Final)

AN ECONOMIC ANALYSIS
OF FACTORS AFFECTING SOUTH AFRICAN EQUITY RETURNS
By
JUSTIN BEUKES
Submitted in partial fulfilment of the requirements for the degree of
Baccalaureus Commercii Honores (Economics)
IN THE FACULTY OF BUSINESS AND ECONOMIC SCIENCES
AT THE NELSON MANDELA METROPOLITAN UNIVERSITY
Supervisor Mrs. D. Du Preez
JANUARY 2009
I
ACKNOWLEDGEMENTS
I would like to express profound gratitude to the following individuals for their
involvement in this dissertation:
 Deborah Du Preez, my supervisor, for her continued support throughout the year.
Thank you for helping me through a difficult year. Without you, this would not have
been possible.
 Mario Du Preez, for being willing to always give a hand. Your guidance on the
proposed topic was invaluable. Your enthusiasm in economics also rubbed off on me.
 Leann Cloete, for being all that a friend can ask for. You did not once doubt my
abilities.
 Marius Wolmarans, for having a big impact on my life. Thank you for steering me in
the right direction.
 I am as ever, especially indebted to my family. Thank you for the love, support and
counsel I could not do without.
II
EXECUTIVE SUMMARY
The efficient market hypothesis declares that the efforts of investors who attempt to
gain returns on share markets is futile. The current price of a share is said to reflect all
available information (Fama 1970) and that analysing available information with the
goal of earning a return will be unsuccessful.
Nonetheless, share price valuation has sought much attention because of the potential
gains to be realised by investors. The search for ways of reading the share market has
brought about two different approaches to share price valuation, namely, technical and
fundamental analysis. Technical analysis is a short term approach to valuation and is
the study of the action of the market (Edwards & Magee 2001: 4). That is, only the
prices of the companies concerned are studied ignoring forces outside the market.
Fundamental analysis is the second approach to share price valuation; it is basically
the study of value (Bodie et al., 2008: 569). A company’s value is determined by
examining virtually every aspect possible. The macroeconomy is one aspect that is
evaluated in order to determine the company’s macroeconomic environment.
This relationship, however, between certain macroeconomic variables and share

prices is not well established. There is no generally accepted asset pricing model to
explain this link (Asprem 1989). This is particularly the case for South Africa’s
Johannesburg Securities Exchange (JSE), as research on the JSE is limited.
The dissertation takes on a fundamental approach instead of a technical one to share

price valuation, to see whether fundamentals drive the JSE. It examines the
relationship between four macroeconomic variables and the JSE. The variables
considered are real activity, proxied by real GDP growth, the exchange rate as proxied
by the real effective exchange rate, inflation expectations as proxied by inflation
expectations for one year ahead, and the interest rate as proxied by the prime overdraft
interest rate.
An empirical analysis was carried out in order to determine if any of these four
variables help explain movements in the JSE All Share Index (ALSI).
It was hypothesised that an increase in real activity results in higher earnings and
therefore an increase in the ALSI, a depreciation of the currency improves firm’s
III
competitive position, thus increasing earnings and consequently increasing the ALSI,
higher inflation expectations are associated with increased interest rates which results
in a decrease in the ALSI, and lastly higher interest rates would lead to higher returns
through higher than usual short term inflows, thus improving the performance of the
ALSI.
The resultant model had some problems, i.e. it suffered from serial correlation. It
could not , however, be corrected for, as serial correlation still existed after running
the generalized least squares (GLS) equation using the AR(1) method.
Another attempt to correct for serial correlation was to re-specify the equation,
lagging the ALSI by one period and substituting inflation expectations for one year
ahead with current inflation expectations. This did not, however, solve the problem of
serial correlation and made all the variables insignificant. The initial regression was
thus reported on.
It was found that inflation expectations and the interest rate were statistically
significant variables in helping to explain movements in the ALSI. The other two,
namely GDP growth and the exchange rate were found to be insignificant.
Further research should thus be undertaken in order to identify possible significant

variables that will help to give investors a better understanding of the movements in
the ALSI, using the fundamental approach to share price valuation.
IV
LIST OF TABLES
Page
Table 2.1: Comparison of industry profitability ratios in South Africa

(2004 - 2005) 16
Table 3.1: Variables used in estimation 27
Table3.2: Regression output of equation 3.2 30
Table 3.3: Unadjusted R-squares and VIFs of independent variables 32
Table 3.4: The first-order serial correlation coefficient 34
Table 3.5: Generalized least squares AR (1) method 35
Table 3.6: White heteroskedasticity results 36
V
LIST OF FIGURES
Page
Figure 2.1:Bar chart and Point-and-figure chart 12

Figure 2.2:How resistance forms and How support forms 12
Figure 2.3:Dow Theory trends 14
Figure 2.4:Moving average for Microsoft as of 18 January 2005 15
Figure 2.5:Industry cyclicality 17
TABLE OF CONTENTS
Page
ACKNOWLEDGEMENTS I
EXECUTIVE SUMMARY II
LIST OF TABLES IV
LIST OF FIGURES V
CHAPTER ONE: INTRODUCTION

