Question

Charles Dow was the original editor of the Wall Street Journal. He was the originator of​ "Dow Theory," which holds that the prices of transportation​ stocks, such as Heartland​ Express, can predict changes in the price of industrial​ stocks, such as ExxonMobil. An article in the Wall Street Journal refers to Dow Theory as the​ "granddaddy of technical​ analysis."

​Source: Spencer​ Jakab, "Keep on Trucking Despite Dow​ Theory," Wall Street Journal​, July​ 16, 2012.

Dow Theory is considered technical analysis rather than fundamental analysis because it​ _______.

A. requires complicated computer programs to generate its results

B. requires analysis of multiple stocks to generate its results

C. relies on forecasting future profits of firms in order to forecast future stock prices

D. relies on patterns of past stock prices to predict future stock prices

Would an investor be able to earn an​ above-average return on her stock investments by selling industrial stocks whenever she saw declines in transportation stocks and buying industrial stocks whenever she saw increases in transportation​ stocks?

A. ​Yes, the long history associated with this theory illustrates its ability to guarantee​ above-average returns.

B. ​No, this strategy neglects all available information except for past stock prices.

C. ​No, this strategy only focuses on expected future returns and neglects past performance.

D. ​Yes, rational expectations theory predicts that investors employing technical analysis are likely to earn​ above-average returns

​?[Related to the Chapter Opener​] The chapter opener states that​ "many investors who bought stocks in 2000 and held them through 2010 found that they had received a negative real return on their investment over the​ 10-year period." Why would investors have invested in stocks during those years if they received a negative real​ return?

A. Investors may have used rational expectations to predict continued growth in the markets.

B. Investors may have believed the high rate of returns from the 1980s would continue.

C. Investors may have used adaptive expectations to formulate their future stock price forecasts.

D. All of the above.

An article in the Economist noted that while economic growth in China was​ slowing, stocks have more than doubled in value. The article stated that unlike in developed countries where large institutional investors buy the overwhelming majority of the stock​ purchased, in China​ 90% of buying is done by individual investors. It described the demand for stock by these investors as a mania.

​Source: A Crazy ​Casino, Economist​, May​ 26, 2015.

What does the article mean when it describes stock buying by individual investors as a​ mania?

A. Investors are purchasing stock irrationally.

B. Investors are crazy.

C. Investors are enthusiastic about purchasing stock.

D. The demand for stock is incredibly high.

? Individual investors would be More likely to exhibit this behavior than institutional investors.

An article in the Economist in 2016 noted that since​ 2000, an investor in the United Kingdom would have earned a higher return from buying British government bonds than from buying stock issued by British firms. The article concluded​ that: There has been a negative equity risk premium this century.

​Source: Stocks for the Long ​Run? Economist​, January​ 13, 2016.

?Equity premium represents the additional return investors must receive in order to invest in stocks.

?Why might the equity risk premium in the United Kingdom have been negative during this​ period?

A. Banks were paying high interest rates on bonds.

B. The returns on bonds outpaced the returns on stocks.

C. Investors fled to other countries.

D. The returns on stocks outpaced the returns on bonds.

​?[Related to Making the​ Connection] Economist Peter Temin of MIT argues​ that, If the crash of 1929 was an important independent shock to the​ economy, then the crash of 1987 should have been equally disastrous.

​Source: Peter​ Temin, Lessons from the Great Depression​, ​Cambridge, MA: MIT University​ Press, 1989 p. 41.

Which of the following events would be considered important independent shock to an economy​?

A. A stock market crash.

B. The breakout of war in the Europe.

C. Inflation.

D. An increase in the Federal Funds rate.

?What reason might Temin give to support his argument that what happened to the economy following the crash of 1987 is evidence against the crash of 1929 being an important shock to the​ economy?

A. Economic conditions were more severe after the crash of 1929 even though the decline in the market in 1987 was twice as large as the decline in the market in 1929.

B. The market decline in 1929 was twice as large as the market decline in 1987.

C. The market decline in 1987 was twice as large as the market decline in 1987.

D. Economic conditions were more severe after the crash of 1987 because the decline in the market was twice as large as in 1929.

Christina Romer would argue that the impact of the crash of 1929 was more severe because of its effect on consumer confidence as well as the lack of regulations in place at the time.

