1.

Dow Theory with an example & diagram

The Dow theory is a financial theory founded on a set of ideas derived

from Charles H. Dow’s editorials. It fundamentally states that a
significant shift between bear and bull sentiment in a stock market will
occur when multiple indices confirm it.
The identified trend is accepted when it is backed by solid proof. The
theory explains that if two indices move in the same direction, the
identified primary trend is real. Whereas if the two indices do not match,
then there is no clear trend. It focuses on price movements, trade
volumes, capturing the trends with the help of pictorial representations
and comparison of indices.

Dow Theory Explained

The Dow theory developed from the market price action analysis, views
on speculation, etc., put forth by Charles H. Dow formed a foundational
step for technical analysis when the software’s aided technical analysis
like today didn’t exist. Its evolution and usefulness in speculation are
well portrayed by Robert Rhea in his book ―The Dow Theory‖ by
meticulously examining the Wall Street Journal editorials by Charles H.
Dow and William Peter Hamilton in the 19th century. It was among the
earliest attempts to understand the market by using fundamentals that
indicated future trends.
The original version of the theory focused on comparing the closing
prices of two averages: the Dow Jones Rail (or Transportation) (DJT)
and the Dow Jones Industrial (DJI). The argument was that if one rose
above a certain threshold, the other would follow it. To illustrate it,
Dow’s compared the market to the ocean. According to the economist, if
you are on one side of the beach and the waves go up until a point,
waves in another part of the beach will eventually reach the same point.
The same happens with markets because they’re also a part of a whole.

The Paradigms of Dow Theory

To explain the theory, understanding the several rules devised by Dow is

vital. These paradigms are generally known as the tenets or principles of
Dow theory.
 Three significant market trends: They are primary, secondary,
and minor trends defined by their duration. Primary trends can be
uptrend or downtrend lasting months to years, while secondary
one moving opposite to the primary will last weeks or a few
months. Minor trends are treated as insignificant variations lasting
from a few hours to weeks, and they are not as important as the
others.
 Primary trends have three distinct phases: The different phases
in bear markets are distribution, public participation, and
panic. Bull markets, on the other, have accumulation, public
participation, and excess phase.
 Stock market discount everything: The market indexes react
quickly to all forms of information. It can be related to the entity
or economy as a whole. For instance, any economic shock or
issues in the company management will affect stocks and move
the indices upward or downward.
 Volume confirms the trend: Trading volume increases during an
uptrend and decrease during depressions.
 Indices confirm each other: Multiple indices moving in an
identical pattern reveal a trend since they give the same signal.
Whereas if two indices move in the opposite direction, it is difficult
to deduct a trend.
 Trends continue until solid clues imply the reversal: Traders
should be aware of trend reversals. It’s easy to confuse them with
secondary trends, so Dow cautions the investor to be careful and
confirm trends with several sources before believing it’s a reversal.
Example

The technical analysis in line with the theory confirms a particular trend
and validates the buy or sell signal if both averages confirm each other.
If one average is moving towards a new high or low, then the other must
soon follow. To further illustrate how Dow’s theory work, check the
following chart that shows the relationship between the industrial and
transports indices and what would constitute clear buy and sell signals in
this model.
2. Random Walk Theory

Random walk theory suggests that changes in asset prices are random.
This means that stock prices move unpredictably, so that past prices
cannot be used to accurately predict future prices. Random walk theory
also implies that the stock market is efficient and reflects all available
information.

A random walk challenges the idea that traders can time the market or
use technical analysis to identify and profit from patterns or trends in
stock prices. Random walk has been criticized by some traders and
analysts who believe that stock prices can be predicted using various
methods, like technical analysis.

