Author Archives: enjar

Forward Guidance as Stabilizer

We all know that the Fed has been conducting an “unconventional” monetary policy since the end of the recession. The policy consists of bond-buying program and forward guidance program.  A familiar role that Fed’s forward guidance play is to insure investors and market that the Fed will be pursuing low interest rate policy during the period of time described in the guidance statement.

In this post I want to emphasize another role the forward guidance program take in the successful stable economic recovery. By being as transparent as possible about its ongoing monetary policy and future policy, through the forward guidance tool, the Fed officials try to give as much information as possible to market on the future moves in the monetary policy. Why the Fed has been doing this?

The answer relates to rational expectations. According to rational expectation model, economic outcome will depend on what agents, such as investors, firms, and consumers, expect to happen. By providing statements on the future unfolding of monetary policy, the Fed changes and strengthens market’s expectation about the monetary policy. Market then includes their expectations of monetary policy, which are partially created by the forward guidance, in their decision making. When the actual time of policy change comes, the market will react to it little or not at all depending on how their expectation was true. That means, a policy change, in this case, increasing federal funds rate, will receive a little reaction from the market at the time of the event since the market will have foreseen the coming of the policy change. In other words, the market will be considerably stable at the moment of the announcement.

Now, if the Fed hasn’t been pursuing the forward guidance policy for these years, there would have been a much greater monetary policy guessing game before every Fed meeting and more expectations would have been wrong in the absence of the forward guidance. As rational expectation theory would say, the agents whose expectations weren’t met by the policy change would have to make a change in their economic decision after the time of the event. That means there would have been greater stability in the financial market since the Fed’s raise of the interest rate started looking imminent.

In conclusion, the Fed has been stabilizing the markets since the end of the recession partially through its forward guidance program to give clear direction on the market’s expectation of monetary policy. Janet Yellen’s speeches following the Fed’s meeting in March have been to clarify the uncertainty created by the Fed’s meeting regarding the timing of the interest rate rise. That is what Yellen should be doing to ensure that market will not be surprised by the Fed’s move sometime in 2015 and react to it creating instability in the markets.

When Are We Happy?

(Tune in while reading: http://www.youtube.com/watch?v=y6Sxv-sUYtM)
Every person has different answers for this simple question. But we don’t know an exact answer for what makes us happy for what reasons. There are more questions that human kind has been trying to find an answer for like whether being happy is what people seek in life.

The word “happy” is itself very ambiguous. People can describe them happy in two different ways:

-depending on their mental state at the moment; reflecting short term condition

-depending on whether they are living lives they want; reflecting long term condition

Regarding the first sense of the term “happy”, there have been studies and recommendations trying to find out in what condition people feel happiness. In an episode of the TED Radio Hour Show, guest speakers talked about their findings on being happy. Harvard PhD student Matt Killingsworth conducted survey based research on happiness, and his result shows that if we want to be happier, we should live at the exact current moment. In other words, according to his smart-phone app based survey, people in the study answered they are happy when their minds were focused on what they were doing at the exact moment. On the other hand, people answered that they are happy less times when their minds were on something else such as what they are going to do after they finish their current tasks. Simply put, if you want to be happier, enjoy the moment!

Also, on the same show episode, Carl Honore, an author, advises us to slow down our speed of lives to be happier. He argues that today, people speed in their most tasks, and this leads to less happiness, less productivity and less quality of life. Another speaker Graham Hill, a designer, talk about how we are happier when we have less stuff in life! More elaborately, his point is that we are happy when we have simpler stuff in life.

If we can be happier by following above advises, how can we be happier in our whole lives, in general? Even though I don’t want to say this, most people feel pressure and unhappiness by choosing to compare themselves with others. We make ourselves unhappy by envying others. In other words, people choose to be less happy because of other’s fortune, luck and possession. This tendency to compare ourselves with others come just naturally to us. However, people should try to control their happiness by what they possess instead of what others possess.

Also, in addition to comparing what we have with what others have, we seemingly compare what we have with what we thought what we would have. In other words, in some sense, we feel happy whenever we experience somewhat unexpected pleasure giving events. Then again even though I don’t want to say this, we should lower our expectations in life to be happier. Maybe we can expect the worst and hope for the best!

