Exam 3

Closing Arms

(trading index) is the ratio of average trading volume in declining issues to average trading volume in advancing issues. Using data from the "Previous Close:"

Loss Aversion

- A reluctance to sell investments after they have fallen in value. Also known as the "breakeven" effect or "disposition" effect. - If you suffer from this Loss Aversion, you will think that if you can just somehow "get even," you will be able to sell the stock. If you suffer from this, it is sometimes said that you have "get-evenitis."

Gambler's Fallacy

- Assuming that a departure from what occurs on average will be corrected in the short run.  - because an event has not happened recently, it has become "overdue" and is more likely to occur. ex. you think that it is more likely for a black number to "hit" after a series of red numbers have hit.

Dot-Com Bubble

- By the mid-1990s, the rise in Internet usage and its global growth potential fueled widespread excitement over the "new economy." - Investors seemed to care only about big ideas. - Investor euphoria led to a surge in Internet IPOs, which were commonly referred to as "DotComs" because so many of their names ended in ".com." - The lack of solid business models doomed many DotComs. Many of them suffered huge losses.

Price-Sales Ratio

- Current stock price divided by annual sales per share - A high P/S ratio suggests high sales growth, while a low P/S ratio suggests sluggish sales growth

judgement errors

- Frame Dependence - Loss Aversion - The House Money Effect

Technical analysis

- Many investors try to predict future stock price movements based on investor sentiment, errors in judgment, and/or historical prices. - Differs greatly from Fundamental Analysis - analysts essentially search for bullish (positive) and bearish (negative) signals about stock prices or market direction

Price-book ratio

- Market value of a company's common stock divided by its book (accounting) value of equity - A ratio bigger than 1.0 indicates that the firm is creating value for its stockholders.

Firm- Specific Risk

- Most obvious risk - Suppose you believe that GM's stock price is too low, so you buy. - Then, some unanticipated bad news drives GM's stock price lower.

Illusion of Knowlege

- One aspect of overconfidence typically stems from a belief that information you hold is superior to information held by other investors. - You believe, therefore, that you are able to make more informed judgments.

Rational Investing

- Rational investors do not systematically overvalue or undervalue financial assets. - If every investor always makes perfectly rational investment decisions, it would be very difficult to earn an excess return.

Markets are efficient if:

- Security selection becomes less important, because securities will be fairly priced. - There will be a small role for professional money managers. - It makes little sense to time the market

Noise Trader

- Someone whose trades are not based on information or financially meaningful analysis. - could act "together" to worsen a mis-pricing

Arbitrators Exist

- Suppose collective irrationality does not balance out. - Suppose there are some well-capitalized, intelligent, and rational investors. - If rational traders dominate irrational traders, the market will still be efficient.

Independent Deviations from rationality

- Suppose that many investors are irrational. - The net effect might be that these investors cancel each other out. - So, irrationality is just noise that is diversified away. What is important here is that irrational investors have different beliefs.

Tests for Weak form

- Tests of independence - Trading rule tests

Market Sentiment

- The prevailing mood among investors about the future outlook for an individual security or for the market. -often believe that once 80% of the investors are bullish or bearish, a "consensus" has been reached. - Once a consensus is reached, market sentimentalists believe there is an impending turn in the direction of the market. - One way to measure market sentiment is to ask investors whether they think the market is going up or down.

The Elliot Principle

- There is a repeating eight wave sequence. - The first five waves are "impulse" waves. - The next three-waves are a "corrective" sequence.

Head and Shoulders

- This formation is characterized by two small peaks on either side of a larger peak. - This is a reversal pattern, meaning that it signifies a change in the trend.

Trading Test Rules

- Try to determine whether given trading rules based on past price data, volume, and so forth, can be used to beat naïve buy-and-hold approach - When the price of the stock rises above (or goes below) its 200-day average price. - Simulates conditions under which a given trading rule is used to determine if superior returns were produced after considering transaction costs

Dow's three factors

- a primary direction or trend, - a secondary reaction or trend, and - daily fluctuations.

Fibonacci Numbers

- a series where each succeeding number is the sum of the two preceding numbers. - The first two Fibonacci numbers are defined to be 1, and then the series continues as follows: 1, 1, 2, 3, 5, 8, 13, 21... - As the numbers get larger, the ratio of adjacent numbers approaches the Golden Mean: 1.618:1. - This ratio is found extensively in nature, and has been used in architecture since the ancient Greeks (who believed that a rectangle whose sides had the ratio of 1.618:1 was the most aesthetically pleasing). - Technical analysts use this ratio and its inverse, 0.618, extensively to provide projections of price moves.