1.1 INTRODUCTION AND PRELIMINARY LITERATURE REVIEW 1
1.2 MODELS USED FOR PREDICTION PURPOSES 1
1.2.1 Technical Analysis 1
1.2.2 Fundamental Analysis 2
1.2.3 Fundamental Analysis Research 2
1.3 THE MACRO-ENVIRONMENT 3
1.3.1 Real Activity 3
1.3.2 Exchange Rates 4
1.3.3 Inflation Expectations 4
1.3.4 Interest Rate 5
1.4 PROBLEM STATEMENT 5
1.5 OBJECTIVES OF THE STUDY 6
1.6 RESEARCH HYPOTHESES 6
1.7 RESEARCH METHODOLOGY 6
1.8 ORGANISATION OF THE DISSERTATION 7
CHAPTER TWO: ALTERNATIVE APPROACHES TO SHARE

PRICE VALUATION
2.2 INTRODUCTION 8
2.3 THE THEORY UNDERLYING THE EFFICIENT MARKET
HYPOTHESIS 8
2.3.1 The Fair Game Model 9
2.3.2 The Submartingale Model 9
2.3.3 The Random Walk Model 9
2.3.4 The Forms of EMH 10
2.4 ALTERNATIVE APPROACHES TO SHARE PRICE VALUATION 10
2.4.1 Technical Analysis 11
2.4.2 Fundamental Analysis 15
2.4 A FUNDAMENTAL ANALYSIS OF SHARE PRICE VALUATION
IN SOUTH AFRICA 20
2.4.1 Real Activity 21
2.4.2 Exchange Rate 22
2.4.3 Inflation Expectations 22
2.4.4 Interest Rate 23
2.5 CONCLUSION 24
CHAPTER THREE: AN EMPIRICAL ANALYSIS OF SHARE PRICE

VALUATION USING A FUNDAMENTAL
ANALYSIS APPROACH
3.1 INTRODUCTION 25
3.2 DATA SOURCES USED 26
3.2.1 Data Description 27
3.2.2 The Econometric Method of Estimation 28
3.3 AN EMPIRICAL APPROACH TO SHARE VALUATION
USING FUNDAMENTAL ANALYSIS 29
3.3.1 Model Structure 29
3.3.2 Presentation and Analysis 30
3.3.3 The Overall Fit of the Estimated Model 31
3.3.4 Violations of the Classical Linear Regression Model 31
3.4 CONCLUSION 37
CHAPTER FOUR: CONCLUSION

4.1 INTRODUCTION 39
4.2 GENERAL FINDINGS 39
4.3 CONCLUDING REMARKS 40
LIST OF SOURCES 42
CHAPTER ONE: INTRODUCTION
1.1 INTRODUCTION AND PRELIMINARY LITERATURE REVIEW
Conventional wisdom in economics suggests that share price changes are highly
unpredictable. This unpredictability is mainly caused by the fact that the fundamental
operation of the share market is very well understood. In essence, share prices exhibit
a random walk – this means that if shares did well last week, they are no more likely
to either do well or do poorly this week than at any other time. This so called random
walk is perceived by economists to be an indication of market efficiency and is
termed the efficient market hypothesis (EMH).
Market efficiency is theorised in three forms, namely, the weak, the semi-strong and
the strong. The weak form claims that share prices reflect all information from the
past, and thus an investor cannot predict future share prices on the basis of past share
prices. The semi-strong form argues that all publicly available information is already
represented in the share price; this information includes the quality of management,
fundamental data on the product, and so forth. This information cannot be used for
predictive purposes either. Finally, the strong form states that share prices reflect all
available information i.e. even unpublished information, and this (insider) information
cannot be used for predictive purposes (Bodie, Kane & Marcus 2007: 246) .
Notwithstanding the unpredictable nature of share prices, economists and those

intimately involved with share markets, still require processes or procedures to
explain and predict share market behaviour.
1.2 MODELS USED FOR PREDICTION PURPOSES
In the search for predictive models of share prices, two alternative models have come
to the fore, namely, fundamental analysis and technical analysis.
1.2.1 Technical Analysis
Technical analysis is basically the making and interpretation of share charts where the
analysis of averages and moving averages of share prices takes place. Technicians
study records of past share prices in order to find patterns they can profit from in the
1
future. They believe the market is 10 percent logical and 90 percent psychological.
They subscribe to the castle-in-the-air theory. This theory suggests that the crowd of
investors is likely to build their hopes during times of optimism into castles in the air.
The technician attempts to anticipate the crowd behaviour and thus buy before the
crowd makes their move (Malkiel 2003: 127).
1.2.2 Fundamental Analysis
In fundamental analysis, investors believe the market is 90 percent logical and 10

percent psychological. This model is based on the firm-foundation theory; the value
of a share is based on the present value of all future dividends. This value is known as
the intrinsic value. If the intrinsic value is greater than the quoted price the investor
should buy (Malkiel 2003:127). Fundamental analysts start their analysis with a study
of past earnings. In addition, an analysis of the management, the firms’ position in the
industry, and the prospects of the industry are taken into account (Bodie et al.,
2007:247). Fundamental analysts attempt to take all factors into consideration that
affect share prices, both firm specific and those pertaining to the macro-economy.
1.2.3 Fundamental Analysis Research
Asset prices are often thought to react to fluctuations in macroeconomic variables.

