1 To 4 Overview and Technical Analysis

Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2020.
Instructor: Dr. Sohail Zafar. TAs: Ms Maheen Chaudhry and Ms Nosheen Khan
Lectures 1 to 4
The word “investment” is used in different contexts and in each context; it has a different
meaning therefore, it is important to know what is meant by “investment” in this course. This
course is about investment in securities market, or in other words, investment in financial
assets. This is not a course about investment in corporate assets such as NWC and FA; as
typically these decisions are called investing decisions in corporate finance. This course is not
about investment in an a country’s or province’s or city’s infrastructure such as roads, bridges,
schools, hospitals, etc; as this is the meaning attached to the word investment by economists.
This course is not about foreign direct investments (FDI) as depicted by foreign entities building
factories in this country. The course may have some relevance for foreign portfolio investment
(FPI) by foreigners who may be contemplating investing in securities markets in Pakistan. Both
individual Investors as well as professional money managers in Pakistan working for institutional
investors such as mutual funds, commercial banks, insurance companies, investment banks,
pension funds, etc, are expected to benefit from this course.
THREE QUESTIONS FACED BY INVESTORS

Any person or institution contemplating investments in securities markets must face three
questions:
1. What to buy?
2. What combination to buy?
3. When to buy?
Let us treat these questions in some detail in this lecturer; the rest of the course is also about the
further details, derivations, and analytical skills needed to answer these 3 questions.
Question One: What to Buy (or Sell):

Common sense answer to the question “what to buy” (or” what to sell”) is: buy those shares
that would make you wealthy. But more correctly the answer depends on your position in the
market. If price of a share is likely to increase then take long position because that position
would give you positive rate of return (ROR), and thus would increase your wealth. In other
word buy those shares whose price is likely to increase in future so that when you sell at higher
price in future you become wealthier. On the other hand if price of a share is likely to decline
then take short position because that position would give you positive ROR, and thus increase
your wealth. In any case you can become wealthier by taking appropriate long or short position
depending if price is likely to increase or decrease in future respectively because as long as you
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earn positive ROR (percentage rate of return) your wealth would increase. This increase in wealth
can be written as:
W1 = Wo (1 + ROR)= 100(1 + 0.1) = 110 Rs. In this example 10 % ROR increased your wealth
from 100 Rs to 110 Rs.
Note: In the above expression , ROR (Rate of Return) is written in fraction . For example 10%
ROR is written as 0.1; W0 is wealth now at time zero (at the beginning of a period, or the
wealth you invested) and W1 is wealth after one period. Wealth in this context means OE (
owner’s equity), that is your own funds, and does not include the borrowed funds used to
make investment in securities.
In financial markets, selling is the flipside of buying. You are in the market as investor as long as
you have bought some shares and have not sold them as yet. It is called having an open long
position in that security. And you would have this open long position until you sell those shares
though it may be after 10 years; so in that case you would have an open long position in that
share for 10 years. Once the shares you had bought earlier have been sold then you have “closed
your long position”, or simply you are out of the market; it is also called profit taking. Because
naturally you sell those shares if their price has increased and selling gives you profit. Usually on
a day when a lot of investors have closed their long position by selling the shares they had held,
the prices and therefore share price index falls, and the media reports that due to profit taking
by the investors the index had fallen on that day.
On the other hand if you initiated your entry in the market by selling some shares first which you
did not have but you had borrowed those shares from a broker and then sold these in the hope
that in future the price would go down then you would buy these shares and returned to the
person from whom you had borrowed those, then it is called short selling , or simply you have
short position in the market. You have an open short position as long as you do not close your
short position by buying the same shares from the market and returning them to the broker.
Until you do that you are in the market, though it may be for a few months. It is necessary to
close your short position ultimately by buying the shares and returning the same to the broker
who had initially lent you these shares. Closing of short position is called short covering, because
the share you initially sold were not owned by you, in fact you had borrowed those shares from
the broker and sold them in the market in the hope of making profit by buying these shares
when share price would go down in future. Usually on a day when a lot of investors buy shares
to close their short position, and due to this action of investors demand for shares goes up, and
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therefore share price also go up, consequently share price index goes up; and media reports that
share price index has increased on that day due to short covering by the investors.
So in short selling you borrow shares and sell them first and buy the same shares later when
their price has fallen; and you have an open short position in the market until you buy the
shorted shares and return those to the broker from whom you had borrowed. On your long
position you earn positive ROR if price goes up in future, and on short position you earn positive
rate of return if price goes down in future.
Examples of Long Position

For example you bought share of a company at Rs 100 and it is expected to give 10 rupees cash
dividends during next year (DPS1, Dividend per share in period one or next period) and you
estimate its price after one year would be 120, then your expected rate of
Return:
Example of Positive ROR on long position (ROR is symbolized as Kc or R)
Expected Kc = (DPS1/P0 ) + (P1 - P0)/P0
Expected Kc = (10/100) + (120 - 100)/100
Expected Kc = 0.10 + 0.20
Expected Kc = 0.30 or 30%
Please note P1 refers to price after one period , such as one year; and P 0 refers to price at time
zero, that is now; and DPS1 refers to cash dividends per share during the next year assumed to be
given at the end of the year one.
You expect to earn 10% ROR in one year, so your wealth after one year is going to be:
W1 = Wo (1 + ROR)
W1 = 100 (1 + 0.3) = 130. Please note 30% ROR was written as 0.3 in decimal points.
In this case 30% positive expected ROR is going to increase your wealth from 100 to 130 Rs and
this long position would make you wealthier. Therefore you should take long position in this
share.
Common sense:
Profit were 10 Rs DPS and 20 Rs capital gains due to increase in price, so total profit = 30 Rs.
Please note even though you do not sell the share at 120 and have 20 Rs cash as profit in your
pocket, still 20 Rs is increase in your wealth and would be counted as profit and would be used to
calculate %age ROR as shown below:
Percentage Rate of Return (ROR) = Profit / buying price or initial investment
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= 30 Rs / 100 Rs = 0.3 or 30%