Circuit Breakers

- are triggered if the DJIA drops by 10, 20, or 30 percent. - A 10 percent drop will halt trading for at most one hour - A 20 percent drop will halt trading for at most two hours - A 30 percent drop will halt trading for the remainder of the day

The Crash of 1987

- began on Friday, October 16th. - The DJIA fell 108 points to close at 2,246.73. - First time in history that the DJIA fell by more than 100 points in one day. - On October 19, 1987, the DJIA lost about 22.6% of its value on a new record volume (about 600 million shares)  - The DJIA plummeted 508.32 points to close at 1,738.74. - During the day on Tuesday, October 20th, the DJIA continued to plunge in value, reaching an intraday low of 1,616.21. - But, the market rallied and closed at 1,841.01, up 102 points

Noise Trader Risk

- important because the worsening of a mis-pricing could force the arbitrageur to liquidate early (and sustain steep losses). - If this risk exists, then this risk is another source of risk beyond systematic risk and unsystematic risk.

Dow Theory

- is a method that attempts to interpret and signal changes in the stock market direction. - Dates to turn of the 20th century. - Named after Charles Dow

For the Market to be inefficient

- it must be that many, many investors make irrational investment decisions, and - the collective irrationality of these investors leads to an overly optimistic or pessimistic market situation, and - this situation cannot be corrected via arbitrage by rational, well-capitalized investors.

The Snakebite Effect

- makes people less confident in investing following a loss - the unwillingness of investors to take a risk following a loss.  - considered to have the opposite influence of overconfidence.

Bubbles

- occurs when market prices soar far in excess of what normal and rational analysis would suggest. Investment bubbles eventually pop - Eventually pops, when it does investors find themselves holding assets with plummeting values - Can form over weeks, months or years

Elliott Waves

- that repeating stock price patterns, which he called "waves," collectively expressed investor sentiment.  - Mr. Elliott believe that by using sophisticated "wave counting" techniques, a wave theorist could forecast market turns accurately.

Market efficiency needs:

1) Investors use their information in a rational manner. 2) There are independent deviations from rationality. 3) Arbitrators Exist

analysis tools

1. P/Earnings or Earning/P 2. P/cash flow 3. P/Sales 4. P/Book 5. PEG 6. Dividend yield

Semistrong-form info

All Publicly available info

Strong Form Info

All info of any kind, public or private

Efficient Market Hypothesis

All securities are correctly priced at any point in time" Implies neither fundamental analysis nor technical analysis work to profitably predict security valuation

Momentum

An investment strategy that aims to capitalize on the continuance of existing trends in the market. The investor believes that large increases in the price of a security will be followed by additional gains and vice versa for declining values.

Rest of the days

Any daily return that does not fall into this three-week period.

Anchoring

Associating a stock with its purchase price, i.e., fixating on a reference price.

Representativeness Heuristic

Concluding that there are causal factors at work behind random sequences. Or, if something is random, it should look random.

Price- earnings ratio

Current stock price divided by annual earnings per share (EPS)

Price-cash flow ratio

Current stock price divided by current cash flow per share In this context, cash flow is usually taken to be net income plus depreciation

Turn of the Month Days

Daily returns from the last day of any month or the following three days of the following month returns exceed "Rest of the Days" returns

Growth Stocks

High-P/E stocks are often referred to as

Earnings Yield

Inverse of the P/E ratio: earnings divided by price (E/P)

Strong Form Efficient Market

Is one in which information of any kind, public or private, is of no use in beating the market. If so, then "inside information" is of little use.

Clustering Illusion

Our human belief that random events that occur in clusters are not really random. Ex. If a fair coin is flipped 20 times, there is about a 50 percent chance of flipping four heads in a row. If you flip four heads in a row, do you have a "hot hand" at coin flipping?

Weak-form Info

Past price and volume

Crash

Significant and sudden drop in market values generally associated with a bubble. are sudden, generally lasting less than a week. However, the financial aftermath this can last for years.

Tests of Independence

Test based on the frequency and extent of runs in stock price data - sequences of two or more price changes in the same direction - also tends to indicate that stock price movements are independent over time

Bubbles and Crashes ex.

