Damodaran's pearls of wisdom: Part II - Views on News from Equitymaster

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Damodaran's pearls of wisdom: Part II

Jul 5, 2013

In our first article of the series on Professor Aswath Damodaran's Pearls of Wisdom, we introduced the concept of 'investment philosophy'. We talked at length about 'intrinsic value investment philosophy' as enunciated by Damodaran. In this article, we would talk about the Professor's thoughts on technical analysis, arbitrage and information trade.

Technical Analysis

Prof. Damodaran believes that the followers of these schools of thought are mostly concerned with price. They do not really focus much on value, contrary to intrinsic value investors to whom an estimate of value is of utmost importance. Technical Analysts are basically 'Chartists' who study price movements with the help of technical indicators. This study is the basis for investing for them.

While this school of thought has been predominantly sidelined by the 'intrinsic value' investing camp, Damodaran mentions that there is a growing body of evidence to suggest that 'technical analysis' does actually work in practice. He admits that he personally does not use technical analysis. However, he does not dismiss technical analysis as an irrelevant mumbo-jumbo. The reason being that the basic premise on which technical analysis rests lies on the fact that price is a function of demand and supply. And, that is a proven economic concept. Technical Analysts also believe that stock prices move in trends that persist for some time. They believe that any change in the trends, caused by shifts in demand and supply, can be detected. Damodaran says that a trend continues because price changes themselves offer information to markets. "Thus, the fact that a stock has gone up continuously may be viewed as good news by investors, making it more likely that the price will go up than down."

The two main theories that back up Technical Analysis are the Elliott Wave Theory and the Down Jones Theory.

  1. Elliott Wave Theory: According to this theory, a market moves in waves lasting from a few trades to a century on the basis of which it is possible to determine the position of a market at all times.

  2. Dow Jones Theory: This theory divides market movements into three time periods: daily fluctuations, fluctuations ranging from a few weeks to a month and the long-term, four years movements in trends.

The indicators used in technical analysis vary widely. The contrarian school of thought proclaims that as people overreact to news, extreme movements in stock prices will be followed by more extreme movements in the reverse direction. The indicators for this school of thought are support and resistance lines, moving averages and volume indicators. Another school of thought believes that some investors are savvier than the market and can anticipate market moves in advance. For this school of thought, which relies on price drifts for making excess returns, relative strength index and trend lines are of utmost importance.

Arbitrage and Information Trade

Damodaran has also discussed the concepts of arbitrage and information trade. He classifies arbitrageurs as people who discover price differences for the same asset on different markets. They trade the asset from one market to the other and make a profit on the difference. Here again, the importance lies on price rather than on value, akin to technical analysis.

Information traders, on the other hand, rely on taking advantage of new information that could result in a change in price. However, this pursuit has two primary disadvantages. Firstly, information traders react to whatever the market does and have no anchor such as intrinsic value. Therefore, they tend to be pushed back and forth with price movements. Secondly, the key to their success lies in detecting shifts in the perception of other investors. This, according to Damodaran is next to impossible, as crowd behaviour is very tough to analyse.

Equitymaster's thoughts

As such we are advocates of value investing for we feel that the philosophy is best suited to earn superior returns in the long term. However, there is no denying that concepts like technical analysis, arbitrage or even information trading do have their own place in the stock markets.

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