Returns on shares have a complicated relationship to macroeconomic variables.
Accordingly, research has being undertaken to understand this complexity.
Previous research by Solnik (1984: 69), was undertaken to find a correlation between
monetary variables and share prices. Variables considered were, interest rates,
inflation and the exchange rate. According to Solnik, the specific influence of
international monetary variables such as exchange rates is weak in comparison to
domestic variables such as changes in inflation expectations and interest rates. This
suggests that domestic variables are more influential.
Asprem (1989: 590) investigates the relationships, in ten European countries, between
the countries’ respective major share index and various macroeconomics variables.
This research showed that changes in share prices are positively correlated to certain
measures of real economic activity. These measures included a) industrial production,
b) real gross national product, c) gross capital formation, and d) exports. Positive
correlations were shown to exist between changes in the share indices and the United
2
States yield curve, as well as the M1 monetary aggregate and lagged values of share
indices themselves. Negative correlations are found between changes in share indices
and employment (a measure of real activity), the exchange rate, imports, inflation and
interest rates.
1.3 THE MACRO-ENVIRONMENT
Based on work done by Asprem (1989), the macroeconomic variables considered in

this dissertation include: a) real activity, b) exchange rates, c) interest rates and d)
inflation expectations.
1.3.1 Real Activity
In fundamental analysis, the constant growth model, also known as the Gordon
growth model, is used in calculating the intrinsic value of a firm. Value is based on
the future series of dividends that grow at a constant rate. Given a dividend per share
that is payable in one year, the required rate of return , and the assumption that the
dividend grows at a constant rate in perpetuity, the model solves for the present value
of the infinite series of future dividends (Howells & Bain 2005: 347).
Asprem (1989: 593), who assumes rational markets, suggests that asset prices should
reflect expectations of these future earnings, which are inclined to be influenced by
measures for real activity.
The perceptions of investor’s on future dividends must be responsive to changes in

the outlook for the economy as a whole. The movement from boom to recession, for
example, will lead to a demoted perception of dividend forecasts. Thus in the Gordon
growth model, this will lead to a reduced dividend in the numerator, and therefore a
downgraded present value.
The business cycle represents different levels of real activity. The different stages of
the cycle will exhibit differing levels of performance. In an expansionary phase,
performance will be greater, and expectations of future earnings thus increase. The
opposite is true for a recession, where expectations will be lower (Bodie et al., 2005:
577).
3
These expansionary phases can be accounted to market growth, thus the gross
domestic product (GDP) growth rate will be used as a measure of this growth or
increase in real activity.
1.3.2 Exchange Rates
According to Phylaktis and Ravazzolo (1998), the adoption of more flexible exchange
rate regimes by developing countries has increased the volatility of foreign exchange
markets and the risk associated with such investments. The choice of currency
denomination is an important dimension in the overall portfolio decision of the
investor. Exchange rates volatility also affects real activity in that it changes the prices
of imports and exports.
A depreciation of a currency improves the competitive position of domestic

industries. The earnings of an export or international firm will increase when the
currency depreciates, as domestic goods will be cheaper relative to other international
goods (Asprem, 1989: 596). However, domestic firms that need to import capital
equipment will experience a negative impact on their share prices.
Any investor should be concerned about how their domestic capital market reacts to
international monetary disturbances such as exchange rate fluctuation. Solnik (1984:
71) maintains that the international investor who uses his home currency to value his
portfolio measures return as the sum of his assets’ return, in local currency, plus any
currency movements. The portfolio thus bears both market and currency risk. Leaving
market risk aside by way of diversification, the investor still needs to pay attention to
reactions of share prices to fluctuations in the currency of measure.
It is thus expected that a negative relationship exists between exchange rates and
share prices, due to the impact on domestic industries.
1.3.3 Inflation Expectations
The higher inflationary expectations are, the more likely one’s real returns on share
investments are going to be negatively affected.
Higher inflationary expectations also bring about higher interest rate expectations.
Central banks are generally forward looking in the application of monetary policy,
implying that if they expect higher inflation in the future, then they will apply
4
restrictive monetary policy today. This usually involves an increase in the interest
rates. Indirectly, inflationary expectations in most cases, leads to increases in interest
rates, which generally suppresses share market performance.
1.3.4 Interest Rate
The most considerable source of market wide influences can be contributed to interest
rates or expectations of interest rates. The required rate of return in the denominator of
the Gordon growth model is the sum of a risk-free rate and a risk premium derived
from the market’s current pricing of risk in general and the firm’s relative risk
characteristics. An official change in interest rates causes a change in the risk free rate
which will cause the required rate of return to change. An increase in the denominator
caused by increased interest rates will reduce the present value of the shares in
question; the opposite is true for a decrease (Howells and Bain, 2005: 356).
However, investors consider how much interest can be earned in all investment
opportunities (Malkiel 2003: 112). The risk free rate provides a base for all risky
assets. Once the interest rate changes the opportunity cost for investors in equity
markets changes (Asprem 1989: 598).
Interest rates are thus expected to be positively related to share prices according to the
opportunity costs investors undertake.
1.4 PROBLEM STATEMENT
Investors are observers of numerous factors that might affect return on equity. Returns
on shares have a complex relationship with macroeconomic variables. Thus there is no
consensus on a generally accepted asset pricing model that explicitly takes economic
variables into account (Asprem, 1989: 589).
This complex linkage of macroeconomic variables when related to shares on the

