14.3 Asset Valuation

14.3 a. Fundamental Analysis

Fundamental analysis is a method of evaluating a security in an attempt to measure its intrinsic value, by examining related economic, financial and other qualitative and quantitative factors ^[14].

Example: Analysts looked at fundamental indicators of the S&P 500 for the week of July 4 to July 8, 2016. During this time period, the S&P rose to 2129.90 after the release of a positive jobs report in the United States. In fact, the market just missed a new record high, coming in just under the May 2015 high of 2132.80. The economic surprise of an additional 287,000 jobs for the month of June specifically increased the value of the stock market on July 8, 2016 ^[14].

^{Fundamental Analysis [15]}

14.3 b. The Efficient Markets Hypothesis

The efficient market hypothesis (EMH) is an investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. While academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. ^[16]

The random walk theory suggests that stock price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement. ^[18]

Informationally Efficient Market is a theory, which moves beyond the definition of the efficient market hypothesis that states that new information about any given firm is known with certainty, and is immediately priced into that company’s stock. ^[19]

Example: Detractors of the EMH point to events such as the 1987 stock market crash, when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values. ^[16]

^{Efficient Market Hypothesis [17]}

14.3 c. Market Irrationality

Irrational exuberance is when investors are so confident that the price of an asset will keep going up, they lose sight of its underlying value. They overlook deteriorating economic fundamentals in the pursuit of ever-higher returns. Instead, they get into a bidding war and send prices up even higher. Irrational exuberance drives the peak phase of the business cycle. ^[20]

Example: The latest boom-bust cycle happened with oil prices in 2014. After reaching $100.14 in June, West Texas Intermediate crude oil prices plummeted 15 percent to $53.45 on December 26, 2014. ^[20]

^{Market Irrationality [21]}