Chapter 2 notes 2012 08 02


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Chapter 2 notes 2012 08 02

  1. 1. finlogIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIALChapter 2The Framework for Making InvestmentDecisionsAugust 2012
  2. 2. Chapter summary and outlineThis chapter describes how fundamental analysis and technicalanalysis should be applied within the framework for makinginvestment decisions, and also describes market sentiment, whichis another factor that should be considered when providinginvestment advice.Chapter outline:• Fundamental analysis• Technical and Statistical Analysis• SentimentfinlogIQ 2
  3. 3. Introduction• Fundamental Analysis – concerned about demand-supply factors driving the markets• Technical and Statistical Analysis – use of chart patterns and statistical studies for timing the market• Over time, markets have also become more highly correlated and interdependent – Market players often comment about risk sentiment: whether it is “risk on” or “risk off” – When stock markets decline, the USD automatically rallies due to money flowing to a safe haven, and commodities prices decline as the growth outlook dims or due to the unwinding of risk positions.finlogIQ 3
  4. 4. Fundamental Analysis• Forms the foundation of knowledge in analysing the market – Deciding whether to buy or sell• Each market can be unique and driven by its own set of factors – Knowing the primary drivers for specific markets would help to identify the better investments and appropriate instrumentsExample• An investor, after analysing the US fiscal deficit, came to the conclusion that USD will decline over the next six months• He could express that view through selling USD against EUR or GBP• If he ignored the market concerns for peripheral European sovereign debt and chose to buy EUR, he might have seen the EUR declining first before rallying against the USD• The instrument which he chose to express that view might also have had a different returns profile• Buying EUR in the futures market in a contract around 6 months before the settlement date or buying a EUR call with nearly 6 months’ tenor might be a profitable strategy• Conversely, buying a EUR futures contract with around 1 month before the settlement date or worse selling a EUR call might have a totally different outcomefinlogIQ 4
  5. 5. Fundamental Analysis - 2• There are times when various market can be correlated and respond to the same set of factors or news, – E.g. news about poss default by Greek government has driven stock markets lower globally, affecting commodity prices as well• The same factors could have different relevance at different points of the economic cycle, and hence different impact on the market – E.g. Retail sales would be more closely scrutinized at the start of economic recovery compared to after a period of sustained growth.• Fundamental analysis – helpful in developing a macro view of market and understanding the economic cycle – Performance of each asset class can then be evaluated – Important to differentiate between long and short term factors as investment horizons of clients would then vary accordingly.finlogIQ 5
  6. 6. Technical and Statistical Analysis• Not only helps to identify the entry and exit point but also helps to identify the trend if one exists,• Whether market is trending or range trading would affect the decisions on investment horizon (short-term or long-term trades)• In a trending market, a trader or investor needs to ride with the trend or cut the loss if the position is wrong• In a market downtrend he should not take a contrarian view and advise investors to buy at a certain level simply because it is the support point – Conservative approach or a stronger support point needs to be identified for entry• Like wise in a consolidating or sideways market it would be wrong to advise the clients to buy and hold for long-termfinlogIQ 6
  7. 7. Technical and Statistical Analysis - 2• Can be relied as forecasting tool• There are many different studies that can be combined to develop a trading system• Algorithm trading approach incorporates: – Different studies or parameters, and – Optimised through back-testing• Most representatives providing advisory would rely on technical reports prepared by others where several support and resistance levels are identified, – The analysis should be kept simple by using maybe two to five studies – Over time and through experience, one would identify which are the more reliable studies and how to interpret them properlyfinlogIQ 7
  8. 8. Sentiment• Market sentiment is basically the dominant bias of the market and it can be a combination of factors that drive it• Reasons include bearish chart formations, redemption of investors’ money from funds or even reduction of risk appetite stemming from large losses suffered by speculative funds.Example:• When Asian equity markets were sold down on news of the possible Greek sovereign default despite the absence of direct adverse factors affecting Asia, such an event could be attributed to bearish market sentiment• When markets were bought up despite the high valuations and overbought conditions, such moves could be attributed to bullish sentiment• Factors would include market positioning, technical factors like the breach of crucial chart points, and risk management considerations like loss-cutting or profit takingExample:• After an extended rally, when markets were heavily positioned long and due to a sudden drastic down move, markets were then sold down followed by a long period of erratic sideways consolidation. Despite some positive data, markets were unable to rally - one can attribute this scenario to bearish market sentiment.finlogIQ 8
  9. 9. Sentiment - 2• In major markets with good liquidity: – Such markets tend to be dominated by institutional clients like hedge funds or asset managers. – Among the hedge funds, there are long-term and short-term players with diverse strategies like algorithm trading which tends to be high frequency, value versus growth strategies and so on• In the smaller markets: – The retail players can be dominant and irrational at times. – Hence, some of the volatilities observed could be hard to explain• The winning strategy is one which is: – Well-researched, supported by careful fundamental analysis – Well-timed with proper entry and exit points as determined through technical analysis – It is important that the strategy is consistent with the clients’ objectives, investment horizon, profile and sound advice on money management.finlogIQ 9