities always trade at their fair value.

Key Assumptions:
Information is instantly and accurately reflected in prices: All public and private
information is quickly absorbed and incorporated into asset prices.
Investors are rational: Investors will act on the information they receive in a rational
manner.
Unpredictability of price movements: Since all information is reflected in stock prices, it is
impossible to consistently outperform the market through either fundamental or technical
analysis.
Forms of EMH:
Weak Form: Stock prices reflect all historical price and volume data. Technical analysis cannot
consistently yield superior returns.
Semi-Strong Form: Stock prices reflect all publicly available information (including financial
reports, news, etc.). Neither fundamental nor technical analysis can lead to consistent
outperformance.
Strong Form: All information, public and private, is reflected in stock prices. Even insiders
cannot consistently outperform the market.
Goal: EMH suggests that it's not possible to "beat the market" through analysis, and the best
approach for investors is to diversify and invest in index funds or similar instruments.

Example: An investor following the EMH belief would argue that it's futile to attempt to beat the
market using fundamental or technical analysis, and would prefer investing in a broad market
index fund that tracks overall market performance.

Summary Table

Approach Key Focus Goal Key Tools

Intrinsic value, financial

Fundamental Determine the true value of Financial statements,
health, macroeconomic
Analysis a security ratios, industry analysis
trends

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 Approach Key Focus Goal Key Tools

Charts, technical
Price trends, volume, chart Predict future price
Technical Analysis indicators, oscillators,
patterns movements
volume
Show that consistent
Efficient Market Market efficiency, price Market prices, efficient
outperformance is
Hypothesis (EMH) reflection of all information pricing theory
impossible

Each approach offers a different perspective on how to analyze securities and make investment
decisions, and some investors use a combination of these approaches.

explain Fundamental Analysis

– EIC Framework, Economic Analysis, Industry Analysis, and Company Analysis.

Fundamental analysis is a method used to evaluate the intrinsic value of a security by analyzing
various qualitative and quantitative factors. One of the commonly used frameworks for conducting
fundamental analysis is the EIC Framework, which stands for Economic Analysis, Industry Analysis,
and Company Analysis. Each of these components helps in assessing the value of an asset, typically a
stock, by looking at different layers of influence that affect its price.

1. Economic Analysis

Economic analysis refers to examining the broader economic environment to understand how
macroeconomic factors can impact a company or industry’s performance. This is the first step in
fundamental analysis because the overall economy often influences market trends, interest rates,
inflation, and other key financial conditions.

Key Components of Economic Analysis:

Gross Domestic Product (GDP): Growth in GDP signals a healthy economy, which is generally
positive for businesses. A shrinking GDP could indicate recessionary trends, negatively
affecting stocks.
Interest Rates: Central bank policies, especially changes in interest rates, significantly affect
the cost of borrowing and consumer spending. Higher interest rates tend to reduce
consumer demand and business investments, leading to lower stock prices.
Inflation: Inflation impacts purchasing power, production costs, and corporate earnings.
High inflation can erode profits and lead to market instability.
Unemployment Rates: High unemployment can reduce consumer spending, which in turn
affects corporate earnings.
Government Fiscal Policy: Government spending and taxation policies can impact economic
growth, inflation, and corporate profitability. Stimulative fiscal policies can benefit stocks,
while restrictive policies can hinder growth.
Goal: Economic analysis helps investors understand the overall health of the economy, identifying
potential risks or opportunities that may affect industries and individual companies.

2. Industry Analysis
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Industry analysis focuses on evaluating the competitive dynamics within a specific industry. This step
helps investors understand the prospects of an industry and how external forces (like economic
conditions) and internal factors (like competition) might affect the companies within that industry.

