Question

1. “Given the recent climb in stocks that cannot be explained by fundamental, a correction is inevitable." -- Interpret the statement and provide current examples.

2. You have noticed that investors tend to invest more heavily in stocks after interest rates have declined. You are considering this strategy as well. Is it rational to invest more heavily in stocks once interest rates have declined?

3. Assume that you are about to select a specific stock that will perform well in response to an expected run-up in the stock market. You are very confident that the stock market will perform well in the near future. Recently, a friend recommended that you consider purchasing stock of a specific firm because it had decent earnings over the last few years, it has a low beta (reflecting a low degree of systematic risk), and its beta is expected to remain low. You normally rely on beta as a measurement of a firm’s systematic risk. Should you seriously consider buying that stock? Explain.

4. You are considering an investment in an initial public offering by Marx Co., which has performed very well recently, according to its financial statements. The firm will use some of the proceeds from selling stock to pay off some of its bank loans. How can you apply stock valuation models to estimate this firm’s value, when its stock is not yet publicly traded? Once you estimate the value of the firm, how can you use this information to determine whether to invest in it? What are some limitations involved in estimating the value of this firm?

5. Assume that you were also asked to manage a portfolio of European stocks. How would your method for measuring your performance in managing this portfolio differ from the U.S. stock portfolio in the previous question?

Answer 1

Q-1) The correction is inevitable means that when the stock prices are rising, it is normally during the time of economic boom when economy is doing very well and the sentiments in the market is very positive and the even the company which does not have good fundamental, their stock price are rallying. This happens because when the stock price go up, more people buy that stock and price continue to rise but if the fundamentals of the company are not strong enough then after a certain point investors will realize that the company stock is not worth that and then they start to sell their position and when some large investors will sell their position then small investors will also have to do that or bear loss, so eventually the stock price will fall to a level where the intrinsic value of the stock should be and this is known as correction in the market. If the stock price is not supported by the fundamentals and beyond a certain price correction will happen.

Take the example of companies during the internet bubble and e-commerce companies. Everyone was investing in these companies because they were said to be the future industries but those company were burning cash far more than generating return for investors. Prices continued to rise but beyond a point when investors started to sell their stock, most of those company’s stock prices collapsed.