Johannesburg Securities Exchange (JSE) has not found much attention. Research on
this topic with regards to the South African equity market is thus limited. A model
needs to be developed to explain macroeconomic variations in share prices on the JSE.
5
1.5 OBJECTIVES OF THE STUDY
(a) Primary objective:
The primary objective of this work will be to research the link between certain
macroeconomic variables and share prices on the JSE.
(b) Secondary objective:
The secondary objective is to provide a simple and useful model that can be used by
investors and prospective investors in the South African equity market, to predict the
general movement of future equity returns.
1.6 RESEARCH HYPOTHESES
The following hypotheses will be tested:
 Increased real activity in the form of GDP growth results in higher earnings and
therefore an increase in the JSE All Share Index (ALSI).
 An expected depreciation in the exchange rate places domestic firms in a greater

competitive position, owing to cheaper exports, thus increasing earnings and
therefore increasing the ALSI.
 Higher inflation expectations will have a negative impact on the ALSI.
 Investors see a chance of higher returns with higher interest rates thus boosting the
short term inflows and increasing the ALSI.
1.7 RESESEARCH METHODOLOGY
Data will be obtained through secondary sources using the following methods:
(a) Historical method:
This involves obtaining data from published sources such as journals, research
reports, articles and the internet.
(b) Analytical method:
This involves the drawing up of an econometric model to establish statistical

relationships between the ALSI and certain macroeconomic variables investigated.
6
1.8 ORGANISATION OF THE DISSERTATION
Chapter two presents a literature overview, which explains both technical and
fundamental analysis. Fundamental analysis is further expanded on with regards to the
four factors considered, namely, real activity, exchange rates, inflation expectations
and interest rates. Chapter three entails an econometric analysis of the correlation
between the considered factors and the ALSI. Chapter four involves an overall
conclusion and highlights key points from each section.
7
CHAPTER TWO: ALTERNATIVE APPROACHES TO SHARE PRICE
VALUATION
2.1 INTRODUCTION
The potential gains which the share market holds to those who read it correctly are
colossal; then again, the potential losses to those who don’t can be severe. It has
drawn people from all walks of life in an endeavour to reap these enormous gains
(Edwards & Magee, 2001: 3). The share market has been extensively studied in
finding a way to predict share price behaviour. Early research on share prices could
find no predictable patterns (Kendall 1953). Prices seemed to behave randomly; there
was no economic rationale to explain this until the development of the efficient
market hypothesis (EMH). The EMH explained the random movement in prices as the
result of a well operating market (Bodie et al., 2008: 357). Despite this theory of
market efficiency, two divergent approaches to predicting share prices have evolved,
namely, technical analysis and fundamental analysis.
The purpose of this chapter is to expand on the EMH and the two approaches
mentioned above, and give a more comprehensive explanation of each. The grounding
theory of the EMH is illustrated by Fama (1970) in three models namely, a) the Fair
Game model, b) the Submartingale model and c) the Random Walk model. The
differing versions of the EMH are explained by Bodie et al. (2008). Technical
analysis will be divided into two areas, according to Teweles and Bradley (1982:
373), namely; a) patterns on price charts, and b) trend-following methods.
Fundamental analysis is explained by Bodie et al. (2008) using macroeconomic and
equity analysis. Lastly, macroeconomic factors based on work done by Asprem
(1989), namely: a) real activity, b) exchange rates, c) interest rates and d) inflation
expectations, are applied to share price valuation in South Africa.
2.2 THE THEORY UNDERLYING THE EFFICIENT MARKET HYPOTHESIS
The EMH plays an important part in financial economic literature. An asset market is
said to be efficient if the asset price reflects all information. If this is true, investors
are wasting their time in an attempt to earn abnormal returns.
8
Fama (1970) suggested the following models for testing stock market efficiency: the
Expected Return or Fair Game model, the Submartingale model, and the Random
Walk model.
2.2.1 The Fair Game Model
The fair game model states that investors cannot achieve above average returns based
on historic information because such information is fully integrated into the share
price (Bhatti et al., 2006: 230). Fama (1970: 384) defines more exactly what is meant
by the term “fully reflected”. He hypothesizes that equilibrium prices are generated in
a two parameter world. These prices are conditional on some information set, and the
equilibrium expected return on a share is a function of its risk. This information is
fully utilised in determining equilibrium expected returns i.e. “fully reflected”.
Furthermore, the model hypothesises, that expected profits or returns in excess of
equilibrium are a fair game with respect to this information set. What is meant by
“fair game” is that expected profits or returns are zero.
2.2.2 The Submartingale Model