Lesson: take long position in that share whose price is expected to rise; in other words that share
which is undervalued at its current price.
Example of Negative ROR on long position

if current price is 100 and after one year price is expected to be 93, and cash dividends of 5 Rs
are expected from this share, and you want to take long position in that share by buying it now at
100, then after one year
Expected ROR = DPS1/P0 + (P1 – P0)/ P0
= 5/100 + (93 - 100) / 100
= 0.05 + - 0.07
= - 0.02 or - 2%
As ROR from this share is negative 2% and if you took long position in it, then after one year your
wealth would be:
W1 = Wo (1 + ROR)
W1 = 100 ( 1 + - 0.02)
W1 = 98 Rs.
Therefore taking long position in a share that is expected to give negative ROR would make you
poorer, your wealth would decrease from 100 to 98 after one year. Lesson: Take long position in
those shares that are expected to give positive ROR and do not take long position in those shares
that are expected to give negative rate of return. As a reminder those shares that are expected
to experience increase in their price will give positive ROR, so take long position. In such shares.
So you take long position in those shares that are likely to rise in price because
such shares would give positive ROR and would make you wealthier by taking
long position.
Examples of Short Position
It is possible for you as an investor to increase your wealth by investing in a share whose price is
likely to fall in future. In such share you can become wealthier by short selling it. In short selling
you borrow the share (usually from a broker) and sell it in the market at current high price; and
then hope its price would fall in future, and then you would buy it at that low price and give it
back to the person from whom you had borrowed it. If during that period when you had open
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short position that share gave dividends, then you would pay these dividends as well to the
broker. Moreover since broker is lending the share, therefore he/she would charge an interest
rate from you on this loan. So short selling, or taking short position, requires selling FIRST and
buying LATER; while taking long position requires buying FIRST and selling LATER.
Example of Positive ROR on Short Position

Suppose a share has current market price of 100. You believe it is overvalued and its fair value is
70 . You can make profit by taking short position in such a share. You borrowed it from broker
and sold it at 100 at its current price now and the waited for one year for its price to fall; and
then after one year bought it at 70. Let us assume 10 Rs per share cash dividends are expected
to be given by this share; but since you do not own the share therefore you won’t receive cash
dividends. On the other hand the broker from whom you had borrowed this share expects to
receive these dividends because he just loaned you the share and is owner of the share;
therefore you would have to give dividends to the broker (lender of share) from your pocket.
Hence the negative sign in ROR calculations in front of DPS in the formula given below. You also
agreed to pay 10% per year interest on the borrowed share value, which was Rs 100, so 10%
interest on 100 Rs = 10 Rs that you would pay to the broker every year that you keep your short
position open and do not return the borrowed share back to the broker. If your expectation
about 10 Rs DPS, and 70 Rs share price after one year come out to be correct then your ROR
%age on this short position would be:
ROR = - DPS1 / buying Price + (selling price - buying price ) / buying price
ROR = -10 / 70 + (100 - 70) / 70
ROR = - 0.1428 + 0.4285
ROR = 0.2857 or 28.57% for one year investment
And your wealth after 1 year from this short position would be:
W1 = Wo(1 + ROR) .
W1 = 70(1 + 0.2857)
W1 = 90
Wo is taken as 70 by assuming you had 70 Rs a year ago when you borrowed the share and short
sold it in the market at 100 Rs
You made profit, capital gains, of 30 =(100 - 70) by selling at 100 now and buying it later after
one year at 70; but you paid cash dividends to broker/lender Rs 10 therefore your profit after
paying cash dividend is 30 – 10 = 20 Rs on the investment of 70 Rs.
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So common sense says your ROR = Profit / buying price = 20 / 70 = 0.2857 or 28.57% in one
year.
But that is not the end of the story.

Since broker has loaned you this share therefore you would also have to pay interest on the loan
to the broker , that is 10 Rs on loan of a share worth 100 Rs. That is if you kept it for one year. If
you had kept borrowed share for 6 months and then bought it and returned it to broker then
interest you would have paid would be 100 * 10% * ½ year = 5 Rs.
Therefore your net profit after paying interest to broker would be 20 – 10 = 10 Rs
Therefore your one year investment in the form of taking short position for one year, your ROR
%age is calculated as:
%age ROR = net profit / buying price
= 10 / 70 = 0.1425 or 14.25%
And your wealth after 1 year from this short position would be:
W1 = Wo(1 + 0.1425) = 70(1 + 0.1425) = 79.97 Rs
Please note increase in wealth from 70 to almost 80 = 10 Rs, and it is same as your net profit
after paying dividend to the lending broker and interest on borrowed share to the lending
broker.
Again the lesson is you take short position in a share, if you expect to earn positive ROR, as we
saw in the above example, because positive ROR makes you wealthy. And positive ROR from
short position is likely to be earned by you only when the share price is expected to fall in future,
as in the above example it fell from 100 to 70. Therefore you can short sell overvalued share in
the hope that its price would fall in the future, and if that happens , you would make positive
%age ROR from short selling. So generally shares that are likely to experience a fall in their price
are short sold or “ shorted”.
Example of Negative ROR on Short Position

