Read the Signs
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Wish you could gauge equity market sentiments before investing in stocks? Though predicting equity markets and stock movements are not easy, equity analysts use many methods and indicators to predict market movements. These indicators are both fundamental (price-to-earning, or P/E, ratio, price-to-book value, or P/B, ratio, interest rates) and technical(put-call ratio, volumes traded).
While indicators such as P/E and P/B ratios are often quoted, we will discuss some indicators that are widely used by traders and fund managers to predict market movements but are not known to many retail investors.
FUNDAMENTAL INDICATORS
Dividend Yield
Dividend yield is calculated by dividing the annual dividend paid on each share by its current price. Dividend yield=(Annual dividend/current price)*100
For example, if a stock paid an annual dividend of Rs 22 and the current market price is Rs 440, the dividend yield of the stock is 5%.
So, what does dividend yield tell about the future price of a stock?
If the dividend yield is low, the share price is relatively higher than the dividend paid and hence the stock may be overvalued. This indicates a possible decline in the future.
A high dividend yield, on the other hand, means subdued interest in the stock and that the company is trying to woo investors by paying higher dividends. It means the stock price is undervalued.
This can be extended to a stock index too. One can calculate the aggregate dividend yield of an index, compare it with past dividend yields and see if the current yield is low or high. A low dividend yield indicates an overpriced market and vice versa.
Let’s demonstrate it by a simple calculation. According to the National Stock Exchange data, the average dividend yield of the Nifty in the last couple of months has been around 1.5%. On 2 November 2011, the Nifty closed at 5,263. The current dividend yield is Rs 79.
If analysts expect Nifty companies to increase their dividend payouts by 10% every year for the next three years and investors expect at least a 4 percentage point premium(12.5%) on equity returns over the risk-free 91-day Treasury bill rate, which is currently 8.5%, then,
Where,
Expected dividend=current dividend x 1.1
Present value=Expected
dividend/(1.125)
The expected dividend in the 4th
year will be
(105.15 x 1.1)=Rs 115.66
The value of the index at the end of the 3rd year (Terminal
Value)=105.15/(.125-0.1)=4,206
The present value of the termi
nal value=4,206/1.125=3,739
The present value of the index is the sum of the present value of dividend paid during the three years and the present value of the terminal index value
=77.24+84.96+93.46+3,739
=3994
Hence, at its present value (5,263), the Nifty is overvalued and may fall in the immediate future.
(The above calculation is purely based on assumptions)
Insider Moves
Though the name smells of something unlawful, not all insider trades are illegal. According to Indian laws, an insider is a top official, director or shareholder who owns 10% or more shares and has access to unpublished price-sensitive information about the company.
A member of the board, merchant banker, share transfer agent, debenture trustee, broker, portfolio manager, investment advisor, subbroker or even a relative of any such individuals is also an insider.
Insider trading based on unpublished price-sensitive information is illegal.
An ‘insider’ can buy or sell shares provided they inform the stock exchanges on which the stock is listed if the transaction goes beyond a certain threshold.
If the shareholding of an insider changes by more than Rs 5 lakh in value, 25,000 shares or 1% of total shares or voting rights, it has to be brought to the notice of stock exchanges and the company.
Information on insider trading is available on websites of stock exchanges and can be used to predict future prices. Here’s how.
Studies suggest that while an insider may have many reasons to sell, the only reason for buying can be that he is bullish on the prospects of the company.
Interest rates
Changes in interest rates impact companies. Conventional wisdom says one must buy shares when short-term rates (treasury bills) are low and sell when they are high.
Rajeev Thakkar, CEO, Parag Parikh Financial Advisory Services, says: “The corporate sector is a net borrower of funds and an increase in interest rates is usually negative for it. Higher rates also hit demand in rate-sensitive sectors such as real estate and automobiles.”
Usually, short-term rates(treasury bills) are lower than longterm rates (10-year government bonds) as the latter factors in uncertainty in the long term.
However, when rates on shortterm securities are higher than that on long-term ones, it hints at a possible recession. At present, the two rates are close—on 2 November 2011, the 10-year government bond and three-month treasury bills were around 8.7%.
TECHNICAL INDICATORS
Trading volume
Trading volume indicates the num- ber of shares or contracts traded in the market. It tells if a particular price trend is supported by market players.
If the price of a share is increasing with higher than normal volume, it indicates investors support the rally and that the stock would continue to move upwards. However, a falling price trend with big volume signals a likely downward trend.
A high trading volume can also indicate a reversal of trend. For example, a drop in the share price with very high trading volume is viewed as a sign that the stock has hit the bottom.
Put-Call Ratio
A put option is an agreement between two parties to exchange an asset at a pre-determined rate on or before a specific date. The buyer of the put option has the right but no obligation to sell the asset (stock, commodity) at a specified price on or before a fixed date, while the seller has the obligation to buy at the pre-specified price if the buyer wishes to exercise the option.
A call option, on the other hand, gives the buyer of the option the right but no obligation to buy a particular asset from the seller of the call option at a fixed price on or before a particular date.
The put-call ratio is calculated by dividing the number of traded put options by the number of traded call options.
If the put-call ratio is increasing, it means the number of traded put options is increasing, signaling that either investors fear the market will fall or are hedging their portfolios foreseeing a decline.
Sahaj Agrawal, associate vicepresident, derivatives, Kotak Securities, says, “A high ratio indicates an over-cautious stance by market participants and hence chances of the market falling are low. Contrary to that, a low ratio indicates over-optimism, and hence caution should be exercised.”
Though these indicators are frequently used by traders and fund managers to predict market movements, they may lead to wrong results if used separately, as they are not fool-proof. You can use these together to arrive at a more credible conclusion.