This model is similar to the fair game model, but the dissimilarity is that the expected
return is positive. Prices are expected to increase over time. Returns on investments
are expected to be positive due to the risk involved in capital markets. The expected
value of next period’s price, as forecast on the basis of the information set, is equal to
or greater than the current price. If the expected value of next period’s price is equal
to the current price, then the price sequence follows a martingale (i.e. zero expected
return) (Fama 1970:386).
2.2.3 The Random Walk Model
Two hypotheses constitute the random walk model. Firstly, the statement that the
current price of a share “fully reflects” available information is assumed to imply that
successive price changes are independent. Secondly, it is assumed that successive
price changes are identically distributed (Fama 1970: 387). The random walk model
states more than the fair game model. The fair game model states that the mean return
of the next period is independent of the current information set, however, the random
9
walk model, in addition, states that the entire distribution is independent of the current
information set.
2.2.4 The Forms of EMH
The EMH can now be described in more detail in accordance with the available
information that is reflected in the price. Fama (1970: 383) classified the information
set into three groups and put three forms of EMH forward, depending on the
definition of the relevant information set. These three forms are the weak, semi-strong
and strong forms.
The weak form hypothesis is the lowest form of efficiency. It maintains that share
prices already reflect all information that can be obtained by examining market
trading data, for example, past prices and trading volume. This form implies that past
data cannot be used for predictive purposes (Bodie et al., 2008: 361). The information
set applicable in the semi-strong form is publicly available information. This
information includes, in addition to past prices; annual reports, quality of
management, interest rates, information on money supply and the exchange rate, to
name a few. Consequently, investors are unable to reap superior returns from
analysing this data available to the public (Bodie et al., 2008: 361). The strong form is
concerned with whether given investors or groups have monopolistic access to any
information relevant to price formation (Fama 1970: 383). This version of the
hypothesis is extreme in that both private (inside information) and public information
is reflected in the price (Bodie et al., 2008: 361).
2.3 ALTERNATIVE APPROACHES TO SHARE PRICE VALUATION
The two different approaches to share price valuation include technical and
fundamental analysis. These theories have been put forward despite the EMH, which
states that both past and public information cannot be used for predicting future share
prices. Technical analysis is concerned with the market and the reading of charts (i.e.
past information), whereas fundamental analysis takes a scope of variables that lie
outside the market into account (i.e. public information).
10
2.3.1 Technical Analysis
Technical analysis is the study of the action of the market and ignores the study of the
goods in which the market deals (Edwards & Magee 2001: 4). In contrast,
fundamental analysis looks carefully at fundamental economic and political
conditions – forces inside and outside of the market. Technicians do not reject the
value of fundamental information, but believe prices only gradually close in on
intrinsic value (Bodie et al., 2008: 407). Technical analysts, primarily, are short run
traders and only seek capital gains. The technical approaches of patterns on price
charts and trend following methods, will be discussed below (Teweles & Bradley
1982: 372).
Patterns on Price Charts
Among the most oldest and popular approaches is the use of patterns on price charts.
Chartists believe that patterns repeat themselves and that charts can be used to
forecast significant price movements (Teweles & Bradley 1982: 373). Charts are used
to record historical movements of share prices and to forecast future movements
(Badger & Coffman 1967: 187). The two most commonly used charts are bar charts,
and point and figure charts.
An illustrative comparison of a bar chart and a point and figure chart is given in figure
2.1 for the same price fluctuation and time period. Bar charts indicate time on the
horizontal axis and price on the vertical axis in figure 2.1 (a). Price is represented by a
vertical line for a specified length of time, usually a day. The bar drawn indicates the
price range from high to low. Tick marks are added to indicate the opening and the
close of the market, and the midrange may be specified. Each period is plotted
chronologically from left to right. Additional data may be added that may be of
importance to the trader, such as volume (Teweles & Bradley 1982: 374).
Point and figure charts in contrast, in figure 2.1 (b), take no consideration of time or
volume – they are only designed to indicate price change. Significant changes,
considered by the individual trader, are represented by each box. Increases of this
amount are indicated by an X. Each successive rise is indicated by an X on top of the
previous X. If there is a decrease of the selected amount, an X is entered in the
following column and one box down. This is called a reversal. To make interpretation
11
easier, rises may be indicated by X’s and falls by O’s. Closing prices can also be
blacked in (Teweles & Bradley 1982: 375).
Price
Price
Weeks Weeks
(a) (b)
Figure 2.1: (a) Bar chart (b) Point-and-figure chart (from Teweles & Bradley 1982).
Since technicians are only interested in the action of the market, much analysis is
centered around the interaction between demand and supply for a share. Increasing
prices are indicative of more demand than supply, and decreasing prices indicate the
opposite. Accordingly, a support level is a price at which a considerable increase in
the demand for a share is to be expected, whereas a resistance level is the price where
a substantial increase in the supply of a share develops. At these levels, a relatively
large amount of shares change hands (Badger & Coffman 1967: 198).
Price
Price
(a) (b)
Figure 2.2: (a) How resistance forms (b) How support forms (from Badger &
Coffman 1967).
In panel (a) of figure 2.2, for example, a number of investors may have purchased
shares between R20 and R22. Say the share slips to R18 then recovers to the R20-R22
range. Holders hope the share will rise above R22, but some are happy to get out even
and start to sell when the share hits R22. This liquidation prevents the share from
going above R22, thus R22 forms as a resistance line. Perhaps this pressure from
12
liquidation overwhelms new buying of the share, and the share breaks through the
lower support line. Then this range of R20-R22 (a congestion range) is interpreted as
a resistance level. In panel (b) of figure 2.2, the opposite is illustrated. Buyers in the
range R20-R24 are content with their purchase. When the share drops to R20, buyers
are attracted, and the resistance level of R24 meets sustained pressure. Eventually, the
prices break out on the upside, the area R20-R24 becomes known as a support level
(Badger & Coffman 1967).
Although many statistics books show how to construct charts, none present any
statistics indicating that charts will probably lead to significant profits over time
(Teweles & Bradley 1982: 375).
Trend Following Methods
A great deal of technical analysis is the identification of trends in market prices.