Happiness has been a topic of economic researches for decades. Richard Easterlin’s study on human’s well being during 1970’s has greatly shaped following studies by economists. His main finding, later called Easterling Paradox, was that well-being and happiness are greatly correlated with people’s income, but until income reaches certain point. The latest research on happiness done by University of Michigan professor Justin Wolfers shows how economic and demographic factors play a role in being happy. Even though I don’t believe the title is appropriately given, an article “Money can buy happiness, economist says” pinpoints results of his study. Here are some interesting ones:

 

• Men in recent decades in America are happier than women. “No one knows exactly why,” Wolfers told the audience. It may be that women have internalized several measures of success, more than the basic “am I popular” focus young women faced growing up in the 1960s, he said.

• In general, not only are the rich happier than the poor, but globally, richer nations are happier than poorer ones, Wolfers noted.

• Among Americans in the lowest 12 percent of income-earners, 21 percent said they were happy. Of those earning more than $150,000 per year (the top 10 percent), 53 percent said they were happy.

Flipping the question, among the lowest-earning 12 percent, 26 percent said they were unhappy in general, based on a set of factors such as enjoyment of meals, depression and feeling respected. Of the top 10 percent, only 2 percent reported feeling unhappy, he said.

The notion that riches are happier than poors isn’t totally groundbreaking news even it wasn’t true. But at the end, most of us seek to get higher salary jobs assuming that it makes us happier. Then from this study, we can advise ourselves that get rich to become happier!

 

Academic Job Looks Promising

The recent article, “Tech Leaps, Job Losses and Rising Inequality” on the New York Times by Eduardo Porter talks about how growing technology is contributing to widening of income inequality in the U.S. As implementing cheaper technologies to industries, low skilled workers are replaced by these new machines. The article points out how certain medical conditions are tried to be diagnosed by technology. One example given is how researchers at Microsoft Research are developing a system that can predict with accuracy a probability of a pregnant woman’s suffering postpartum depression by looking at her tweets on Twitter. Science has made almost impossible things possible in the last century. If technology gets developed at the same rate as it has been for last decades, we could see today’s impossible ideas to come in our hands.

So, if technology is going to grow as it has been and if new technologies are going to replace workers whose job can be done by the new machines, what human beings are left to do?

The answer is simply that those jobs which are hard for robots to perform will be the jobs that humans will be competing for. The main function of these jobs include interpersonal communication, in which today’s technology hasn’t been developed to the extent to compete with humans. The jobs that require this characteristics include teachers and professors, variety of advising jobs, and motivational speakers!  Because, as of today, the technology hasn’t reached to the point where we can substitute another human with a machine to communicate our feelings. Even though we are experiencing growth of online schools and free Massive Online Open Courses (MOOC) offered by such as edX, Coursera and Khan Academy, human to human communication which these online education technologies lack is why teachers and professors will not have to worry about their jobs as for now. Even though we can get same amount and quality of education by taking online classes or MOOC, these courses can’t offer a type of relationship we can have with our professors in college. Professors not only teach the content of the course, but they motivate students to achieve more (Remember, most of us are going to make at least $2 million in our life time according to Professor Kimball). In other words, robots haven’t been programmed to motivate us emotionally.

Another reason that demand for academic jobs will be greater in the future is that as technology replaces jobs that require low skills or skills that can be programmed in a machine, people will be looking for to get skills that machines cannot possess. Most of these skills require higher education as how advising job requires to deep knowledge about the topic from the adviser. Therefore, demand for higher education will surge in the awakening of greater technology. Presumably so, then teachers and professors will be demanded in higher numbers.

Academic job will be demanded in greater number in the future because of its inherent function of interpersonal communication and demand for higher education.

(Revised) Fed Officials Expect Overshooting in 2016

Following the Fed’s March 18-19 meeting, the policy making committee provided a collection of charts showing the projections of macro economic main variables in the coming years. Before discussing the projections, I should note here a little bit of confusion I have. In the projection file, it states that these projections are “based on FOMC participants’ individual assessments of appropriate monetary policy.” Therefore, these number’s aren’t actually projections as done by someone outside of the Fed, but these are the expected values of these economic variables that could be seen according to Fed officials’ own appropriate policies. 

In other words, when looking at these projections, we should take into consideration that these projections are influenced by each committee member’s policy recommendation.

The recent post on the WSJ touches on how this projection could be misleading the market into expecting that interest rate rise will come sooner than expected. According to the article, some Fed’s policy committee members raised their expectation of interest rates in 2015 and 2016. This could signal market that the Fed policy makers are looking at possible rate increase which is sooner than expected prior to March meeting.