Key Components of Industry Analysis:

Industry Lifecycle: Every industry goes through different stages: introduction, growth,
maturity, and decline. Understanding where an industry stands in this cycle helps predict its
future performance. For example, industries in the growth phase tend to perform well, while
those in the decline phase may struggle.
Competitive Landscape: Assessing the level of competition in an industry is critical. Highly
competitive industries (with many players) might have lower profit margins, while industries
with little competition (e.g., monopolies) may offer better returns.
Regulation and Government Influence: Some industries (e.g., energy, healthcare, financial
services) are heavily regulated. Regulatory changes can have a significant impact on
companies within these sectors.
Market Demand: Understanding supply and demand dynamics within the industry is crucial.
Is demand growing, stable, or shrinking? A growing demand environment typically translates
to increased revenues for companies in that industry.
Technological Innovation: Technological advancements can disrupt industries. For example,
the tech industry's constant innovation leads to both risks (e.g., obsolescence of products)
and opportunities (e.g., new product markets).
Goal: Industry analysis helps investors assess whether a specific industry is positioned for growth
or decline, and whether the industry has favorable or unfavorable economic characteristics. It also
aids in identifying trends that may influence the success of companies within that industry.

3. Company Analysis

Company analysis focuses on the individual company level, examining the financial health, competitive
position, and operational effectiveness of a company. This is the most specific level of analysis in the EIC
framework, and it typically includes a deep dive into the company’s financial statements.

Key Components of Company Analysis:

Financial Statements: Analyzing the company's income statement, balance sheet, and cash
flow statement helps to assess its profitability, liquidity, solvency, and overall financial health.
Income Statement: Provides insight into a company’s revenues, costs, and profitability
over a given period. Key metrics include net income, operating income, and earnings
before interest and taxes (EBIT).
Balance Sheet: Lists the company’s assets, liabilities, and shareholder equity, helping to
assess the financial strength and risk profile.
Cash Flow Statement: Tracks the cash generated and used by the company. Positive
cash flow is critical for maintaining operations and funding future growth.
Valuation Metrics: Common valuation ratios, such as Price-to-Earnings (P/E), Price-to-Book
(P/B), and Debt-to-Equity (D/E), help determine if the stock is overvalued or undervalued.
Management Quality: The competence and vision of the company's management play a
crucial role in its performance. Good management can lead to improved profitability and
stock value, while poor management can lead to inefficiency and risk.
Competitive Position: Analyzing the company's position relative to its competitors helps
determine its market share, pricing power, and ability to sustain profits over time. Key factors
include brand strength, intellectual property, and economies of scale.

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 Growth Prospects: Looking at the company’s potential for future growth in terms of
expanding markets, new products, or international reach. This can be assessed using growth
metrics like revenue growth rate and earnings growth rate.
Goal: The aim of company analysis is to determine whether a specific company is a strong
investment opportunity by evaluating its financial stability, market position, growth prospects, and
management.

Summary Table: EIC Framework

Component Focus Key Considerations

Economic Macroeconomic factors affecting the
GDP, interest rates, inflation, government policy
Analysis market
Industry Industry dynamics, competition, and Industry lifecycle, competition, market demand,
Analysis regulatory factors regulations
Company Individual company performance and Financial statements, growth prospects, competitive
Analysis prospects position, management quality

Conclusion

The EIC Framework allows investors to analyze a security systematically by examining the broader
economic environment, the specific industry’s dynamics, and the individual company’s financial health
and prospects. By following this framework, investors can make informed decisions about whether a
stock is undervalued or overvalued, based on both quantitative and qualitative factors.

explain Technical Analysis – Basic Tenets of Technical Analysis, Tool of Technical Analysis – Charts,
and Technical Indicators, and various Limitations of Technical Analysis.

Technical analysis is the study of historical price and volume data to forecast future price movements.
Unlike fundamental analysis, which focuses on the intrinsic value of a security, technical analysis is
primarily concerned with market behavior, aiming to identify patterns, trends, and signals that could
predict future market movements.

1. Basic Tenets of Technical Analysis

The foundation of technical analysis is based on several core principles or tenets that guide its
application. These include:

a. Price Discounts Everything

Principle: All relevant information, both public and private (including news, earnings, economic
data, etc.), is reflected in the current price of a security. This is based on the idea that markets are
efficient in processing information, meaning price movements are driven by all available
information.