KEY TAKEAWAYS

 Random walk theory states that stock prices are random, so that past
movement or trend of a stock price or market cannot be used to
predict its future movement.
 Random walk theory implies that it’s impossible to beat the market
without assuming additional risk.
 Random walk theory considers fundamental analysis undependable
due to the often-poor quality of information collected and its ability to
be misinterpreted.
 Random walk theory also suggests that investment advisors add little
or no value to an investor’s portfolio.
Understanding Random Walk Theory
Economists had long argued that asset prices were essentially random
and unpredictable—and that past price action had little or no influence
on future changes. This, indeed, was a key assumption of the efficient
market hypothesis (EMH). Random walk theory is based on the idea
that stock prices reflect all available information and adjust quickly to
new information, making it impossible to act on it.

Economist Burton Malkiel’s theory aligns with the semi-strong efficient

hypothesis, which also argues that it is impossible to consistently
outperform the market. The theory thus has important implications
for investors, suggesting that buying and holding a diversified
portfolio may be the best long-term investment strategy.
Random walk theory was popularized by Malkiel in his 1973 book, A
Random Walk Down Wall Street.1

In the book, Malkiel argues that trying to time or beat the market, or
using fundamental or technical analysis to predict stock prices, is a
waste of time and can lead to underperformance. Instead, he claims that
investors are better off buying and holding a broad index fund.
While random walk theory has been met with critics who believe that
there are, in fact, ways to predict stock prices and outperform using
various techniques, it remains a widely accepted theory in the world of
financial economics. By accepting that stock prices are unpredictable
and efficient, investors can focus on long-term planning and avoid
making rash decisions based on short-term market movements.
Ultimately, random walk theory reminds investors of the importance of
remaining disciplined, patient, and focused on their long-term
investment goals.

Criticisms of Random Walk Theory

The main criticism of random walk theory is that it oversimplifies the

complexity of financial markets, ignoring the impact of market
participants’ behavior and actions on prices and outcomes. Prices can
also be influenced by nonrandom factors, such as changes in interest
rates or government regulations, or less ethical practices like insider
trading and market manipulation.

Market technicians argue that historical patterns and trends can, in fact,
provide useful information about future prices, challenging the theory’s
assertion that past prices are not informative. They claim that technical
analysis can intuit market psychology to identify. Other investors have
also challenged the theory by pointing to examples of successful stock
pickers, such as Warren Buffett, who have consistently outperformed
the market over long periods of time by looking closely at company
fundamentals.

Another critique is that a random walk implicitly assumes that all

investors have the same information, when in reality, some investors
have access to more and better information than others (such as large,
institutional investors). Indeed, information asymmetries have been
found in real-world markets that cause markets to be inefficient.

One key critic was Benoit Mandelbrot, a mathematician who argued that
stock prices are not random and do not follow a normal distribution,
which are key assumptions of random walks. He observed that stock
prices exhibit long-term dependence and are better modeled by fractal
geometry, where investors should consider the risks associated with
extreme black swan events. These ideas were influential in the
development of the field of chaos theory in finance.

Random Walk Theory in Action

A historical example of random walk theory in practice occurred in 1988,

when The Wall Street Journal sought to test Malkiel’s theory by creating
the annual Wall Street Journal Dartboard Contest, pitting professional
investors against darts for stock-picking supremacy. Journal staff
members played the role of the dart-throwing monkeys.2

After more than 140 contests, the Journal presented the results, which
showed the experts won 87 of the contests and the dart throwers won
55. However, the experts were only able to beat the Dow Jones
Industrial Average (DJIA) in 76 contests. Malkiel commented that the
experts’ picks benefited from the publicity jump in the price of a stock
that tends to occur when stock experts make a
recommendation. Passive management proponents contend that,
because the experts could only beat the market half the time, investors
would be better off investing in a passive fund that charges far lower
management fees.
3. Fundamental analysis & its types

Fundamental analysis (FA) refers to the process of studying any

security’s intrinsic value with the object of making profits while trading in
it. The primary purpose of fundamental analysis is to determine whether
the security or stock is undervalued or overvalued and thereby make an
informed decision to buy, hold, or sell it in order to maximize the
potential for gains.