ProjectionFed_March

From the above chart we could see what rate Fed officials are expecting fed funds rate target to be in 2014, 2015, 2016 and long-run. In 2014, according to the chart, we see that the policymakers almost unanimously expect the fed funds rate target be at the current level of 0 to 0.25 percent target. In 2015 and 2016, the averages of the Fed officials’ expected fed funds rate are around 1 percent and 2.5 percent, respectively. The policy makers expect the rate to be around 4 percent in the long-run. This rate is slightly lower than the historical average of the fed funds rate target since 1990, which is 4.2 percent. In general, the committee members expect to have similar fed funds rate target that it has had since 1990.

Note that, the expected fed funds rate target is still lower than long-run expected rate of 4 percent at around 2.5 percent in 2016. Hence, it is plausible that somewhat easy monetary policy will be taking place until 2016. But we should always remember that low interest rate doesn’t always mean expansionary monetary policy as Milton Friedman put it, “After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

The surprise of the projection comes when we look at another chart which was included in the same projection report. The following chart shows how the committee members expect the unemployment rate to be under appropriate policy in coming years and in the long-run.

ProjectionFed_MarchUn

 The central tendency among the policy makers regarding the expected unemployment rate in 2016 is along with the long-run projection: at 5.2-5.6 percent.

So, what can we conclude about the Fed’s future policy from these two charts?

The Fed policy makers are believing (or seems to be) that under appropriate policy, the Fed will be pursuing expansionary policy even after the unemployment rate reaches the long-waited long-run average. In other words, the Fed policy makers think overshooting the unemployment rate is a viable option for the Fed policy in coming years. This is along the line with the worry about low inflation in coming years. Another chart in the projection shows how the policy makers expect inflation to be in coming years.FedINflation

 As we see from the chart that central tendency among the officials regarding the expected inflation in 2016 is below the Fed’s target of 2 percent inflation. It is kinda counter-intuitive; they target 2 percent, but expect it to be below it. Or are they really targeting 2 percent?

Then, given the the below target inflation rate, the Fed officials shouldn’t be worried about their fed funds rate target expectation below the long-run expectation.

From the Fed officials’ projection, we can conclude that the Fed will be still operating somewhat stimulus policy in 2016 relative to their long-run policy. if we assume these projections are made with rational expectation

Let Them Borrow and Build Schools

In his recent column on The Boston Globe, Lawrence Summers, a economics professor at Harvard and former Treasury Secretary (fun fact: he has two Nobel Laureate uncles on both of his parents side), wrote on public investing in the infrastructure. His main point was that while the economy is running on low interest rate  coupled with still troublesome high unemployment rate for considerable period, the U.S. government should borrow more and invest it on the public infrastructure such as airports, transportation and schools.

I agree with Summers because of three reasons: high unemployment in construction sector, inevitable investment in those infrastructures and more equal externality in the society.

Let me emphasize on each point.

First, with unemployment rate in the construction sector is hovering at 11.3 percent currently, there should be policy directed to those unemployed people, who suffered most during the recession. The beneficiaries of the investment in infrastructure will be the those unemployed people in the construction sector.  Those people who would be employed for these new projects could continue their employment for other private projects once the economy recovers and construction and housing sector picks up. At that moment, these people would be already have been employed for two years, so their opportunity to get back on the employment list increases compared to the case when those people would be long-term unemployed people. Regarding the interest rate,

Second, these infrastructures including transportation and schools are inevitable in the future even though it doesn’t get done today because of increasing population and imminent increase in need for them. It might be  the case that, today, primary and secondary schools are enough in numbers, but these will be insufficient as the population grows and socioeconomic status of low income families get better, and their children attend to school in growing numbers. Aside from new school buildings, there are still already built school infrastructures  which don’t fulfill the need of better learning environment. In other words, it is evident that America will need more of schools and better transportation and education infrastructure, so why shouldn’t the policy makers tackle this projects now?

Last, these new projects will benefit most citizens- if not all- regardless of their today’s socioeconomic standings. At the end, who don’t drive on highways and wouldn’t like their children to attend better schools? As income inequality has been a discussion topic lately, the investment in public infrastructure will help to decrease the gap between people on different socioeconomic ladder.

Not only these projects put today’s unemployed people to work, these new infrastructures will benefit U.S. economy in the long-run as more children attend to school let alone better school. Investment in education is certainly inevitable if the U.S. seeks to improve its education system to be a front-runner in the world.