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 Implication: Investors do not need to consider external factors like company earnings or news, as
they are already incorporated into the stock price. What matters is how the price is behaving.

b. Price Moves in Trends

Principle: Prices tend to move in trends. These trends are directional movements (upward,
downward, or sideways) that persist over time, and they often continue until a clear reversal
occurs.
Types of Trends:
Uptrend: Prices consistently make higher highs and higher lows.
Downtrend: Prices consistently make lower highs and lower lows.
Sideways/Range-bound Trend: Prices fluctuate within a certain range without any clear
upward or downward movement.
Implication: The trend is your friend—an investor should trade in the direction of the prevailing
trend until signs of reversal appear.

c. History Tends to Repeat Itself

Principle: Market psychology and investor behavior often repeat over time, forming recognizable
patterns. These patterns are driven by emotions such as fear, greed, and euphoria, which lead to
similar price movements in different market cycles.
Implication: Past price behavior can provide clues about future price movements. Chart patterns
(e.g., head and shoulders, double top/bottom) are based on this principle.

2. Tools of Technical Analysis

Technical analysis utilizes various tools to analyze price action and forecast future market movements.
These tools are typically charts and technical indicators.

a. Charts

Charts are the primary tool of technical analysts. They represent the historical price movements of a
security and provide a visual representation of trends, patterns, and other signals.

Types of Charts:
Line Charts: A simple chart that connects closing prices over a period of time. It gives a clear
view of the overall trend.
Bar Charts: Displays the open, high, low, and close (OHLC) for each time period. This provides
more information than a line chart.
Candlestick Charts: Similar to bar charts but visually more appealing. They display the OHLC
data, and candlestick patterns are often used to indicate bullish or bearish signals. For
example, a "Doji" indicates market indecision, and a "Bullish Engulfing" pattern signals a
potential uptrend.
Point and Figure Charts: Focuses on price movements without considering time. This chart
filters out small price movements, providing a clearer view of longer-term trends.

b. Technical Indicators

Technical indicators are mathematical calculations based on the price and volume of a security. These
indicators help identify trends, momentum, volatility, and market strength.

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 Types of Technical Indicators:
Trend Indicators: Help identify the direction of the market trend.
Moving Averages (MA): Smooth out price data to create a trend-following indicator.
Common types are the Simple Moving Average (SMA) and Exponential Moving Average
(EMA).
Moving Average Convergence Divergence (MACD): A momentum indicator that shows
the relationship between two moving averages. A signal line crossover can indicate buy
or sell signals.
Momentum Indicators: Measure the speed and strength of price movements.
Relative Strength Index (RSI): Measures the speed and change of price movements. An
RSI above 70 typically signals overbought conditions, while below 30 signals oversold
conditions.
Stochastic Oscillator: Compares a security's closing price to its price range over a
specific period. It helps identify overbought and oversold conditions.
Volatility Indicators: Measure market volatility and help gauge market sentiment.
Bollinger Bands: Consists of a middle band (usually a 20-day moving average) and two
outer bands that are two standard deviations away from the middle band. Price
touching or crossing the outer bands indicates high volatility.
Volume Indicators: Examine the strength of price movements through trading volume.
On-Balance Volume (OBV): Combines price and volume data to measure buying and
selling pressure. Rising OBV suggests buying pressure, while falling OBV signals selling
pressure.

3. Limitations of Technical Analysis

While technical analysis is widely used, it has several limitations that investors and traders should be
aware of:

a. Subjectivity and Interpretation

Challenge: Technical analysis often involves interpreting chart patterns, which can be subjective.
Different analysts may interpret the same chart or indicator differently, leading to varying
conclusions.
Example: One analyst might view a candlestick pattern as a bullish signal, while another might
interpret it as a sign of indecision.

b. Past Data Limitation

Challenge: Technical analysis relies on historical data to predict future price movements, but past
performance is not always indicative of future results. Market conditions change, and new factors
may affect prices.
Example: A stock that has followed a clear uptrend may suddenly experience a major downturn
due to new economic conditions or unexpected news, invalidating prior patterns.

c. Over-reliance on Indicators

Challenge: Over-relying on technical indicators can lead to false signals. No indicator is foolproof,
and relying solely on them without considering broader market context or fundamental factors can
result in poor decisions.