Suppose a share is trading at currently at 100 Rs , and is expected to give Rs 5 cash dividends
during next year, and after one year its price is expected to be 105 Rs. If you took short position
in it now by borrowing it from broker and selling it at 100, and then buying it after one year at
105, then your ROR would be:
ROR = - DPS1 / Buying Price + (Selling price - buying price ) / buying price
= -5/105 + (100 - 105)/105
= - 0.048 + - 0.048
= - 0.095 or - 9.5%
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Your net profit are -10 Rs (5 Rs cash dividends paid to broker and five Rs capital loss for buying at
105 while earlier it was sold by you at 100). This loss of 10 Rs is on the investment of 105 Rs. So
generically your ROR was = net profit / cash invested = -10 / 105 = -0.95 or – 9.5%.
Your wealth after one year would be
W1 = W0(1 + ROR)
W1 = 105(1 + - 0.095)
95 Rs
Please not your 105 investment reduced to 95 after one year because of loss of 10 Rs as shown
above. But story does not end here.
Suppose broker is charging 15% interest per year on the loaned share of 100 Rs, therefore one
year interest would be 15 Rs that you would also pay to the broker. And your net profit after
paying interest would be: -10 – 15 = -25 Rs.
ROR = profit / buying price = -25 / 105 = - 0.2381 or – 23.81%
Your wealth after one year would be
W1 = W0(1 + ROR)
W1 = 105(1 + - 0.2381)
80 Rs
So by taking short position by borrowing and then selling the borrowed share at 100, which you
covered after one year by buying the share at 105 (making capital loss of 5 Rs) and returning it
back to the broker and paying 5 Rs cash dividends to broker and paying 15 Rs interest on
borrowed share to the broker, you ended up with loss of 5 + 5 + 15 = 25. Due to loss your rate of
return on this short position is negative and your wealth shrank from 105 to 80 Rs , that is shown
above as W0 was 105, and W1 after one year is 80; and this reduction in wealth is (105 - 80) = 25;
and is exactly equal to the loss.
Lesson: Take short position in those shares that are expected to give positive ROR on short
position , and do not take short position in those shares that are expected to give negative rate
of return on short position. Taking short position in a share that is expected to experience
increase in price would give you negative ROR, make you poorer, do not do that. Take Short
position in only those shares that are expected to fall in price in future, that would give positive
ROR and make you wealthier. So you take short position in those shares that are
likely to experience fall in their price.
You saw in the above examples that you can become wealthier by taking long position in shares
that are expected to rise , and by taking short position in those shares that are expected to fall in
price in future. You also learned that you become wealthier only by earning positive ROR %age
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regardless of taking short or long position. Bust positive ROR %age in long position is earned if
share is likely to experience price increase in future; and positive ROR %age on short position is
earned if share is likely to experience a fall in price
It is important to note that regulators in all countries from time to time impose restriction on
short selling for a few days or even months in a period when share prices are falling rapidly.
Regulators do so to stabilize the market prices and to discourage speculative short selling which
can further aggravate downward trend of prices and therefore cause panic in the stock market.
How To Select Shares That Would Make You Wealthy?

Now you are clear that in financial markets it is possible to buy first and sell later (taking long
position); and also to sell first and buy later (taking short position). For investors it is possible to
earn positive %age ROR by taking long position in those shares that are going rise in price ; and
also it is possible to earn positive %age ROR by taking short position in those shares that are
going to fall in price. The question that is still unanswered is : how to identify shares
that are either going to rise; or going to fall in future ? So that you can
decide to take appropriate long or short position to earn positive ROR that would make you
wealthy. Naturally you would do some kind of analysis of the shares, and that is called Security
Analysis or Investment Analysis. In other words, investors should do some kind of security
analysis before deciding to take long or short position in any share. Two types of securities
analyses are done by analysts; and are discussed below in some detail.
SECURITY / INVESTMENT ANALYSES

To select shares which are expected to increase your wealth, two types of analyses are done by
security analysts: fundamental analysis and technical analysis. Security analysis is done to
identify mispriced securities. Mispricing means either a share is overvalued or undervalued at
its current market price ( P0). It is assumed as common sense that price of overvalued stocks is
likely to decline in future and you should take short position now in such shares to earn positive
ROR. And price of undervalued shares is likely to increase in future and you should take long
position now in such shares to earn positive ROR.
Saying that a security is currently mispriced also implies that there is a fair or just or correct or
innate or theoretical price of that share; and in future the price of a currently mispriced share
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would sooner or later tend to move toward its fair value. That means presently overvalued
shares would experience a decline in their price in future; and presently undervalued shares
would experience an increase in their price in future.
Role of Efficient Market Hypothesis (EMH)