Fed Officials Expect Overshooting Unemployment Rate

Following the Fed’s March 18-19 meeting, the policy making committee provided a collection of charts showing the projections of macro economic main variables in the coming years. Before discussing the projections, I should note here a little bit of confusion I have. In the projection file, it states that these projections are “based on FOMC participants’ individual assessments of appropriate monetary policy.” Therefore, these number’s aren’t actually projections as done by someone outside of the Fed, but these are the expected values of these economic variables that could be seen according to Fed officials’ own appropriate policy. 

In other words, when looking at these projections, we should take into consideration that these projections are influenced by each committee member’s policy recommendation.

The recent post on the WSJ touches on how this projection could be misleading the market into expecting that interest rate rise will come sooner than expected. According to the article, some Fed’s policy committee members raised their expectation of interest rates in 2015 and 2016. This could signal market that the Fed policy makers are looking at possible rate increase which is sooner than expected prior to March meeting.

ProjectionFed_March

 

From the above chart we could see what rate Fed officials are expecting fed funds rate target to be in 2014, 2015, 2016 and long-run. In 2014, according to the chart, we see that the policymakers almost unanimously expect the fed funds rate target be at the current level of 0 to 0.25 percent target. In 2015 and 2016, the averages of the Fed officials’ expected fed funds rate are around 1 percent and 2.5 percent, respectively. The policy makers expect the rate to be around 4 percent in the long-run. This rate is slightly lower than the historical average of the fed funds rate target since 1990, which is 4.2 percent. In general, the committee members expect to have similar fed funds rate target that it has had since 1990.

Note that, the expected fed funds rate target is still lower than long-run expected rate of 4 percent at around 2.5 percent in 2016. Hence, it is plausible that somewhat easy monetary policy will be taking place until 2016. But we should always remember that low interest rate doesn’t always mean expansionary monetary policy as Milton Friedman put it, “After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

The surprise of the projection comes when we look at another chart which was included in the same projection report. The following chart shows how the committee members expect the unemployment rate to be under appropriate policy in coming years and in the long-run.

ProjectionFed_MarchUn

 

The central tendency among the policy makers regarding the expected unemployment rate in 2016 is along with the long-run projection: at 5.2-5.6 percent.

So, what can we conclude about the Fed’s future policy from these two charts?

The Fed policy makers are believing (or seems to be) that under appropriate policy, the Fed will be pursuing expansionary policy even after the unemployment rate reaches the long-waited long-run average. In other words, the Fed policy makers think overshooting the unemployment rate is a viable option for the Fed policy in coming years. This is along the line with the worry about low inflation in coming years. Another chart in the projection shows how the policy makers expect inflation to be in coming years.FedINflation

 

As we see from the chart that central tendency among the officials regarding the expected inflation in 2016 is below the Fed’s target of 2 percent inflation. It is kinda counter-intuitive; they target 2 percent, but expect it to be below it. Or are they really targeting 2 percent?

Then, given the the below target inflation rate, the Fed officials shouldn’t be worried about their fed funds rate target expectation below the long-run expectation.

From the Fed officials’ projection, we can conclude that the Fed will be still operating somewhat stimulus policy in 2016 relative to their long-run policy.– if we assume these projections are made with rational expectation

(Revised) Fed, Raise the Inflation Target

Originally posted on March 29th

Friday’s report of the personal consumption expenditure price index, which the Fed prefers, shows that year-to-year price index grew by 0.9% in February. This means that the inflation rate has been below the Fed’s target of 2 percent inflation rate for 21 consecutive months.

While this low inflation rate has been allowing the Fed to pursue its quantitative easing program and low interest rate policy , the Fed policy makers also know that higher inflation rate around their target of 2 percent would make their job easier, simply lowering the real interest rate. But it seems like the Fed has been short of achieving its “target” for 21 months. A question we should ask from ourselves is that: is the Fed unable to hit its target? or is the Fed actually targeting lower than their so-called “target”? In my Monday’s post, I made a case for the second question getting an answer “yes!”. If the Fed is indeed targeting inflation rate lower than its 2 percent “target”, the points following are useless since the Fed policymakers want low inflation anyways.

Now if we are in the world where the Fed has actually been unable to hit its inflation “target” given that it wants to hit it so badly, my policy prescription for the Fed is to increase its inflation target from 2 percent to 3 percent or somewhere around that for the duration of the recovery. Note that, I am not suggesting to raise inflation target to 4 percent or other for the long-run as Laurence Ball and Olivier Blanchard suggested, but to raise it until the economy recovers.

