Advanced Equity Trading

This is based on the "Efficient Market Hypothesis" By Fama and French which contend that all information on a companies's stock is reflected in the stock price and that if positive or negative news is released , it is not possible to profit from the information as the price already reflects this information. Given this theory the best investment is to pour money into a broad based index as recommended by Burton Malkiel. The opposite of this view contends that the markets are not efficient and that it is possible to profit from intelligent and carefully thought out investing strategies. This article will discuss both theories.

An equity or a stock gives the owner of the stock a partnership in the company. The proportion of the partnership is a function of the amount of shares he owns compared to the total number of shares outstanding. A holder of common stock has the right to receive dividend and can sell the stocks for less or more of the amount he paid for it.

Equity Analysis

There are two components in stock price evaluations. The oldest method is a value or sum of parts approach where the book value of the company is determined. In this method the analyst or investor calculates the total assets of the company which comprise of short term assets (e.g. cash and liquid securities) as well as the long term assets (e.g. building and machinery) and subtracts the liabilities (e.g. debt outstanding). The net figure is referred to as the book value of net equity of the company. This should be the theoretical price of the company.

The other method is the discounted cash flow of the company. Here the analyst calculates the future profits accrued by the company. Once the profits are calculated he discounts them using a present value function and sums them to derive the stock price. The use of each method is dependent on the style of the analyst as well as the industry convention.

Other methods include comparisons of price earnings ratio’s, Enterprise Value /EBITDA and price to book ratio’s relative to the industry average, each dependent on the industry convention and what is known to “drive the stock”.

Technical Analysis

Technical analysis is based on the foundation that history repeats itself and that there is a statistical relationship between financial variables that allows for subtle cyclical patterns to re-emerge. Various technical analysis tools are employed by the markets. Examples include:-Moving Averages, Bollinger Bands, momentum indicators (like MACD) and others. The underlying principles behind each strategy range from expectations of price reversals to momentum. Statistical arbitrage is a very sophisticated strategy used by quantitative analysts where a computer model works behind a trading engine and buys and sells securities based on highly sophisticated and quantitative trading models. These models are very often developed by mathematicians and scientists.

Efficient Market Hypothesis on the attack

The EMH theory maintains that the price of a stock fully reflects all information on the value of a stock. Meaning that if news came out that company’s earnings are better than expected that should immediately reflect in the stock price. If a company is selling at a 52 week high, this means that there is a reason for it and one cannot use the simplistic view that shorting the stock would be the ideal strategy. The same is true with the reverse; a historical low does not mean that the stock is necessarily cheap.

Similarly if a company is selling at a low P/E or low Price to Book ratio it simply means that this is a fair multiple and that the assets of the company are actually worth less than what accountants are estimating or the earnings estimated by the analysts are over or understated and the market has the “correct” multiple.

Different Forms of the EMH

1. Weak Form EMH states that the current stock price reflects all historical available price of a security and that one cannot consistently yield excess returns from technical analysis. The weak form however does believe in fundamental analysis.
2. The semi strong form EMH asserts that the stock prices incorporate all public and non public information, the conclusion being that an investor cannot achieve excess returns using fundamental analysis.
3. The strong form EMH assumes that stock prices fully reflect all public and non public information. No one has monopolistic information and insiders do not have an edge over any other investor. Markets are perfect and information is cost free and available to everyone.