A finance theory called EMH (Efficient Market Hypothesis) says that as new information arrives,
share prices adjust accordingly very quickly so that due to arrival of good information prices
increase and due to arrival of bad information prices decrease very quickly; and therefore
observed market price of any share on any day is very close to its fair price. The EMH implies
that attempt by investors to discover mispriced securities (under or over valued) is fruitless
because of market’s efficiency; and it means current prices reflect all the past and present, public
and private, information; thus the current price of a share is very close to its fair price.
Therefore, if EMH is correct, then any attempt to identify mispriced shares is just a waste of time.
Further detail of EMH describes three types of market efficiencies: 1) weak-form of efficiency; 2)
semi-strong form of efficiency; 3) strong form of efficiency. Weak form of market efficiency
means all past information has been incorporated in the current prices , therefore there is no use
of analyzing past information or trend or past prices, ROE, etc, to discover whether a share is
now overvalued or undervalued. It is so because share prices have already responded to past
information and have already changed according to that past information, therefore you as
analyst cannot discover anything new by analyzing past data of EPS, DPS, growth rate, NI, Sales,
past patterns of price changes and volume of trading, etc, of the companies about whose shares
you want to make a judgment about their overvaluation or undervaluation. Such past patterns
of prices and volume of trading are studied by technical analysts, therefore if weak form of
efficiency is a correct theory then technical analysis of securities is a waste of time. And all types
of charts such as “head and shoulder’, Reversal, momentum, relative strength, etc are useless
waste of time.
Semi-strong form of market efficiency proposes that all public information, both past and
present, has been incorporated in the current share prices, and current share prices have
adjusted accordingly. Therefore, according to this theory, you as analyst, cannot discover
something new by analyzing past and present publically available information about a company
in an effort to judge if a share is now overvalued or undervalued. And if such a judgment about
over or under valuation cannot be made then there is no guiding rule to decide whether you
should take short or long position in a share. Fundamental analysts of securities use publically
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available past and present information about economy and a company, such as DPS, EPS, TA,
Sales, Financial Leverage, ROE, ROA, beta, risk adjusted required ROR, expected ROR, inflation,
interest rate, GNP growth rate, company’s growth rate, etc; and collectively such information is
called fundamental economic and financial data. Therefore if semi-strong form of market
efficiency is a correct then fundamental analysis of securities is also a waste of time.
Strong form of market efficiency proposes all past and present as well as public and private
information has been incorporated already in the current share prices, and current share prices
have already adjusted according to that information; therefore you as analyst cannot discover
something new by analyzing private and secret and confidential information about a co to judge
if a share as overvalued or undervalued. Strong form of efficiency implies that current share
prices reflect all that is possibly knowable about that company including g the secret and
confidential plans of the top management about future course of actions, and any search for
internal policy decisions (private confidential information, insider information) won’t give
advantage to an investor to make a judgment about overvaluation or undervaluation of a share
at its current price. This claim of strong form of market efficiency has not been supported by
the research; as insiders who have private information about future plans of a company have
been found making abnormally high profits by trading on the basis of such insider/ private
information related to a company; and some of such insider traders have been punished for
doing so by the courts in USA. Trading on the basis of access to inside information is illegal in
almost all the countries, including Pakistan. For example if some directors (insiders) sell part or
all of their holding of the shares in their company then they have to make this action public so
that general investing public also knows that some director (top executives) do not consider this
share worth holding, so general public may also have a fair opportunity to off load such share as
well before share falls and public suffers losses . In USA, people have gone to jail for trading on
the basis of insider information, though proving such crime is not easy; and one can assume a
certain amount of trading in any share is based on leaks from insiders to their friends and family
members. It is obvious that trading based on insider information gives unfair advantage to those
investors who have gained access to insider information about a company’s future plans, or
current problems, etc.
If strong form of efficiency is true then there is no benefit of even searching for inside
information; and no benefit of doing any kind of analysis; and there is no basis of judging a share
as over or under valued at its current price. This line of reasoning ultimately leads to conclusion
that doing stock picking or stock selection is a waste of time, and the best investment strategy is
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buy and hold for long periods such as a decade, and do no trading. It is a sort of passive
investment strategy. As you shall learn Passive Strategy is a technical term with specific
meaning, and it involves the whole market portfolio by investing in an index mutual fund that
mimics a stock index such as KSE-100 index and investing in a risk free asset. By changing the
%age of your own funds (OE) invested in Index mutual fund and risk free t-bills, you can
theoretically build portfolios of any desire level of expected rate of return (ROR) or any desired
level of total risk. Interestingly, as you will learn in this course, passive investment strategy is
also the recommendation that finally comes out of the Modern Portfolio Theory (MPT).
Though EMH says that searching for mispriced shares by using past and present information, and
also by using public and private information, is useless activity; and by implications any type of
security analysis is a waste of time and money, yet in real life millions of analysts all over the
globe still do security analysis to discover mispriced securities. Security analysts seem to
operate on the belief that they have the skills to identify mispriced shares. Security analysts
believe they can identify undervalued shares and by taking long position in such shares they can
earn positive ROR as price of such shares are expected to increase in future (and if market is
informational efficiency such increase in price should take place very soon). They hold believe
about stock which are deemed as overvalued at their current prices that their prices would fall in
future, and they short sell such shares to make high positive ROR.
Technical Analysis of Securities

