Contributions in Global Financial Theories

Contributions in Global Financial Theories

Dow Theory

The foundation of today's analysis or more precisely what we say Technical Analysis is the 100 year's old Dow Theory which was presented by Charles H. Dow, a famous journalist of his time. Born in 1851, Charles Dow was the founder of the famous Journal named “Wall Street Journal”. Dow Theory was never formally presented by Charles Dow himself in his life. Thought later on after his death his several followers and associates expanded the theory and was formulated from different Wall Street Journal publications and articles that were written by Charles Dow. Dow Theory was about the stock market behaviors and the measurement of the health of the business environment.

Contributions of Dow's Theory

Some of the most important contributions to Dow Theory were William P. Hamilton's "The Stock Market Barometer" (1922), Robert Rhea's "The Dow Theory" (1932), E. George Schaefer's "How I Helped More Than 10,000 Investors to Profit in Stocks" (1960) and Richard Russell's "The Dow Theory Today" (1961).

In the theory it is described that as whole stock market is a reliable way to measure the overall business conditions prevailing within the economy. And by analyzing the market those conditions can be accurately gauged and identified that are market trend setters. The famous Dow Jones Industrial Index and Dow Jones Rail Index which is now known as Dow Jones Transportation Index were created by Dow with the help of this theory. Dow felt that these indices will provide accurate reflection of the business environment with in the economy, because they will cover two major segments. Though over the last 100 years, there have been lot of changes in the indices but still this theory applies in the current market indices.

There was a simple logic behind the theory. The industrial companies were engaged in the manufacturing of goods and the rail companies were responsible to deliver them. When one average recorded a new Secondary or Intermediate high, the other average was required to do the same in order for the signal to be considered valid.

Business Cycles

Business Cycles will be from 40 to 60 years and has the average life of about 50 Years. A Russian economist Nikolai Dmitriyevich Kondratiev, presented these business cycles. According to him these cycles will have boom and recession. He developed these cycles after a long historical review and intense study of different market trends and proposed that economy had cycles that it goes at the top and then it has to go down as well. These cycles were later known as “Kondratieff Cycles”. It consists of four phases that he called:





Currently economy is facing a severe recession and all the investments are on hold. In fact investors are trying to save their already invested money. So if we look at this theory then its in the 2nd phase. And if the proper planning and policies were not developed then it can go to fourth phase which is depression. World has already scene a Great Depression after World War 2 and is not in a position to see another depression. It will be disastrous for the economy and especially for the third world countries.

Creative Destruction

Joseph Schumpeter was the first which introduced the term creative Destruction in his theory. He was an Austrian School economist. He believed that innovation is a factor which changes the economy of the world. In Schumpeterian vision , entrepreneurs was the force that sustained long term economic growth, even as it destroyed the value of establish companies that some degree of monopoly power. In Schumpeter's approach, dynamic aspects of economic activity such as innovation and development are closely linked to the creation of money in the form of credit. Schumpeter regards credit creation by banks as the main source of finance. Schumpeter emphasized that the reflected value of money is rarely proportionate to the quantity of money because variations in latter often imply variations in relative prices and redistribution effects.

Though Schumpeter's wrote many books, but the most popular book is “Capitalism, Socialism and Democracy”. This book opens with a treatment of Karl Marx. His theory somehow agrees with Marx`s theory in which Marx`s says that capitalism will collapse and it will be converted to socialism, Schumpeter also said that it is not necessary that this will happen as Marx`s stated in his theory. To describe it he borrowed the phrase "creative destruction," this phrase became very famous and by saying that the old ways will be replaced with new ones and we will see changes in economy.

Efficient Market Hypotheses

A generation ago, the efficient market hypothesis was widely accepted by academic financial economists. It was generally believed that securities markets were extremely efficient in reflecting information about individual stocks and about the stock market as a whole. The accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay. Thus, neither technical analysis, which is the study of past stock prices in an attempt to predict future prices, nor even fundamental analysis, which is the analysis of financial information such as company earnings, asset values, etc., to help investors select undervalued stocks, would enable an investor to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks with comparable risk.