Technical analysts believe that once a trend is established, it is more likely to continue
than to reverse (Teweles & Bradley 1982: 377). This is basically the search for
momentum in market prices. Momentum can be absolute - where a trader searches for
upward or downward price trends, or it can be relative - when an analyst seeks to
invest in one sector over another (Bodie et al., 2008: 407).
a) Dow Theory
Trend analysis has its origins in the Dow Theory, established by Charles Dow. The
Dow theory hypothesises three forces working at the same time on share prices,
namely the primary, secondary and tertiary trend. The primary trend is the long term
change of prices over a number of months to a number of years. The secondary (or
intermediate) trends are brought about by short term deviations of prices from the
underlying trend line. The tertiary (or minor trends) are fluctuations on a daily basis,
which are insignificant (Bodie et al., 2008: 408).
13
Price
.
Time
Figure 2.3: Dow Theory trends (from Bodie et al., 2008).
Figure 2.3 above points out the characteristic components of the Dow Theory. The
primary trend here is upward, the intermediate trend has temporary deviations for a
few weeks and the minor trend has no long run impact (Bodie et al., 2008: 408).
b) Moving averages
The most usual trend following device is the moving average. A moving average adds
a new term periodically, for instance daily or weekly, and at the same time drops the
oldest term, thus recalculating the average per day or week (Teweles & Bradley 1982:
377).
The moving average takes in older and higher prices, thus it will be above current
prices after a period that has been experiencing falling prices. When prices have been
rising, the moving average will be below the current price. A break of the market
price (the irregular curve) through the moving average line (the smoothed curve) from
below, as at point A in figure 2.4, is a bullish signal, as it implies a shift from a falling
trend to a rising trend. The opposite is true for point B, the market line cuts the
moving average line from above and is thus a bearish signal.
The followers of trends must decide on the average lengths of time to utilize and what
events induce market action. The method can be checked with respect to past markets
without risking capital as the device allows them to get out of the market as well as
into it. Traders will profit from a major fluctuation in the market, and not lose much
money before the position is abandoned (Teweles & Bradley 1982: 379).
14
Price (in millions)
Time
Figure 2.4: Moving average for Microsoft as of 18 January 2005 (from Bodie et al.,
2008).
2.3.2 Fundamental Analysis
The alternative method to share price valuation is fundamental analysis. Fundamental

analysis not only looks at the action of the market but also examines variables outside
of the market. The core of fundamental analysis is the analysis of the determinants of
value. Value is analysed at a micro and macro level. Analysis takes place at firm
level looking at the financials and even the personal characteristics of management.
However, the individual firm is tied to the broader economy, and thus
macroeconomics factors can have an influence on its future prospects as well (Bodie
et al., 2008: 569).
Macroeconomic and Industry Analysis
If the fundamental analyst first reviews the macro-economy and the specific industry,
a top down approach is being taken. This approach is a way of evaluating a firm’s
prospects by looking at the bigger picture first. After the macroeconomic influences
are considered, the fundamental analyst examines the firms’ position in the particular
industry (Bodie et al., 2008: 571).
Macroeconomic factors can be organised into demand and supply shocks. Demand
shocks are events that affect the demand for goods and services in an economy,
whereas supply shocks are events that influence production capacity and costs.
Demand shocks usually occur by aggregate output moving in the same direction as
interest rates and inflation, while supply shocks are the converse, with output moving
in the opposite direction of inflation and interest rates (Bodie et al., 2008: 574).
15
Industry analysis, similarly with macroeconomic analysis, is important in evaluating a
firms’ performance, as it is generally impossible for a firm to do well in its industry
when the industry in question is suffering. This importance of selecting the correct
industry is illustrated in table 2.1. The profitability ratio1 for industries in South Africa
for 2004 and 2005 are given. In 2005, the profitability ratio for trade was only 4%
whereas real estate and other business services (excluding financial intermediation
and insurance) was 15%. An investor must choose the correct industry, as profitability
between differing industries can be large.
Table 2.1: Comparison of industry profitability ratios in South Africa (2004 –

