Page 122 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 4: Fundamental Analysis

Notes
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Caution Forecasting based solely on leading indicators is a hazardous business. One has to
be quite careful in using them. There is always a time lag it with result that interpretation
can be erroneous, if it is not done well in advance. Interpretation even if performed
meticulously, cannot be fruitfully utilized. Further, problems with regard to their
interpretation exist as well. Indicators are classified under the broad category of leading
indicators. Their various measures may emit conflicting signals about the future direction
of the economy; the use of diffusion index or composite index has, thus, been suggested.
This deals with the problem by combining several indicators into one index in order to
measure the strength or weaknesses of the problem by combining several indicators into
one index in order to measure the strength or weaknesses of a particular kind of indicator.
Care has to be exercised even in this case as diffusion indices are also without problems.
Apart from the fact that its computations are difficult, it does not eliminate the varying
factors in the series. Despite these limitations, indicator approach/diffusion index can be
useful tool in the armoury of a skilful forecaster.

Did u know? What is the role of money supply in determining stock prices?
Analysts have recognized that money supply in the economy plays a crucial part in the
investment decision per se. The rate of change in the money supply in the economy affects
the GNP, corporate profits, interest rates and prices. Accordingly, monetarists argue that
total money supply in the economy and its rate of change has an important influence the
stock prices as a hedge against inflation, and in creases in stock prices sometimes.

Diffusion Index

1. A diffusion index is an indicator of the extensiveness or spread of an expansion or
contraction.
2. It has been developed by the National Bureau of Economic Research, USA.
3. There are two main categories of diffusion index

(a) Composite or Consensus Index: It combines several indicators into one single measure,
in order to measure the strength or weakness in the movements of these particular
time series of data.
For instance, there are ten leading indicators; out of them four are moving up and
others are not. How do we interpret it?
No. of members in the set in the same direction
Diffusion Index =
Total no. of members in the set
In the example, diffusion index = 4/10 = 0.4
Next month, if the index moved to 0.6, it certainly is a strong confirmation of
economic advance.
(b) Component Evaluation Index: This is a narrow type of index, one that examines a
particular series taking into consideration its components. It measures the breadth
of the movement within a particular series.

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