The efficient market hypothesis is associated with the idea of a random walk, which is a term loosely used in the finance literature to characterize a price series where all subsequent price changes represent random departures from previous prices. The logic of the random walk idea is that if the flow of information is unimpeded and information is immediately reflected in stock prices, then tomorrow's price change will reflect only tomorrow's news and will be independent of the price changes today. But news is by definition unpredictable and, thus, resulting price changes must be unpredictable and random. As a result, prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts.

After the fact, we know that markets have made egregious mistakes as I think occurred during the recent Internet bubble. Nor do I deny that psychological factors influence securities prices. True value will win out in the end. And before the fact, there is no way in which investors can reliably exploit any anomalies or patterns that might exist.

The efficient-market hypothesis was developed and presented by Professor Eugene Fama at the University Of Chicago Booth as an academic concept of study through his published Ph.D. thesis.

Efficient-market hypothesis (EMH) asserts that financial markets are "informational efficient", or that prices on traded assets like; stocks, bonds, or property already reflect all known information, and instantly change to reflect new information. In this theory Prof. Eugene says that it is impossible to keep the market in control or change the trends of the market by spreading fake news or information in the market except the luck. Information or news in the EMH is stated as a thing which may affect the market prices in future or in any unknown time period. There are three common forms in which the EMH is commonly stated i.e. Weak-form, Semi-strong-form and Strong-form. Each of which has different implications for how markets work.

The recent global financial crisis has strongly opposed the EMH theory and many negative reviews against it. Market strategist Jeremy Grantham has stated very clearly that the current financial crisis is due to this EMH theory and this theory made financial leaders to have a "chronic underestimation of the dangers of asset bubbles breaking", this statement states that global markets are not that much efficient and EMH should be scrapped and this theory should not be further discussed due to many negative impacts of this theory in this recent global economy effect.

Economic Recession and Its Prediction

It was the mid of 2007 when the world turned around. The economy was at its boost. The firms were earning lot of profits. The Multinational Corporations grew even bigger and the small firms were also earning a handsome amount of profits and were very happy with that and thinking to grow further. Every sector of economy was at its best. Businesses were growing and the life standard of an individual was improving day by day. But this economy boost made the economist and the governments and financial institutions forgot that a business cycle has its own importance. If there is a boom then there is a recession or slow down as well. At the mid of July 2007 an event happened that the investors in the mortgage securities in United States were not so confident and began to lost confidence in the market. This caused a big crisis in the economy. But for the sake of balancing this loss the central banks of United Kingdome, United States and European central bank invested huge amount in the stock markets. But this spread a huge credit risk in the economy and this got even bigger and bigger and the stock markets began to be affected. This grew even bigger and the big stock markets of the world crashed and the crisis spread all across the globe like cancer. The investors totally lost their confidence. Moreover the bankruptcy of the top bank of USA, The Lehman Brothers bankruptcy gave this fire more strength.

Well this global economic recession was well predicted by many of the economists and financial analysts but the issue is that at the time of profits no one wants to look at the possible consequences of losses. At that time every one thinks that this will increase only and the profits and market prospects indicates that the business has more potential and there are lot of markets to expand so there is no chance of economical slow down. But the issue is that the real infected entity of this global economic recession is the poor person, means a small investor/small businessman. The actual responsible people for this economic recession are still safe. The poor policies and following the obsolete theories was the major cause of this economic slow down. There were some instruments and products in financial system that were very complex and became even more complex with the passage of time. Those systems failed and that caused the severe economic recession and this is predicted that this will be even more severing in the coming year.

Keynes was a famous and popular economist of the last century. He believed that if the markets are given full freedom i.e. no government intervention, could lead to the severe destruction of the global economy. To mitigate the worst effects of the business cycle he proposed various ideas and certain monetary steps. These were the role model as it worked in the previous depression. But those were not followed and the imposition of ideas and systems of the influencing government continued. And that lead to the severe economical recession.

The history shows the depression eras that world has seen. In 1873 the depression was of almost same type that started with a bankruptcy and the whole economy collapsed. The strong measures should have been taken by so called think tanks and there should have been a strategy of dealing with such kind of crisis. This economic crisis could have been prevented if the investors and shareholders would have been educated to properly foresee the market and its prospects. In the current financial markets rumors are the driving force of investment in the market. The big investors control the whole market. They may spread a rumor and the whole investments stops and then those big investors buy the stocks when the prices come down and then resell it when the prices come back to its original level.

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