The Crash of 1929 The Crash of October 1987 The Asian Crash 1980s The "Dot-Com" Bubble and Crash The Crash of 2008

Anomalies Ex.

The Day-of-the-Week Effect The Amazing January Effect Turn-of-the-Year Effect Turn-of-the-Month Effect

Behavioral Finance

The area of research that attempts to understand and explain how reasoning errors influence investor decisions and market prices. Stems from Cognitive Psychology

Limits to arbitrage

The notion that, under certain circumstances, it may not be possible for rational, well-capitalized traders to correct a mispricing, at least not quickly.

Implementation Costs

These costs include transaction costs such as bid-ask spreads, brokerage commissions, and margin interest.

Moving Average Charts

are average daily prices or index levels, calculated using a fixed number of previous prices, updated daily.

Anomalies

aspects of stock price behavior that are both baffling and potentially hard to reconcile with market efficiency.

Tests for Semi strong form

attempt to see if investors acting on the basis of newly released public information are able to earn superior returns adjusting for risk and transaction costs

Beating the Market

consistently earning a positive excess return.

Market Efficiency Research

examines the relationship between stock prices and available information.

Value

investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company's long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated.

The Dividend Discount Model

is a method to estimate the value of a share of stock by discounting all expected future dividend payments

Resistance Level

is a price or level above which a stock or the market as a whole is unlikely to rise.

Support Level

is a price or level below which a stock or the market as a whole is unlikely to go.

Fundamental Analysis

is a term for studying a company's accounting statements and other financial and economic information to estimate the economic value of a company's stock. The basic idea is to identify "undervalued" stocks to buy and "overvalued" stocks to sell.

Efficient Market Hypothesis

is a theory that asserts: As a practical matter, the major financial markets reflect all relevant information at a given time.

Growth Stock

is defined as a company whose earnings are expected to grow at an above-average rate compared to its industry or the overall market.

Weak Force Efficient Market

is one in which past prices and volume figures are of no use in beating the market. - If so, then technical analysis is of little use. - No relationship between past prices and volume and future prices of securities - Prices of securities are presumed to be independent over time - Little or nothing is to be gained from studying past stock prices

SemiStrong Form Efficient Market

is one in which publicly available information is of no use in beating the market. - If so, then fundamental analysis is of little use. - All public information is already impounded into value of a security - No learning lag in the dissemination of public information - This may depend upon the size of the firm which issued the stock and attention being paid to it by analysts

Closing Tick

is the difference between the number of shares that closed on an uptick and those that closed on a downtick.

Excess Return

is the return in excess of that earned by other investments that have the same risk.

Relative Strength

measures the performance of one investment relative to another.

Breakout

occurs when a stock (or the market) passes through either a support or a resistance level.

Prospect Theory

provides an alternative to classical, rational economic decision-making. Foundation is investors are much more distressed by prospective losses than they are happy about prospective gains. - Researchers have found that a typical investor considers the pain of a $1 loss to be about twice as great as the pleasure received from the gain of $1. - Also, researchers have found that investors respond in different ways to identical situations. - The difference depends on whether the situation is presented in terms of losses or in terms of gains.

The January Effect

refers to the tendency for small-cap stocks to have large returns in January.

Advance/decline line

shows, for some period, the cumulative difference between advancing and declining issues

GARP

strategy that seeks to combine tenets of both growth investing and value investing to find individual stocks.investors look for companies that are showing consistent earnings growth above broad market levels (a tenet of growth investing ) while excluding companies that have very high valuations (value investing). The overarching goal is to avoid the extremes of either growth or value investing; this typically leads investors to growth-oriented stocks with relatively low price/earnings (P/E) multiples in normal market conditions.

Dividend Yield

tells us what percent return the stock investor is earning through just the dividend payment of the firm.

Turn of the Year Days

the last week of daily returns in a calendar year and the first two weeks of daily returns in the next calendar year. returns are higher than the "Rest of the Days" returns.

Cognitive Psychology

the study of how people (including investors) think, reason, and make decisions. Reasoning errors are often called cognitive errors

Mental Accounting

they tend to segment their money into mental "buckets." Ex. Spending regular income differently than bonuses - Investing prudently in a retirement account, but taking wild risks with a separate stock account. - "House Money

Value Stocks

while low-P/E stocks are often referred to as