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Introduction:

Equity research is a technical study of stocks primarily for the purpose of making investments. Equity analysts do the relevant research and come up with necessary parameters of a stock which guides investors whether to buy, sell, hold or avoid the stock totally. As a retail investor it is difficult and time consuming to do this research and hence these analyses are best left to experts. It is recommended to use their services whenever required.

Fundamental Vs. Technical Analysis:

Technical analysis and fundamental analysis are the two main approaches used in equity research. Fundamental analysis inspects the overall (not just financial) health of a company by looking at the fundamentals of an organization like cash flow statement, income statement, balance sheet, assets, liability etc. It thus tries to gauge the company’s intrinsic value and then conclude if its stock is good for investment or no. On the contrary technical analysis believes that there is no need to inspect the fundamentals of an organization as they are all accounted for in its stock price. Thus, this school of thought studies only the price movement of a stock by analyzing its charts/graphs. It then uses this data to predict its future price movements. Fundamental analysis looks at data over the period of years. Technical analysis on the contrary can be applied on a timeframe of days and weeks. Fundamental analysis is used by investors to make investments which they believe can increase in value over a period of time. Technical analysis is used by traders where they buy stocks they believe they can sell it at a higher price. The type of data needed for fundamental analysis is not easily accessible to individuals and hence is generally difficult to perform. Technical analysis can be easily done as it believes that all the information about a company is reflected in its stock chart. At the level of a retail investor, Technical analysis is preferred over fundamental analysis though fundamental analysis could lead to better conclusions.

Technical Analysis: Introduction

Technical analysis is a way to forecast the price movement of a stock by analyzing the past trading data of a stock through its charts and indicators. By studying the charts, the analyst tries to figure out a pattern (rounding bottom, head and shoulder etc are some patterns) that the stock price creates over a period of time. Once this pattern is identified, the analyst can then forecast the future price movement of the stock. By studying the indicators (moving average, RSI, CCI are some indicators) which are computed from historical market data, an analyst tries to forecast change in trend of a stock. This helps him conclude precisely a BUY or a SELL. The theory of Technical analysis is based on below three assumptions:

  • Stock price discounts everything: A stock’s price accounts for everything that could affect it and its company.
  • Price moves in trends: Once a trend has been established, the stock is likely to follow the same trend in future..
  • History tends to repeat itself: Data that was once analyzed will repeat itself primarily in terms of price movement.

To summarize, applied technical analysis is very subjective in nature. Its success is dependent on how experienced the analyst is. The judgment and experience of an analyst determines whether a trade will be profitable or not. 

Understanding ‘DOW’ Theory:

Dow Theory was articulated from series of editorials of the wall street journal written by Charles H Dow who was the founder and editor of wall street journal. The entire theory of technical analysis today has its roots in Dow Theory though it is more than 100 years old. Any individual who is into technical analysis should know the below important tenets of the theory.

1. The stock market moves in three basic trends

A) Primary: This is the main underlying trend (could be bullish or bearish) of the market. It lasts between 1 to several years. Ex: 2003-2008 saw a bullish Primary movement in the SENSEX

B) Secondary: This occurs within the primary trend and is a correction (10-35%) to it which means it is of opposite nature to the primary movement. Its duration is small and may last between few days to months.

C) Minor: This occurs within the secondary trend and is a correction (10-15%) to it which means it is of opposite nature to the secondary movement. Its duration is small and may last for few days.

3Trends

 

2. Any Market Trend shows three major phases 

A) The accumulation phase: In this phase well informed investors go on buying in huge numbers. This is the start of the bull phase and if difficult to spot on. The valuations in this phase are very attractive.

B) People participation: This phase occurs after the accumulation phase where the overall market sentiments and economy improves. Everyone including the retail investors start participating. This is the longest of the phase where stock prices show heavy movement.

C) Peak/Bubble: This is the last phase where the entire market scenario looks extremely positive. Every Tom, Dick and Harry starts talking about investing in stock markets. Stocks are expensive but appear to them as if they will double in a month. The stage is all set for a downfall.

3Phases

3. The stock market discounts everything

Stock prices reflect the ultimate truth. They represent all the necessary information pertaining to the past, present and future. Economy, interest rates, currency valuation, quarter numbers, crude, sentiments have no value. The stock prices have accounted for everything.

4. Stock market indexes must go hand in hand

Dow considered manufacturing and railway index for this articulation. To him, a trend is confirmed only if both the indexes complement each other. If manufacturing index rallies and railway index rallies too, then an uptrend is confirmed. Basically the two indexes must go hand in hand in the same direction. If they do not complement each other, a trend change is round the corner.

5. Volumes drive the Trends .

An uptrend can be safely assumed if there is buying with heavy volumes. Similarly a downtrend has to show selling with heavy volumes. Dow believed that it is the volumes which finally represent the market view/trend. Trends persist until signals show a confirmed reversal. Dow believed that a trend will continue despite volatility until there are evidences of a trend reversal. Markets might temporarily go in the ‘secondary’ (correction) trend but would soon be back on the ‘Primary’ trend. 

Summary: All that Dow Theory states is very much valid today. It helps us take calculated risks rather than hitting in the dark. It helps us protect our money in times of a collapse. It gives us a technical and calculated way of investing rather than relying on judgments, emotions, news, rumors etc.