Fundamental Analysis in simple terms in the art of evaluating any

business to its basics and getting an accurate picture of how financially
healthy and sustainable it is. It involves studying a company’s potential
for future growth by considering various micro and macroeconomic
factors. This analysis assists in deriving at an intrinsic value of stock that
aids investment decisions.

Key Takeaways

 Fundamental analysis is the method to determine the intrinsic

value of any security or stock by comparing key ratios to find out a
company’s financial health.
 The purpose of conducting fundamental analysis is to identify
investment opportunities and benefit from them.
  There are two types of fundamental analysis – Qualitative and
Quantitative. Qualitative is inclined towards goodwill, market
conditions, brand value, and company performance. In contrast,
the quantitative analysis is statistically driven.
 Fundamental analysis is often compared with technical analysis.
While the former focuses on understanding all factors affecting a
company to help stock selection, the latter involves studying stock
price movements to time buying and selling of stocks.

Understanding Fundamental Analysis Basics

Fundamental analysis assesses a company’s potential based on

financial and non-financial data to obtain the fair value of its security,
stock, bond, or derivative. It is a powerful tool for investors
and stakeholders to understand the growth prospects and financial
health of a company. Therefore, it is one of the most effective ways to
evaluate investments.
It involves examining every aspect of a company’s operations through
its balance sheet, past performance, financial reports, even market
goodwill, management, and consumer behavior to arrive at the intrinsic
value of its securities.
The analysis begins from macroeconomic factors such as the
economy and industry performance and goes down to microeconomic
factors like management, strategic initiatives, and business policies.
Note that the analysis can also start at the microeconomic level and
then move to macro components.
On conducting Fundamental analysis, if an investor deduces that a
stock’s intrinsic value is greater than its market price, it means the
stock is undervalued. In that scenario, the investor buys such stock and
holds it until the market price reaches the intrinsic value. Then, the
investor makes a sizeable profit on selling at intrinsic market price.
Similarly, an investor may decide to sell or refrain from buying an
overvalued security. Being overvalued means that the stock’s intrinsic
value is less than its market price. Thus, FA may guide investors to
manage risks and make informed investing decisions by ascertaining the
intrinsic value of a stock. Financial ratios calculated using data from the
financial statements are the primary tool of FA.
Blindly investing in stocks without conducting FA may result in major
losses, as revealed by the dot-com bubble in 2008-09. Thus, investors
should employ fundamental analysis to make conclusions about
companies and their securities. However, in practice, it should be used
in conjunction with another process called technical analysis.
The technical analysis involves closely observing the stock price
movements to predict the future and make investment decisions. It
depends on past trends, stock charts, and price history to look for
stocks that may perform better in the long run. Hence, technical analysis
can be called the fundamental analysis of the stock market.

Types of Fundamental Analysis

FA is used in many areas and is classified into two types –

#1 – Qualitative analysis

Qualitative analysis involves the study of a company’s goodwill,

consumer behavior, demand, and company recognition in broader
markets. It aims to unearth answers to questions like how it is perceived,
how management decisions or announcements create a buzz in the
market, and how it is different from its substitutes. In addition, its brand
value and other common factors depict its socio and economic position
in the market.

#2 – Quantitative analysis

Quantitative analysis is inclined towards statistics, reports, and data. It is

solely based on its financial statements, quarterly performance, balance
sheets, debt, cash flow, etc. It involves analyzing numbers, ratios, and
values to understand the price of the shares and the company’s overall
financial health.

Steps to do Fundamental Analysis

Two approaches are generally used in performing FA of a company:

#1 – Top-down approach

In this approach, experts start from macroeconomic factors assessing

the economy and industry first. Then, they come down to market
conditions and ultimately to evaluating a company’s progress,
management, and other microeconomic factors.