The focus of technical analysts is not on finding undervalued or overvalued shares directly , nor is
the focus on estimating expected ROR, rather it is focused on estimating the timing of change in
the direction of share price trend. In a sense this method attempt to estimate direction of
future price movement. When technical analyst says that it is time that share would move
upward, she implies currently share is undervalued, therefore now it is likely to move upward to
its fair value, though explicitly the words of undervalued, and fair value are never used by
technical analysts.
Here it should be emphasized that expected ROR is also based on future expected price,P1 ,
therefore attempts to estimate future expected price of the stock next year is also required by
fundamental analysts, but the difference lies in the methodology used by technical analysts and
fundamental analysts.
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Technical analysts insist on using only that data that is generated in the stock market due to
trading in a share, i.e. price of share and volume of its trading, and time. They mostly use daily
price data and graph it on a graph paper placing time at x-axis and share price on y-axis;
sometime they also place daily volume of trading in that share also on the same graph. Similar
exercise is also done with the index of stock prices, or sector or industry indices such as index of
banking share prices, or index of automobile prices. By doing so their purpose is to say
something about the overall share prices, that is share market; or share prices of companies in a
certain industry such as banking. There is no fixed rule that a graph should be prepared using
data of how many past days: 30, 60, 120, 360 days or what ? This approach ignores fundamental
financial data of the company such as sales, total assets, net income, EPS, DPS, growth rate, beta
of share, etc. This approach also ignores fundamental economic data such as growth rate of
GNP, inflation rate, interest rate, exchange rate, etc.
Technical analysts try to read past pattern of a share price over time; and claim to discover from
these past price patterns future direction of price movement. Specifically, they claim to know
when an upward trend in price would change to a down ward trend and vice a versa. Such
recommendations imply now that trend is likely to change from upward to downward then share
price is now too high (over valued) and is likely to move downward towards its fair value. The
important word here is WHEN, which implies this type of security analysis is focused on
discovering the timing of change in the direction of a share price or the change in direction share
price index. Technical analysts are not interested in quantum of price change , and therefore
they are not interested in estimating a future price and nor are they interested in estimating
expected ROR. This approach has an underlying assumption that past is a good predictor of
future, and past price trends are likely to repeat themselves in future. Technical analysts believe
that the past behavior of prices is a good indicator of their future behavior. For example, if in the
past when for certain period price line was lower than the 200 - days moving average price line ,
and then on a certain day the price of share pierced the 200-day moving average price line from
below then it is an indication that now a long term upward trend in the price of that share has
set in; and in future days price would continue to move upward in future days. It is considered a
buy signal for the share has been generated on that day when this piercing of 200-day moving
average line from below was experienced by the share price line.
But, there is no technical rule that tells us for haw many days the expected upward trend would
continue in the share price, nor is there a rule that can guide us about the amount of increase in
price. Nor is there a logic why price would now continue in future days to show upward trend?
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Technical analysts spend a lot of time and energy in discovering the patterns of share price
during the past periods; and then those patterns are taken as a guide for future price patterns.
Practitioner of technical analysis claim to have the ability to time the exit (sell) and entry (buy) in
the market correctly; that is, they claim to know when price has hit the bottom (psychological
floor) and therefore would increase; and they can buy at such low price before increase in price
occurs. And they also claim to know when price is at its peak (psychological ceiling), and would
fall in future days; and thus they conclude this is the time to sell before price falls. This is correct
that if an investor can always buy share before increase in price and sell share before decline in
price, then she stands to make a very high ROR.
It is interesting to note that mostly financial press reports about the performance of stock market
using the jargon (lingo) of technical analysis. The following paragraphs do not give exhaustive
treatment to technical analysis; but the idea is to give you a taste of this method of security
analysis:
1. Dow Theory : This theory identifies 3 types of trend in share prices. A) Primary Trend: It
lasts for a long period such as a few years, and share price or the index of share prices keeps a
long term upward or down ward trend. B) Intermediate Trend: Within primary trend of prices,
interruptions in the opposite direction that may last for a few weeks or months are observed in
the price. C ) Daily Trend: Random movement of prices up or down around primary and
secondary trend.
2. Bulls Market: When successive price ups (Peaks) are above the previous price peaks,
and successive price low (troughs) are at higher price than the previous price low, then it is called
a bulls market. This behavior shows long term upward trend in the price of that share, or if you
are considering the index then upward trend in whole stock market.
3. Bears Market: When successive increases in price fails to cross the previous peak, and
successive falls in price are lower than the previous trough (fall) in the price, then it is called
bears market. This depicts a long term down ward trend in price.
4. Reversal: When in an upward (bullish) trend, the next peak in price is lower than the
previous peak, and the next fall in prices is below the previous trough, then it is called reversal of
the long term upward trend to the long term downward trend. If in the subsequent next
upward price move, the peak is again below the previous peak, and trough is lower than the
previous trough then it is taken as confirmation of reversal or confirmation of change in long
term trend from upward to downward in the price of that share or that market index.
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5. Confirmation: To confirm that upward market trend has changed to the downward
trend in KSE-100 Index, the confirmation is found by looking at the similar price movement in
another index, for example KSE-30 index, or SBP all share index. And if these indices also show
similar price behavior then technical analysts conclude the reversal in KSE-100 index has been
confirmed.
6. Correction and Consolidation: If an increase in price is partially off-set by subsequent
decline in price, then such a decline is called correction. A period of no significant price change
after the correction is called consolidation.
7. Psychological price ceiling: or Resistance Level: A price level above which price hesitates
to go after repeatedly touching that level from below is called ceiling or resistance at that price.
It is assumed that at such a high price supply of share from investors in the form of sell orders is
so big that price fails to go above that level. But there is no rule telling us how many time price
should attempt to cross ceiling before we can conclude it is a ceiling. We are not told whether
this so called ceiling would ever be broken and would share price ever go above it, and if yes,
then when are unanswered questions by technical analysts.
8. Psychological price floor or Support Level: A price level low enough that below which
price is hesitating to fall after repeatedly falling to that level. It is assumed that at such a low
price the demand of shares becomes so high among investors that the price does not fall below
that level. To see that at certain level there is support present one should see that not once, but
many times, price falls very close to that level but does not go below that level.
9. Over-bought market: Refers to unjustified high prices, so it is time to sell. But there are
no rules that tell us why price at that level is judged as unjustifiably high? There are no rules
telling us for how long market would remain over bought?
10. Oversold market: Refers to unjustified low prices, so it is time to buy. Again no rules are
there telling us why at certain price level it is viewed as unjustifiably low? There are no rules
telling us for how long market would remain oversold
11. Profit taking: On a day when investors are selling their already held shares, a general
decline in prices on that particular day is observed due to increasd supply of shares; and this