The Fed could target this higher inflation rate by declaring in its meeting statements that the Fed will be comfortable with inflation rate considerably higher than 2 percent when deciding when to raise the fed funds rate. Let’s look at the Fed’s latest statement:

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

The Fed, in my policy prescription, should change “run below the Committee’s 2 percent longer-run goal” to “run below 3 percent” (or some rate around that). That change should have positive effect on inflation expectation. If the Fed believes the inflation expectation hasn’t been responsive to its inflation rate target, that is great for the Fed since it could further state higher inflation target such as 4 percent to raise the expectation more while not actually raising the inflation higher.

But again, raising inflation target makes sense to me if the Fed does want to raise the inflation expectation. But considering its tapering QE even though their desired 2 percent inflation isn’t seen to be reached for some time, I am puzzled by what inflation rate the Fed wants. Or are the Fed policymakers actually buying Stephen Williamson’s paper?

Overshooting Unemployment Rate

In recent discussions regarding the Fed’s timing of raising the interest rate and stopping the QE, the possibility of overshooting the unemployment rate to make sure the the economy doesn’t slip back to the panic after the Fed’s move. What overshooting the unemployment rate means is that the Fed waits the unemployment to get below “natural rate”, let’s say 5.5 percent, to raise the interest rate. Advocates of overshooting say that by doing so, the economy can gain lost capacity during the recession, and slightly higher inflation and nominal interest rate can benefit the economy in terms of more monetary policy room to kick another panic.

This argument of overshooting unemployment rate is one of the fundamental macroeconomics topics Milton Friedman addressed in his 1967 American Economic Association speech, titled “The Role of Monetary Policy”. According to him, lower than “natural” rate of  unemployment can be achieved through only increasing inflation. The key word here is increasing, since at the moment when he gave the speech, there was spreading view that there is trade-off between higher inflation and lower unemployment. Friedman argues that when the central bank raises the quantity of money supplied by buying bonds, it increases the money supplied higher than the amount people want to hold; therefore, it reduces the nominal interest rate and increase demand for goods. Companies would respond to increase in demand by first supplying more of the goods without increasing the prices. But eventually price would adjust to the demand by rising. At the same time, wages doesn’t rise as much as the price rises. Therefore, real wage would be decreased during this phase. 

Decreasing real wage would lead to higher employment. This is why we could see higher employment or lower unemployment through unexpected inflation rise. However, once the workers starts including the higher inflation rate to decide what wage to receive, they demand higher wages. Since the unemployment was lower than natural rate and the higher wage demand, the real wage starts increasing. The increase in real wage would then increase unemployment back to the normal level. If then the policymakers still want to pursue lower than natural unemployment rate, they now have to increase the supply of money  at higher than previous rate. Hence, we could see increasing price level or inflation as this process goes on forever until the policymakers decides to not target unemployment rate lower than natural rate.

How this discussion relates to current policy making is that if the Fed decides to pursue the unemployment rate below natural rate, 5.5 percent in our case, permanently, the Fed will face a problem of increasing inflation. i believe, the Fed will pursue it for one or two years if it indeed decides to it. Even though one or two years isn’t permanent, it is neither temporary. Therefore, the Fed will face some inflationary pressure. Some might say there won’t be high inflation since we are having low inflation now, but at the moment we pass the natural rate of unemployment, say 5.5 percent, the inflation will be back to the level of normal times.

When making decision of pursuing a low level of interest rate even after the unemployment rate reaches natural rate, the Fed policy makers should calculate the risk of increasing inflation.

Fed Policy Recommendation Continues

In his Monday’s article on Wall Street Journal, Martin Feldsetin writes about how the Fed isn’t showing its strategy if sudden inflation surge comes when the economy gets fully out of the recovery. Feldstein, a professor of economics at Harvard and a former chairman of Council of Economics Advisors under Raegan, is known for being inflation hawk all the way back to 2009. According to him, Fed policymakers should inform about what they can do with their monetary tools if there ever will be an inflation hike in the process of the recovery in their guidance statement. He then explains possible monetary tools the Fed can utilize to fight against inflation. His recommendation includes increasing fed funds rate, increasing interest rate on reserves,  using reverse repurchase program and increasing required reserve in the banks. He believes all of this policies may not be sufficient or politically possible task to do for the Fed.

Then Paul Krugman mocks Feldstein’s being pre-hawkish on his Tuesday blog post.  Krugmans sums up Feldstein’s article in the post:

 The point is that this has to be one of the weakest policy arguments I’ve ever seen: Arguing that the Fed should shy away from doing all it can to create jobs because you’re afraid that at some point in the future Fed officials will be insufficiently hawkish because they’re afraid that people will make fun of them.