The business writer Michael Lewis has quoted Michael​ Burry, a fund​ manager, as​ saying: "I also immediately internalized the idea that no school could teach someone how to be a great investor. If that were​ true, it'd be the most popular school in the​ world, with an impossibly high tuition. So it must not be​ true." Do you agree with​ Burry's reasoning?

Source​: Michael​ Lewis, The Big​ Short: Inside the Doomsday Machine​, New​ York: W.W.​ Norton, 2010, p. 35.

A. ​No, according to the adaptive markets​ hypothesis, attempting to beat average market returns is a futile exercise.

B. ​Yes, according to the adaptive markets​ hypothesis, if you could derive an adaptive model to forecast stock​ returns, it is possible to earn infinitely high profits.

C. ​No, according to the efficient markets​ hypothesis, attempting to beat average market returns is a futile exercise.

D. ​Yes, according to the efficient markets​ hypothesis, if you could derive an efficient model to forecast stock​ returns, it is possible to earn infinitely high profits.

[Related to Making the​ Connection] A column in the Wall Street Journal​, asks the​ question: Are capital gains so different from earned income that they should be taxed at a different ​rate?

​Source: Scott Sumner and Leonard E.​ Burman, It Fair to Tax Capital Gains at Lower Rates Than Earned ​Income? Wall Street Journal​, March​ 1, 2015.

What is a capital​ gain?

A. A distribution of profit to investors.

B. The increase in capital from one year to the next.

C. An increase in the price of a stock.

D. A profit from the sale of an investment.

In what way are capital gains taxed differently than salary and wage​ income?

A. Capital gains are adjusted to account for inflation.

B. Salary and wage income is subject to deductibles.

C. Salary and wage income is taxed at a lower rate than capital gains.

D. Capital gains are taxed at a lower rate than salary and wage income.

One economic argument for taxing capital gains differently than other income is that investors have to pay taxes on their nominal gain without an adjustment for inflation.

Answer 1

1. Dow Theory is considered technical analysis rather than fundamental analysis because it​ _______

relies on patterns of past stock prices to predict future stock prices

(Note: Fundamental Analysis is study of historical financials of company to project future financials, whereas Dow theory relies on past price movement to predict future price movement therefore it i known as technical analysis)

2. Would an investor be able to earn an​ above-average return on her stock investments by selling industrial stocks whenever she saw declines in transportation stocks and buying industrial stocks whenever she saw increases in transportation​ stocks?

​No, this strategy neglects all available information except for past stock prices.

(Note: Though the long term history suggests above average profitability, it does not guarantee​ above-average returns because it ignores all the other factors)

3.  The chapter opener states that​ "many investors who bought stocks in 2000 and held them through 2010 found that they had received a negative real return on their investment over the​ 10-year period." Why would investors have invested in stocks during those years if they received a negative real​ return?

Investors may have used rational expectations to predict continued growth in the markets.

Investors may have believed the high rate of returns from the 1980s would continue.

Investors may have used adaptive expectations to formulate their future stock price forecasts.

The answer is All of the above

(Note: All above points talks about possibilities, and all these are valid possible reasons)

4. What does the article mean when it describes stock buying by individual investors as a​ mania?

Investors are enthusiastic about purchasing stock.

(purchasing stock irrationally is obvious because economic growth in China was​ slowing, but the article talks about retail investors who are only excited about investing in security market)

5. Why might the equity risk premium in the United Kingdom have been negative during this​ period?

The returns on bonds outpaced the returns on stocks.

(Market risk premium is excess of market return from risk free return, in this case bond return, and since bond return is higher, there is negative premium for investing in stocks)

6. Which of the following events would be considered important independent shock to an economy​?

The breakout of war in the Europe.

7. What reason might Temin give to support his argument that what happened to the economy following the crash of 1987 is evidence against the crash of 1929 being an important shock to the​economy?

Economic conditions were more severe after the crash of 1929 even though the decline in the market in 1987 was twice as large as the decline in the market in 1929.

8. Do you agree with​ Burry's reasoning?

Yes, according to the adaptive markets​ hypothesis, if you could derive an adaptive model to forecast stock​ returns, it is possible to earn infinitely high profits.

9. What is a capital​ gain?

The increase in capital from one year to the next.

10. In what way are capital gains taxed differently than salary and wage​ income?

Capital gains are adjusted to account for inflation.