decline is attributed to profit taking, causing a temporary decline in prices in an otherwise
upward moving price trend. But we are not told why investors in large numbers are selling
shares on that day
12. Short covering: On a day when an increase in prices is observed as short sellers are
buying those shares that they had short sold in the past, and therefore demand for shares
increases on that specific day, causing prices to go up temporarily in an otherwise declining
market. But there is no agreed rule telling us why so many investors decided to buy the share
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(covered short position) on that particular day; and why they did not do so on the previous day ,
or the next day. We are also not told why as a group a large number of investors arrived at the
same decision that this particular day is the right day to cover their short position.
13. Market sentiments being bullish: A period when generally share prices are increasing
day after day; vice-a-versa, is called bearish sentiments. But there is no agreed rule to decide for
how long market sentiment would continue ; and when it would change to a different market
sentiment. Nor are there rules to tell why currently market sentiment is bullish, or bearish, and
what would cause sentiments to change from bullish to bearish or from bearish to bullish?
14. Advances to declines ratios : A-D. It is a number calculated by subtracting the number
of companies whose share has declined in price from the number of companies whose share has
experienced an increase in price on a day. For example, on a day shares of 180 companies saw
increase in price and 160 companies experienced decline in price, then A – D = 180 -160 = 20.
Daily this number is calculated and placed on the graph paper and the trend of the line is studied
in comparison with the line of KSE-100 index. If both A-D line and index line are showing upward
trend then technical analysts conclude that the market is technically strong, and if both lines
have negative slope then market is technically weak.
If index line is falling but A – D line is rising then this divergence in trend is taken as a signal of
change in index (the market) trend from down to upward, strengthening of market. If index line
is upward but A-D line is falling then it indicates weakening of the market implying that in future
index would fall. A-D line is also an indicator of the breadth of the market, bigger the A – D
number on a day, more is the breadth of market on that day
15. Breadth of the market: higher A-D indicates higher breadth of market. Fifty weeks high
and low price also indicates breadth of the market. I if large number of shares hit their 52 weeks
high on a day then it is concluded that market for that share was bullish on that day. If in a
period when index is upward sloping, and a large number of shares hit their 52 week low price on
a day then it is taken as a Sign of Trouble for the market index in future; and it is said that market
is in troubled waters.
16. Volume of Trading: If volume of trading is high, it is considered that market is bullish;
and if with high trading volume the prices are also increasing then market is considered very
bullish on that day. For the technical analysts, it is a golden rule to assume that high volume
accompanies rising price, and low volume of trading accompanies falling price.
17. Short interest ratio: number of shares shorted on a day/average daily trading volume
per month ratio. If the ratio is increasing, it is sign for the bearish sentiments about that share.
Short interest ratio is compared every day with the historical range of this ratio, which is
between 3 to 6 in New York. If on a given day, the ratio is above 6 then it is considered high and
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indicates pessimistic sentiments prevailing about that share on that day. The same logic applies
to the whole market as well.
18. Contrary Opinion: When liquidity of mutual funds is low (in their portfolios cash is 5% or
lower) then it means they are fully invested in the market; and it happens close the peak of
market prices of shares. Such view implies that now it is likely that prices have attained their
peak and only direction the price can take in future is downwards, therefore it is time to get out
of the market, that is, time to sell.
19. Moving Average Line: Average price of a last few days, such as last 7 days, or last 30
days, or last 200 days is placed daily on the graph paper, the resulting line is moving average line.
BUY SIGNAL: On a day when price of a share crosses the moving average line from below on high
trading volume, then it is a buy signal for that share. SELL SIGNAL: on a day when share price
falls below its moving average price on high trading volume, then it is a sell signal for that share.
OTHER SELL SIGNALS: on a day when price of a share is below its moving average price line, and
during the day price rises to come close to its moving average price but does not succeed to go
higher than the moving average and turns downward , then it is taken as sell signal generated on
that day about that share. If moving average line has been rising and then flattens and then
declines, and the share price line crosses it from above then it is sell signal on that day for that
share. If moving average price line is falling in a period and the share price line on a day crosses
it from below then it is a sell signal for that share.
20. Abortive recovery: In an upward trend, if price falls and then increases but fails to
surpass the previous peak price; and the next fall goes below the previous trough in price, then it
indicates change in the primary price trend from upward to downward. If the subsequent price
rally (peak) again fail to reach the previous peak and subsequent price fall again penetrates
below the previous trough (low) then change of primary price trend from upward to downward is
confirmed, and bear market has set in for that share.
21. Momentum: is said to be present in a share or in the market because after a rise in one
period, in the next period again a rise is experienced in its price. But it is not clear what is the
period length that should be compared, that is, month to month, week to week, or what. It is
also not clear for how many periods the so called momentum would last.
22. Depth of market: Depth is present in a market by virtue of no single investor being able
to nudge the price in one or the other direction because of the huge size of any asset and huge
quantum of funds needed to nudge the price of any asset in the desired direction. Generally if
trading volume of a share is high it is difficult for a single investor to nudge its price one way or
other, and there is depth in the market.
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23. Market being directionless: On a day if there is no visible trend in prices then it is
conclude that market was directionless, but no body would tell us why?
24. Relative strength: A share shows relative strength because of faster increase in price of that
share compared to increase in index. Three types of relative strengths can be calculated:
P MCB / KSE-100 index ratio: daily this ratio is calculated and placed on the graph, if the graph
makes an upward sloping line then you conclude that MCB share has relative strength compared
to the whole market. P MCB / Index of banking sector. Daily this ratio is calculated and placed on
the graph. If the graph is upward then MCB is showing relative strength in the banking industry,
meaning MCB share price is increasing faster than the index of the prices of banks’ shares. Index
of banking industry / KSE-100 index: this ratio is calculated daily and placed on the graph, if the
line is showing upward slope then banking industry stocks as a whole have relative strength
compared to the overall stock market, meaning the prices of the shares of banks are rising faster
than prices of all the shares in the market. This is how technical analysts recommend industry to
invest in and not invest in.
Similarly if line of relative strength ratio is down ward sloping then it indicates relative weakness
in the price of that share or in the prices of shares of that industry.
As a rule of thumb, if a share is showing relative strength for the last 4 month, then it is taken as
a buy signal for that stock. Relative strength is also used to identify promising sectors of
economy for the investment. For example if relative strength of textile is increasing (the graph is
upward sloping) and of cement is deteriorating (graph is downward sloping) then investors
should divest from cement and invest in textile shares. Be careful about interpreting the relative
strength because it is possible that relative strength of a share is increasing over time simply
because its share price is falling slower than fall in market index.
Conclusion of Technical Analysis
There is a lack of unanimity among those who use technical analysis about even their very basic
calculations. For example moving average of prices of how many days should be used: 7-days
moving average, 30-days moving average, or 200-days moving average while making the moving
average graph. Therefore, usually business school professors do not teach this method of
analysis.
A Final Word About Security Analyses