To me, Krugman clearly doesn’t see the main point of Feldstein’s article. Feldstein says simply that the Fed should be saying what it will be doing if inflation comes from let’s say nowhere. But Krugman interprets it as Feldstein was being hawkish and recommending the Fed to stop expansionary monetary policy as soon as possible.

Feldstein’s recommendation that the Fed should be guiding the market on what it will and can do under the pressure of inflationary period is interesting and actually might be good add-on to their forward guidance for the Fed policymakers because:  by simply reminding the market that there still could be some possibility of inflation hike (however small this possibility is) and showing off their guns and ammo for inflation hike, the Fed could raise public’s inflation expectation.

If the Fed does what Feldstein suggest and includes possibility of higher inflation, the market’s inflation expectation can be shifted because of the Fed’s being pre-hawkish. Increasing market inflation expectation is exactly what the Fed has to do right now when PCE inflation index has been under the Fed’s inflation target of 2 percent for 21 straight months. Moreover, the current doubt that the Fed might be targeting 2 percent inflation as an upper limit for the target, not target, could be cleared if the Fed leaves some room for inflation raise possibility on its statement.

 

ABC for Investing in Stock Market from Malkiel

Having no prior basic knowledge of how stock market is driven and how investors make decisions in the Wall Street, I must say I enjoyed reading “A Random Walk Down Wall Street” by Burton Malkiel. The most interesting and eye-opening part of the book is when he talks about two type of analysis of stocks: technical analysis and fundamental analysis.

How I briefly explain them to someone who has little knowledge of the stock market is following:

Technical analysis: a way of choosing a certain stock to buy or sell based solely on the recent movements of the stock price on the chart. Technical analysts would suggest you to buy a stock if the stock has recent history of upward price movement and sell it if the stock has already started declining.

 

Technical analysts believe that there is momentum in stock price movement and if you can get in and get out of the momentum at the right time, you can make profit by trading stocks, They rationalize their strategy by followings:

-crowd instinct of mass psychology sustains started momentum

-first movement in price often results from insider getting information about the company before the market

-investors tend to be initially less responsive to new information

On the other hand, critics of technical analysis  would say that history of stock price cannot tell you how it will behave in the future. In other words, they claim that the stock price movement is a random walk. A random walk means that  you can’t predict future returns based on past returns.

Malkiel gives examples of technical trading rules such as the filter system, the Dow theory, the relative-strength system. and others. But one thing to take away from his this section is that, according to his research, all of these techniques are showed to be not more profitable than just a buy-and-hold strategy.

However, we can see prolific investors who made wealth out of stock market by using technical analysis approach. These names include James Simons of Renaissance Technologies, Ray Dalio of Bridge Water Associates and Steve Cohen of S.A.C Capital. Of course, they are few of technical analysts who managed to beat the market with their secret technical trading strategies. Above article writes down what these famous managers have common:

  • Mechanical trading models were used my many of the most successful.
  • They all used clearly defined systems and stuck to their rules.
  • Many of them back tested their ideas before implementing them in the real market.
  • Most of them surrounded themselves with exceptional people who had the expertise they needed.
  • Many of them lost money for the first few years before hitting their stride.
  • Each trading system suited their personality.

Fundamental analysis: an approach to choose which stocks to buy and sell based on whether a stock’s foundation value is higher or lower than the market price. When they value a stock, they study how the companies will perform in the future, how much will earnings and dividends be, and how long this sustained growth will continue. In other words, unlike technical analysis, fundamental analysts actually do hand-on research on a company and an industry it is in to forecast its earning and growth for coming years. The fundamentalists focus on four main determinants to get real value of the company:

-the expected growth rate

-the expected dividend payout

-the degree of risk

-the level of market interest rates

The last determinant, the market interest rate, is interesting for current period since the market interest rates have been at their historic low levels. Therefore, according to the fundamentalists, the value of stocks should be increasing.

As there were critics of technical analysis, critics of fundamental analysis say that:

-the information on which the fundamentalists base on could be incorrect

-analysts calculation of the value of the stock could be wrong

-the market value of the stock may not converge to its estimated value

Regarding the first point, when there is too much economic uncertainty, firm’s future earning and other related information is very volatile. For this reason, some fundamental analysts changed their approach to technical analysis after 2008.

On the following chapters, Malkiel gives sufficient amount of advice and suggestions for creating a good portfolio for not only beginners but also others. But to me, as a beginner for stock market investing, I learned ABC of investing in stock market in these chapters where he writes about these two ways of analysis.