#2 – Bottom-up approach

This approach is the vice versa of the top-down course. It starts with
studying the company, digging up its record and performance, and then
slowly moving upwards to macroeconomic factors like industry
conditions and a country’s economy.

A step-by-step execution is initiated to perform a fundamental analysis of

stocks, securities, or companies. The critical aspects of it are –

1. Economic, industry, and company analysis

FA considers the industry’s structure, economy, industry dynamics,

aspects of broader markets, and all the other macroeconomic factors.

The experts study the products, commodities, services rendered, and

substitutes available along with cost structure and revenue model and
composition and the company’s future goals and objectives.

2. Evaluation of financial statements

Every company report is studied closely – the balance sheets, income

statement, cash flow, price to book value of equity, the net market value
of assets, and other vital ratios with revenue.

3. Study of non-financial aspects

Besides a company’s financial statements, non-financial matters like

competition, management, business policies, etc., also influence a
company. Therefore, in the FA of stocks, experts also look for factors
that can influence or undermine the company’s performance.
4. Use of FA tools

Investors and analysts use financial ratios to determine a company’s

financial standing. It is used along with the available financial data from
past reports to measure future growth, stability, and investment.

5. Recommendation

Based on the study, investment decisions are taken. Analysts advise

investors to buy, sell, or hold security after carefully assessing its
intrinsic value and financial stability.

Fundamental Analysis Examples

The disintegration of the auto-giant General Motors stocks in 2009 is

one of the glaring examples of the risks of ignoring fundamental
analysis. Unfortunately, investors who missed the fundamentals bore the
brunt of the massive collapse of the GM stock that led to GM filing
bankruptcy protection.

A 2018 research study by Raúl Navas, Ana Paula Matias Gama, and
Sónia R. Bentes investigates the significance of FA in understanding the
worth of a company. The study concludes that the investors can use FA
scores to create a portfolio that is likely to yield them remarkable returns
within a year or two. The research also adds to the understanding of
mispriced stocks in the European capital market.
4. Efficient Markets

Efficient market theory is a financial theory that states that asset prices
fully reflect all available information.

In other words, it assumes that security prices always accurately reflect

the true value of companies. Therefore, it follows that price variations
are random and cannot be predicted in any meaningful way.

Even after an event which could affect a company's prospects occurs,

share prices are expected to quickly revert back to their original levels.

Proponents of this theory believe that if investors analyze a company in

great detail, they can't expect to earn above the risk-adjusted rate.

Since it's not possible for an investor to know more about a corporation
than what is already reflected in its price, trying to gain a competitive
advantage through knowledge is pointless.

To understand this concept better, consider an analogy from everyday

life: If someone placed a sell order for 1,000 shares at $100 each for
Apple Inc., it would indicate that the seller believes that Apple shares are
currently worth $100 or less.

In turn, a buyer placing an order to purchase those 1,000 AAPL shares

at $100 each – even if it is for a slightly lower price – would mean that
they believe Apple's current market value is greater than $100 per
share.

So, even though someone might feel that the stock is currently
overvalued at $100 per share, they wouldn't attempt to buy it unless they
think its price would increase.

This brings us back to the efficient market theory, which states that any
new information will be immediately reflected in a company's stock price.

How Does It Work?

Market efficiency is determined by how fast new information moves
throughout the market and gets reflected in security prices.
When a significant piece of news about a company becomes public, it's
usually reported on one of several financial media outlets. The price of
the stock will move up (or down) as soon as those media outlets report
this news.

For instance, a natural disaster might cause a company's stock price to

drop as investors price in lower earnings.

In turn, those prices will reflect the information from those reports and
return to their original levels as soon as the event has passed.

In addition, if a company makes an announcement about an upcoming

product launch, its stock price will rise as soon as the announcement is
made.

However, if the company admits that it's struggling financially and

doesn't expect to be profitable in the near future for example, its share
prices would fall on the spot.

Forms of Efficient Market Theory

Generally, there are three main forms of efficient market theory: strong,
semi-strong and weak.