The purpose of both types of security analyses is to identify those stocks that are promising to
increase investors’ wealth. That is identifying undervalued shares so that long position can be
taken in those shares; and identifying overvalued shares so that short position can be taken in
those shares.
17
Regardless of your preference for the use of fundament analysis or technical analysis as the
guiding methodology for identifying good buys, your focus on expected ROR is only half the
story. The remaining half of the story is Risk which must also be considered. Regrettably
technical analysts use no measures of risk while fundamental analysts do try to incorporate
relevant risk of share in the form of beta of that share while doing their analysis. Risk is
uncertainty about expected ROR. Therefore decision to buy a specific share must be guided
both by the consideration of its expected returns as well as its risk. In this course you shall learn
in detail about the relationship of risk and return of securities, and how these are quantified and
then used in decision making about investing in shares.
Question Two: What Combination to Buy

Common sense answer is not to buy a single security. You know that risking everything on one
endeavor is too risky; similarly putting all your money in one stock is too risky. If you put all your
eggs in one basket and then basket of eggs is damaged due to an unexpected shock, then you
stand to lose all your eggs; similarly if you invest in share of one company only and that Co faces
bad times then you stand to lose big. Therefore it is advisable to buy a combination of securities,
such combination of different shares or securities is called portfolio of securities. More
importantly just any combination of securities won’t do. Modern Portfolio Theory (MPT)
,proposed by Harry Markowitz in 1950s, has proven that you should preferably buy an efficient
combination of securities, or in other words you should try to build an efficient portfolio, not just
any portfolio.
The following questions are relevant in this regard. What is meant by an efficient portfolio?
How to build an efficient portfolio of securities? Which securities are included in it, and which are
not? And those included, what proportion of your own money (OE) is invested in each of those
securities, it is called weight of a security in your portfolio and is denoted with symbol ‘x’ . In an
efficient portfolio which securities have positive weight ( that is you have long position in those
securities, i.e. you buy those), and which securities have negative weight (you take short position
)? What is Expected ROR of a portfolio and what is its total risk ? Can total risk of portfolio be
divided into components such as diversifiable risk and non diversifiable risk? For an investor,
which risk is relevant while making investment decision?
It is hoped that this course would help you answer these questions in detail and with
mathematical precision. Such precision is the result of theoretical developments in the Modern
Portfolio Theory (MTP) during 1950s and 1960s due to contribution of Markowitz, Sharpe,
Lintner, and Mossin. The application of MPT in real life took off during 1970s due to the
18
availability of computing power to the investors. A new set of industries based on the
application of MPT emerged such as mutual funds industry, pension funds industry, hedge funds
industry. In short the whole area of professional money management really became an industry
after the wide spread availability of computers made it possible even for small investors to do
the risk and return calculations required by MPT.
Question Three: When to Buy (or Sell)