2005)
Industry Profitability ratio

2004 2005
Forestry and fishing - 0.10
Mining and quarrying 0.06 0.07
Manufacturing 0.06 0.08
Electricity, gas and water supply 0.10 0.10
Construction 0.03 0.05
Trade 0.03 0.04
Transport, storage and communication 0.05 0.11
Real estate and other business services, excluding financial 0.15 0.15
intermediation and insurance
Community, social and personal services, excluding 0.08 0.10
government institutions
All industries 0.06 0.07
Source: Statistics South Africa (2005)
After the state of the macroeconomy is forecast, the analyst must determine the
implications of the forecast for specific industries. Industries have differing
sensitivities to the business cycle. Three factors determine the sensitivity of a firm’s
earnings to the business cycle. Firstly, is the sensitivity of sales. Necessities show
little sensitivity, as demand for these goods remain intact during recessions. Also,
industries for which income is not a crucial determinant of demand, for example, have
low sensitivity. Secondly, operating leverage determines sensitivity. This refers to the
ratio of variable to fixed costs. A firm with more variable costs with respect to fixed
costs is less sensitive to the conditions of business. During a recession, costs can be
reduced as output falls. Whereas, a firm with high fixed costs is more sensitive as
costs cannot be reduced. Operating leverage is measured by how sensitive profits are
to changes in sales. A degree of operating leverage of greater than 1 represents some
operating leverage. The third factor that influences sensitivity is financial leverage.
1
Net profit after providing for company tax divided by turnover
16
The use of debt incurs interest payments which must take place regardless of business
conditions. These payments represent a fixed cost similar to the operating leverage
case (Bodie et al., 2008: 586).
Differing sensitivity to the business cycle of the passenger car and cigarette industries
is demonstrated in figure 2.6 below. Cigarettes (the black curve in figure 2.6) will be
consumed regardless of whether economic times are good or bad and thus are less
sensitive. This is illustrated by the fairly smooth movement within the industry.
Durable goods, however, such as passenger cars (grey curve in figure 2.6) are
sensitive to the swings of the business cycle (Bodie 2008: 586). This is illustrated
through the large fluctuations in the passenger car industry.
Figure 2.5: Industry cyclicality (from Bodie et al., 2008)
Equity valuation
This valuation is at the firm level. Here, individual firm’s shares are valued according
to dividend models and are compared using price-earnings ratios.
a) Dividend Models
17
Fundamental analysts are always on the search for mispriced shares using information
concerning the current and prospective profitability of a company to calculate its fair
value (Bodie et al., 2008: 603). Dividend models are the most accepted and
conventional approaches used by fundamentalists for asset valuation. Investors in
shares expect a return consisting of dividends and capital gains or losses (Bodie et al.,
2008: 605).
This approach states that the present value of an asset is the sum of its future earnings,
each discounted at an appropriate rate that takes time and risk into account (Howells
& Bain 2005: 346). The price of a share at time period zero P0 is the present value
PV of the expected future dividend stream D1. The expected capital gain realised upon
the sale of the share is included in the expected future dividend stream since its size
also depends on the present value of this stream. The approach assumes that expected
dividends grow at a constant rateg, thus eliminating the problem of forecasting an
infinite number of dividends. Finally, the required rate of return is given byk. Taking
these elements into account gives the constant growth model, also known as the
Gordon growth model, in equation 2.1 (Howells & Bain 2005: 347):
D1
P0=PV = ................................................................................................. (2.1)
( k −g )
In theory, the present value model asserts that share prices are determined by
dividendsD and the discount ratek. Therefore any factor that influences the dividend
stream or the discount rate will systematically influence share prices (Moolman & Du
Toit 2005: 81).
b) Price earnings ratios
A great deal of market valuation centres on the firm’s price earnings multiple, i.e. the
ratio of price per share to earnings per share, generally called the price earnings ratio
(P/E ratio). This ratio can serve as a useful indicator of expectations of growth
prospects. Bearing in mind that dividends are earnings not reinvested in the firm;
D 1=E 1(1−b)....................................................................................................... (2.2)
Where, E1 is future earnings and b is the plowback ratio (the fraction of earnings
reinvested in more capital).
18
Dividends initially fall under a policy of reinvestment. However, subsequent growth
in the assets of the firm because of these reinvested profits will generate growth in
future dividends. The return on capital invested in the firm is the return on equity
( ROE). The capital stock increases by the rate at which income was generated i.e.
ROE multiplied by the plowback ratio(b). With more capital the firm earns more
income and therefore pays out higher dividends, growing at a rate of g;
g=ROE ×b.......................................................................................................... (2.3)
Substituting for D1 and g into equation 2.1 and rearranging gives the P/E ratio;
P0 1−b
= ..........................................................................................................
E1 k−ROE × b
(2.4)
The P/E ratio increases withROE. High ROE gives the firm good growth prospects.
Higher plowback ratios also increase the P/E ratio, as long as theROE exceedsk
(Bodie et al., 2008: 622). This shows that a firms’ P/E ratio will be higher if its return
on projects is higher than the return that can be earned elsewhere¿). The P/E ratio thus
gives an indication of the firms’ growth with respect to the industry.
In summary, the main difference between the dividend model and the price earnings
ratio is cited. In the dividend model, fundamental analysts analyse shares to find the
intrinsic value and hope that there are some cracks in the efficient market to uncover
shares whose market value is out of line with the intrinsic value. If the intrinsic value
is greater than market price, the investor makes a purchase, and holds for the long
term until the two values approach each other. Price earnings ratios, however, are
mainly used as comparables, as here the investor is interested in relative evaluation.
Other things being equal, the investor is more willing to pay the lowest price per rand
of earnings. Therefore a firm with a P/E ratio lower than another firm in the same
industry will be regarded as cheap (Howells & Bain 2005: 352). The P/E ratio should
be equivalent to the growth rate; if the P/E ratio is less than the growth rate of
equation 2.3, then a bargain is found (Bodie et al., 2008: 623).
A focus on fundamental analysis, using macroeconomic variables, is embarked on,

since the relationship between share prices and macroeconomic variables is not fully
understood. The analysis is carried out in the South African economy specifically
19
with respect to the Johannesburg Securities Exchange (JSE), as not much research in
this area has occurred for this developing economy.
2.4 A FUNDAMENTAL ANALYSIS OF SHARE PRICE VALUATION IN SOUTH

AFRICA
This dissertation is based on macroeconomic variables studied by Asprem (1989).

