1. finlogIQ
Knowledge for financial IQ
STRICTLY PRIVATE AND CONFIDENTIAL
Chapter 2
The Framework for Making Investment
Decisions
August 2012

2. Chapter summary and outline
This chapter describes how fundamental analysis and technical
analysis should be applied within the framework for making
investment decisions, and also describes market sentiment, which
is another factor that should be considered when providing
investment advice.
Chapter outline:
• Fundamental analysis
• Technical and Statistical Analysis
• Sentiment
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3. Introduction
• Fundamental Analysis – concerned about demand-supply factors driving
the markets
• Technical and Statistical Analysis – use of chart patterns and statistical
studies for timing the market
• Over time, markets have also become more highly correlated and
interdependent
– Market players often comment about risk sentiment: whether it is “risk on” or “risk
off”
– When stock markets decline, the USD automatically rallies due to money flowing
to a safe haven, and commodities prices decline as the growth outlook dims or
due to the unwinding of risk positions.
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4. Fundamental Analysis
• Forms the foundation of knowledge in analysing the market
– Deciding whether to buy or sell
• Each market can be unique and driven by its own set of factors
– Knowing the primary drivers for specific markets would help to identify the better
investments and appropriate instruments
Example
• An investor, after analysing the US fiscal deficit, came to the conclusion that USD will
decline over the next six months
• He could express that view through selling USD against EUR or GBP
• If he ignored the market concerns for peripheral European sovereign debt and chose
to buy EUR, he might have seen the EUR declining first before rallying against the
USD
• The instrument which he chose to express that view might also have had a different
returns profile
• Buying EUR in the futures market in a contract around 6 months before the
settlement date or buying a EUR call with nearly 6 months’ tenor might be a profitable
strategy
• Conversely, buying a EUR futures contract with around 1 month before the
settlement date or worse selling a EUR call might have a totally different outcome
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5. Fundamental Analysis - 2
• There are times when various market can be correlated and respond to the
same set of factors or news,
– E.g. news about poss default by Greek government has driven stock markets
lower globally, affecting commodity prices as well
• The same factors could have different relevance at different points of the
economic cycle, and hence different impact on the market
– E.g. Retail sales would be more closely scrutinized at the start of economic
recovery compared to after a period of sustained growth.
• Fundamental analysis – helpful in developing a macro view of market and
understanding the economic cycle
– Performance of each asset class can then be evaluated
– Important to differentiate between long and short term factors as investment
horizons of clients would then vary accordingly.
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6. Technical and Statistical Analysis
• Not only helps to identify the entry and exit point but also helps to identify
the trend if one exists,
• Whether market is trending or range trading would affect the decisions on
investment horizon (short-term or long-term trades)
• In a trending market, a trader or investor needs to ride with the trend or cut
the loss if the position is wrong
• In a market downtrend he should not take a contrarian view and advise
investors to buy at a certain level simply because it is the support point
– Conservative approach or a stronger support point needs to be identified for
entry
• Like wise in a consolidating or sideways market it would be wrong to advise
the clients to buy and hold for long-term
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7. Technical and Statistical Analysis - 2
• Can be relied as forecasting tool
• There are many different studies that can be combined to develop a trading
system
• Algorithm trading approach incorporates:
– Different studies or parameters, and
– Optimised through back-testing
• Most representatives providing advisory would rely on technical reports
prepared by others where several support and resistance levels are
identified,
– The analysis should be kept simple by using maybe two to five studies
– Over time and through experience, one would identify which are the more
reliable studies and how to interpret them properly
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8. Sentiment
• Market sentiment is basically the dominant bias of the market and it can be
a combination of factors that drive it
• Reasons include bearish chart formations, redemption of investors’ money
from funds or even reduction of risk appetite stemming from large losses
suffered by speculative funds.
Example:
• When Asian equity markets were sold down on news of the possible Greek sovereign
default despite the absence of direct adverse factors affecting Asia, such an event
could be attributed to bearish market sentiment
• When markets were bought up despite the high valuations and overbought
conditions, such moves could be attributed to bullish sentiment
• Factors would include market positioning, technical factors like the breach
of crucial chart points, and risk management considerations like loss-cutting
or profit taking
Example:
• After an extended rally, when markets were heavily positioned long and due to a
sudden drastic down move, markets were then sold down followed by a long period
of erratic sideways consolidation. Despite some positive data, markets were unable
to rally - one can attribute this scenario to bearish market sentiment.
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9. Sentiment - 2
• In major markets with good liquidity:
– Such markets tend to be dominated by institutional clients like hedge funds or
asset managers.
– Among the hedge funds, there are long-term and short-term players with diverse
strategies like algorithm trading which tends to be high frequency, value versus
growth strategies and so on
• In the smaller markets:
– The retail players can be dominant and irrational at times.
– Hence, some of the volatilities observed could be hard to explain
• The winning strategy is one which is:
– Well-researched, supported by careful fundamental analysis
– Well-timed with proper entry and exit points as determined through technical
analysis
– It is important that the strategy is consistent with the clients’ objectives,
investment horizon, profile and sound advice on money management.
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