This is a question about correctly timing your “entry in” and the “exit from” the market.
Common sense answer is: buy a stock when its price is low, and sell it when its price is high. But
in real life how can one know that today’s price is the lowest, and it won’t go down further
tomorrow, and therefore today is the best time to buy. Or today’s price is the highest and
therefore today is the correct time to sell; and tomorrow or in future price won’t go up further.
Is it not possible that price may go down further tomorrow? And if that happens then you would
regret that you should have waited one more day so you could have bought even cheaper that
particular stock?
This dilemma leads to an interesting question: can anyone correctly time her market exit and
entry? This question can be posed also as: If anyone has the ability to beat the market
consistently? Beating the market means being able to always buy a stock before its price goes
up; and always selling it before its price falls; thus resulting ROR would be higher than ROR on
overall market portfolio comprising of all the stocks, usualy percentage change in index is taken
as proxy for market return symbolized as RM. Numerous research studies have shown that no
portfolio manager has shown such ability consistently. Showing this ability once or twice is not
the issue; ability to always buy at the lowest price and sell at the highest price in any given time
period is the issue. It means correctly timing your entry and exit from the market. No investor
has shown such ability: be they individual investors, or professional money managers (portfolio
managers) working for financial institutions that have huge research and computational
resources at their disposal.
Those who do Technical Analysis claim to be able to correctly judge if price is now too high and
therefore it is time to sell (Over Bought Market); or price is now too low and therefore it is time
to buy (Over Sold Market). But empirical testing of their proposed trading strategies (called
technical trading systems) have shown conclusively that no system of trading based on technical
rules was found capable of generating correct buy and sell signals for their users on a consistent
basis. Though some research studies have found support for the “momentum based trading
19
strategies” where a winner stock in past period seems to be a winner in the next period, and a
looser in past period was found to be a likely looser in the next period as well. But even in this
case a universal agreement about acceptable length of period for such comparison is non-
existent because one analyst can use a one week period and the other analyst can use a one
month or one year period, or a one day period to classify winners and losers.
Generally, the issue of timing is more relevant for the short term traders who frequently buy and
sell almost on daily basis. Presently, due to ease in order execution as a result of information
technology revolution, even frequent intra-day trading is becoming easier and popular.
There is strong support in research literature for the “Buy and Hold” strategy over a reasonably
long period. Such long term investors are more likely to be better-off in terms of increase in their
wealth than the short term traders. It must be clearly understood that the nature of corporate
shares is such that these are securities with no maturity, that is, theoretically their maturity is
infinitely long period of time. Therefore holding period envisioned by investors should be a very
long period. But, unfortunately even the professional money managers working for mutual
funds, pension funds, treasury departments of banks, etc, are evaluated on quarterly basis. This
short term performance evaluation culture results in a bias in favor of showing good results
every quarter; and therefore leads to excessive attention to market timing. All this results in
more frequent trading than is warranted by common sense. Probably the only beneficiary of
frequent trading are brokerage-houses, because by virtue of frequent trading activity by
investors, brokerage houses stand to earn commission fee for executing the order of the investor
on the exchange floor. Please understand that an investor pays commission to the broker both
ways, i.e., when a share is bought as well as when a share is sold. Therefore brokers as a
community has an inherent interest in seeing that investors do frequent trading, and do not opt
for the “Buy and Hold Strategy”.
It should be clear to you now that if time horizon for investing in shares is very long then the
question “when to buy” has a common sense answer: that is today. Because it does not matter
much that you wait a few more days in the hope of buying at lower price if your investment
horizon (expected holding period) is next 20 years. Similarly, after holding a share for 15 years, if
a long term investor has decided to liquidate her holding due to certain personal circumstances,
then it is not a matter of great importance to wait for a few more days before selling her shares
in the hope of getting higher selling price: “today” also is the right answer for her.
20
Just looking at the value of major stock indices such as KSE-100 index (Pakistan) or Dow Jones 30
index (USA) or S&P 500 index (USA) over the last 50 years gives very strong evidence in favor of
“buy and hold” strategy while doing investment in corporate shares. Compound annual growth
rate of all these indices has been in double digits for more than the last half a century; and no
other security or investment instrument has give such high rate of return over such a long period
of time. Therefore commonly held belief that investing in corporate shares can make you very
wealthy is correct; but for that to happen investor should have the patience of holding her
investment for a long period: you should buy shares not for yourself but for your grand children.
This approach to investing in shares is not stated in such stark terms by text book authors, nor is
it promoted by professional investment advisers, probably for good reasons of self interest as
their bread and butter is linked with investors indulging in frequent buying and selling of shares.
As an example of the efficacy of long term buy and hold strategy , please note that in 1993 KSE-
100 index was in the range of 900 and these days (end of 2018) it is in the range of 44,000. Using
FC-100 financial calculator, in CMPD mode you enter: -900 PV exe, 44,000 FV exe, 0 Pmt exe, 25
n exe , and solve i , you get 16.83% compound annual growth rate; so annual ROR was more than
16 % per year for the last 25 years. Which, it should be noted, is a very high growth rate of the
wealth of investors; but for that to happen to your wealth you have to show patience by holding
shares of KSE-100 index for 25 years for 900 RS to become 44,000 Rs..
Remember as soon as you get into a mindset of becoming rich overnight; and attempt to chose
shares as the vehicle to attain that goal you are in the arena of gambling and out of arena of
professional investing. Then the only relevant question you should ask yourself is why select
share market to satisfy your urge to gamble? There are available better, easier, and cheaper
modes of doing gamble or playing games of chance than the share market.
What This Course Aims to Teach

This course is aimed at learning the answers to the first two questions: 1) What to buy, and 2)
what combination to buy; because these are answerable questions. The third question ( when to
buy?), is a question about the market timing, and that is not answerable; therefore this course
won’t pretend to teach the answer to the third question.
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2020.

THREE QUESTIONS FACED BY INVESTORS

Question One: What to Buy (or Sell):

Examples of Long Position

= 30 Rs / 100 Rs = 0.3 or 30%

Example of Negative ROR on long position

Examples of Short Position

Example of Positive ROR on Short Position

But that is not the end of the story.

Example of Negative ROR on Short Position

How To Select Shares That Would Make You Wealthy?

SECURITY / INVESTMENT ANALYSES

Role of Efficient Market Hypothesis (EMH)

Technical Analysis of Securities

A Final Word About Security Analyses

Question Two: What Combination to Buy

Question Three: When to Buy (or Sell)

What This Course Aims to Teach

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