Strong Form
This is the most extreme form of market efficiency. The theory states
that it's impossible to make money in the market over any given period
of time. Investors are always right since their expectations are already
reflected in stock prices.

For example, if a stock price drops from $10 to $9 in response to

negative news, it can be considered efficient since the information was
already priced into the market.

If neither new information nor intangible factors can cause stock prices
to deviate from their intrinsic value for any period of time, then the
market is considered to be perfectly efficient.

Semi-Strong Form
The main difference between this and strong form is that in semi-strong
market efficiency, future events are also factored into a stock's
price. However, according to this form, it's still not possible to predict
short-term price movements.

In turn, short-term price movements become predictable if they're based

on new information that's already been reflected in a stock's price.

For example, wide swings in a company's share price following an

earnings report is considered semi-strong efficient market behavior
because the news was expected.

Weak Form
Here, market efficiency refers to security prices that reflect all
information known by relevant market participants at a point in time. This
means that both public and private information is included in asset
pricing decisions.

For instance, if an investor knows that a company's earnings will

increase by 20% in the next quarter, it would be reflected in the price of
its shares.

Thus, someone could trade these shares at an above-average return if

they act before public knowledge is released.
5. Breath & Depth of market

Market breadth indicators analyze the number of stocks advancing

relative to those that are declining in a given index or on a stock
exchange, such as the New York Stock Exchange (NYSE) or Nasdaq.
Positive market breadth occurs when more stocks are advancing than
are declining. This suggests that the bulls are in control of the market's
momentum and helps confirm a price rise in the index. Conversely, a
disproportional number of declining securities is used to
confirm bearish momentum and a downside move in the stock index.

Certain breadth indicators also incorporate volume. They will not only
look at whether a stock is advancing or declining in price, but also at the
volume of those moves. This is because price moves on larger volume
are considered to be more significant than price moves on lower volume.

What Is Market Depth?

Market depth refers to a market's ability to absorb relatively large market

orders without significantly impacting the price of the security. Market
depth considers the overall level and breadth of open orders, bids, and
offers, and usually refers to trading within an individual security.
Typically, the more buy and sell orders that exist, the greater the depth
of the market—provided that those orders are dispersed fairly evenly
around the current market price of that security.

Market depth refers to the market liquidity for a security based on the
number of standing orders to buy (bids) and sell (offers) at various price
levels.

In addition to price levels, market depth considers the order size, or

volume, at each price level.

The greater the market depth, the less likely that large trades will greatly
impact a security's price.

Market depth can be ascertained by looking at level 2 price quotes that

can be found in a security's order book.
Understanding Market Depth

Market depth, or depth of market (DOM), is closely related to liquidity

and volume within a security, but does not imply that every stock
showing a high trade volume has good market depth. Market depth can
be evaluated by looking at the order book of a security, which consists of
a list of pending orders to buy or sell at various price levels. On any
given day, there may be an imbalance of orders large enough to create
high volatility, even for stocks with the highest daily volumes.

6. Objectives of Investments

The meaning of investment is putting your money into an asset that can
grow in value or produce income or both. For example, you can buy
equity stock of a listed company in the hopes of receiving regular
dividends and capital appreciation in the form of the share price.

Your savings become investments when they are put into assets that
carry investment risk or a degree of illiquidity. Such investments help
you create wealth that can be used as an emergency fund, a retirement
corpus, for buying a house, or funding a child's education, etc.
Objectives of Investment
The need for investment will grow as you move ahead in life. Growing
responsibilities will demand an increase in investment. The primary
objectives of investment are listed below:

 Safeguard your Money

Investing keeps your money safe from immediate and unnecessary
expenditures. It also helps you keep your money safe from inflation
effects. Inflation erodes the value of your money unless it is invested in
an interest-earning asset. Thus, investing will help you automatically
keep up with inflation.