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 Example: An overbought reading from the RSI indicator might indicate a reversal, but if the
underlying trend is strong, the stock might continue its rise.

d. Market Noise

Challenge: Technical analysis can be distorted by market "noise," or short-term fluctuations in

price that don’t reflect the true trend. This can lead to false signals, particularly in volatile markets.
Example: A temporary price spike due to news or market rumors may mislead technical traders
into thinking a trend has started when it's just a short-term fluctuation.

e. Ignores Fundamentals

Challenge: Technical analysis focuses only on price and volume, ignoring the underlying
fundamentals of a security, such as its financial health, earnings, or economic conditions. This can
be problematic if fundamental factors outweigh technical indicators.
Example: A company with poor earnings may see its stock price fall, even if technical indicators
suggest that the stock is oversold and ready for a bounce.

f. False Signals in Sideways Markets

Challenge: In range-bound or sideways markets, technical analysis may produce numerous false
signals as prices fail to break out of defined ranges, leading to multiple buy or sell signals that
result in losses.
Example: A breakout attempt above resistance fails, leading to a reversal, and traders relying on
technical signals may get caught in choppy, non-trending markets.

Summary Table: Technical Analysis Overview

Aspect Description

Basic Tenets 1. Price discounts everything, 2. Price moves in trends, 3. History tends to repeat itself.

Tools 1. Charts (Line, Bar, Candlestick), 2. Technical Indicators (MA, RSI, MACD, Bollinger Bands).
Limitations 1. Subjectivity in interpretation, 2. Over-reliance on indicators, 3. Ignores fundamentals.

Conclusion

Technical analysis provides a powerful toolkit for forecasting market movements based on past price
data and patterns. However, it has limitations, particularly around the subjective nature of chart
interpretation and its reliance on historical data. Traders often combine technical analysis with
fundamental analysis to gain a more holistic view of market conditions.

differentiate Technical and Fundamental Analysis with basis in tabular form

Here’s a detailed comparison between Technical Analysis and Fundamental Analysis in a tabular
format:

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 Aspect Technical Analysis Fundamental Analysis

Focuses on predicting future price Aims to determine the intrinsic value of a

Objective movements based on historical price and security by analyzing economic, financial, and
volume data. qualitative factors.

Long-term oriented, based on the overall

Short-term oriented, looking at trends,
Approach financial health of a company and its growth
patterns, and price action.
potential.
Financial statements, economic data, industry
Price and volume data (charts, patterns,
Data Used performance, and qualitative factors
indicators).
(management, competitive advantage).

Primarily short-term, though can be used Primarily long-term, focusing on the intrinsic
Time Horizon
for medium-term trading. value of an asset over time.

Charts (line, bar, candlestick), technical

Financial analysis (income statement, balance
Tools and indicators (RSI, MACD, Moving Averages,
sheet, cash flow), valuation ratios (P/E, P/B,
Techniques etc.), patterns (head & shoulders, double
D/E), economic data analysis, industry trends.
tops).

Market Price movements and patterns; market Economic, industry, and company
Behavior Focus psychology and trends. fundamentals; long-term value.

The market may misprice a stock in the short

Price reflects all information, and historical
Assumptions term, but over the long run, the stock's price
price movements tend to repeat.
will reflect its true value.

Focuses on price trends, momentum, and Focuses on company value, financial health,
Investor Focus
timing market entry/exit points. and long-term growth potential.

Types of Day traders, short-term traders, swing Long-term investors, value investors, growth
Investors traders. investors.
Top-down analysis starting with economic
Top-down or bottom-up analysis based on
Methodology factors, then moving to industry, and finally
market behavior and trends.
analyzing individual companies.

Looking for a bullish reversal pattern or a Analyzing a company's earnings, debt levels,
Example of
breakout from a resistance level to make a and market position to determine if its stock is
Analysis
trade. undervalued.

Long-term focus, might miss short-term

Subject to market noise, may generate false
Limitations trading opportunities, assumes markets will
signals, ignores fundamentals.
eventually price correctly.

Conclusion

Technical Analysis and Fundamental Analysis offer distinct approaches for evaluating and predicting
asset price movements. Technical Analysis is more focused on short-term trends and market behavior,
relying on price data and patterns, while Fundamental Analysis is about understanding the intrinsic
value of a company or asset, focusing on its financial health, industry position, and long-term growth
potential. Many investors use a combination of both approaches to make informed decisions.

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