 Grow your Savings

Investment is the only way to start growing your invested money. It
allows your money to earn interest and if you keep the interest invested
it will also start to earn interest.
 Build Funds for Emergencies
Life is usually a series of ups and downs. Few times you are earning
decent and saving money while other times you need a large sum for an
emergency. Building investment pools help you on such rainy days.

 Secures your Retired Life

Retired life is where you don’t have a source of income to sustain your
life. Once you have built a retirement corpus, you can experience the
freedom that comes with it.

 Save Tax
Investment in tax-saving instruments like life insurance plans, ULIPs,
PPF, NPS, etc allows you to claim deductions on your taxable income.
Thus, investing in specific assets can help you reduce your tax liability.
Many of these investments also help you reduce your future tax with tax-
free maturity values.

 Fund Bigger Life Goals

Your monthly income will not be enough to purchase your next car or
build a house for your family. However, if you invest a small sum in a few
years both could be possible.
7. Semi-Strong form of market efficiency

Semi-strong form efficiency is an aspect of the Efficient Market

Hypothesis (EMH) that assumes that current stock prices adjust rapidly
to the release of all new public information.

Basics of Semi-Strong Form Efficiency

Semi-strong form efficiency contends that security prices have factored
in publicly-available market and that price changes to new equilibrium
levels are reflections of that information. It is considered the most
practical of all EMH hypotheses but is unable to explain the context for
material non-public information (MNPI). It concludes that
neither fundamental nor technical analysis can be used to achieve
superior gains and suggests that only MNPI would benefit investors
seeking to earn above average returns on investments.

EMH states that at any given time and in a liquid market, security prices
fully reflect all available information. This theory evolved from a 1960s
PhD dissertation by U. S. economist Eugene Fama. The EMH exists in
three forms: weak, semi-strong and strong, and it evaluates the
influence of MNPI on market prices. EMH contends that since markets
are efficient and current prices reflect all information, attempts to
outperform the market are subject to chance not skill. The logic behind
this is the Random Walk Theory, where all price changes reflect a
random departure from previous prices. Because share prices instantly
reflect all available information, then tomorrow’s prices are independent
of today’s prices and will only reflect tomorrow’s news. Assuming news
and price changes are unpredictable then novice and expert investor,
holding a diversified portfolio, would obtain comparable returns
regardless of their expertise.

Efficient Market Hypothesis Explained

The weak form of EMH assumes that the current stock prices reflect all
available security market information. It contends that past price and
volume data have no relationship to the direction or level of security
prices. It concludes that excess returns cannot be achieved
using technical analysis.

The strong form of EMH also assumes that current stock prices reflect
all public and private information. It contends that non-market and inside
information as well as market information are factored into security
prices and that nobody has monopolistic access to relevant information.
It assumes a perfect market and concludes that excess returns are
impossible to achieve consistently.

EMH is influential throughout financial research, but can fall short in

application. For example, the 2008 Financial Crisis called into question
many theoretical market approaches for their lack of practical
perspective. If all EMH assumptions had held, then the housing bubble
and subsequent crash would not have occurred. EMH fails to explain
market anomalies, including speculative bubbles and excess volatility.
As the housing bubble peaked, funds continued to pour into subprime
mortgages. Contrary to rational expectations, investors acted irrationally
in favor of potential arbitrage opportunities. An efficient market would
have adjusted asset prices to rational levels.

Example of Semi-Strong Efficient Market Hypothesis

Suppose stock ABC is trading at $10, one day before it is scheduled to

report earnings. A news report is published the evening before its
earnings call that claims ABC's business has suffered in the last quarter
due to adverse government regulation. When trading opens the next
day, ABC's stock falls to $8, reflecting movement due to available public
information. But the stock jumps to $11 after the call because the
company reported positive results on the back of an effective cost-
cutting strategy. The MNPI, in this case, is news of the cost-cutting
strategy which, if available to investors, would have allowed them to
profit handsomely.