Asprem (1989) examines the relationship between share indices, asset portfolios and
macroeconomic variables in ten European Countries. The countries considered where;
Denmark, Finland, France, Germany, Italy, Norway, Netherlands, Sweden,
Switzerland and the United Kingdom. The macroeconomic variables taken into
account were; several measures of real activity (changes in industrial production, real
gross national product, gross capital formation, employment and exports), the
effective trade-weighted exchange rate, consumption (measured by changes in
imports), the interest rate (measured by interest rates on long term bonds and the
United States yield curve), and inflation (measured by past and future values and the
money supply). Share indices were also regressed on the S&P 400 and a basket of
European share indices.
However, Asprem’s (1989) study was about European markets and not about a
developing market such as South Africa’s. Sources of literature on the study of share
markets are dominated by studies on developed economies, whereas studies on
emerging markets and in particular, South Africa’s are scarce. However, according to
Moolman and Du Toit (2005: 77) the most important studies that examine structural
determinants of the JSE are those of Van Rensburg (1995), and Barr and Kantor
(2002).
Van Rensburg (1995), estimates the simultaneous linear relationship between the JSE
and four macroeconomic factors, namely the unexpected changes in the term
structure, unexpected returns on the New York Stock Exchange, unexpected changes
in inflation expectations and unexpected changes in the gold price. The results of this
study indicate that all four variables significantly influence share prices.
Barr and Kantor (2002), developed an econometric model of the South African
economy that focused on the linkages between the real and financial markets and
between domestic and foreign financial markets. They identify the gold price, the
20
short term interest rate, foreign share markets and local business confidence as factors
that significantly influence returns on the JSE (Barr and Kantor 2002: 53).
Another contribution to the study of returns on the JSE is that of Jefferis and
Okeahalam (2000). Research was carried out for the share markets of South Africa,
Botswana and Zimbabwe. Their approach lacked a theoretical background and was
empirical in nature. Variables investigated in the South African case consisted of the
real exchange rate, real GDP, long term interest rates and United States (US) interest
rates.
According to Jefferis and Okeahalam (2000: 24), the prices of individual company
shares should be influenced by the following sets of economic factors: those relating
to individual firms; to specific sectors of the economy; to the national economy; and
to the international economy. Given that this dissertation considers a national share
market index, the JSE All Share Index (ALSI), only the national and international
factors will be taken into account. This dissertation will limit the number of factors
considered to real activity, the exchange rate, the interest rate and inflation
expectations.
2.4.1 Real Activity
The Gordon growth model reflected by equation 2.1 dominates the literature on
fundamental analysis. Also referred to as the present value model, it maintains that
share prices are determined by dividends and the discount rate (Moolman & Du Toit
2005: 81). Since growth of dividends are assumed to be constant, anything that
changes expected future profits (i.e. dividends), or the discount rate will therefore
affect share valuation (Jefferis & Okeahalam 2000: 24).
Asprem (1989: 593) states that, assuming rational markets, asset prices should reflect
expectations of future earnings (dividends) which are likely to be influenced by
measures of real activity. Jondea and Nicolai (1993), show that only in the case of US
shares do dividends directly explain share prices, while in other countries, dividends
have to be replaced by proxies. Since dividends are usually proxied by variables such
as industrial production, unemployment or the state of the business cycle, the Gross
Domestic Product (GDP) growth rate will be used as a proxy in this dissertation
(Moolman & Du Toit 2005: 81).
21
2.4.2 Exchange Rate
Fang (2002: 195) mentions that little empirical research has examined the interaction
between share returns and foreign exchange rates. According to Branson and
Henderson (1985), the portfolio balance model contends that investors will usually
hold a greater proportion of any asset the higher return it offers and the lower the
return offered on competing assets, other things being equal. Fang (2002: 195)
focuses on the effects of currency depreciation and states that if the domestic currency
is expected to depreciate, against the dollar, for example, investors would shift their
funds from domestic assets to American assets. According to this model, currency
depreciation should have negative effects on stock prices and returns, and hence it is
assumed that an appreciation will have the opposite effect.
Asprem (1989: 596) moves away from the focus on the investors’ portfolio decisions
and looks at the possible effect of currency depreciation on domestic industries. A
depreciation of a currency improves the competitive position of domestic industries as
their prices relative to international industries are cheaper. Together the prices and
volume of production can result in higher earnings. This is especially the case for
international or export orientated firms that have a large foreign customer base.
2.4.3 Inflation Expectations
The discount rate in the Gordon growth model of equation 2.1 is determined by three
factors: 1) the economy’s real risk-free rate, 2) the expected rate of inflation, and 3) a
risk premium (Reilly 1989). According to Van Rensburg (1995: 51), rational investors
are only concerned about real returns and thus nominal returns should offset the
inflation rate. Investors want to be compensated for expected inflation (Moolman &
Du Toit 2005: 81). An upward revision in inflationary expectations should lead to a
higher discount rate and thus a drop in the current share price, other things being
equal (Van Rensburg 1995: 51).
According to Van Rensburg (1995: 51), three studies have examined the relationship
between inflation and share returns in South Africa. Bethlehem (1972) studied the
inflation adjusted performance of a randomly selected sample of industrial shares over
twenty years. It was found that these shares yielded positive real returns; however, the
study occurred prior to the high rates of inflation experienced in the late 1970’s.
22
Gultekin (1983) tested the Fisher Hypothesis that a unitary relationship exists between
share returns and inflation, yet no significant relationship was found. Lastly, Correia
and Wormald (1987) found no significant relationship when using the present rate of
inflation as a proxy for expected inflation when regressed on the ALSI. However,
Correia and Wormald (1987) used the short term interest rate on three month
negotiable certificates of deposit as a measure on inflationary expectations, and found
a negative relationship with share returns.
Asprem (1989: 603) investigated the relationship between share returns and inflation
(past, present and future measures on inflation). It was found that there is a stronger
correlation between share returns and future measures of inflation. Asprem (1989:
604) also considered the money supply, since most economic theory relates inflation
and the money supply. This is the monetarists approach to inflation that indicates that
increased money supply results in increased inflation. It was found that the monetary
base generally showed negative relationships, but this was only significant in the
United Kingdom. However, broader measures of money supply, showed a stronger
relationship to share returns than base measures of money. Positive coefficients
indicated that there was a liquidity effect in place. The effect of changing monetary
supply is to increase the liquidity in the financial markets. Increased liquidity is
transferred into demand for financial assets which results in asset prices being bid up
(Asprem 1989: 604).
2.4.4 Interest Rate
As mentioned above, Reilly (1989) states that the discount rate in the Gordon growth
model is determined by three factors. These factors are summed up by the long term
interest rate. The expected future short term interest rates are used to discount future
earnings in the Gordon growth model. However, these short term interest rates are
usually captured by the long term rate as the long term rate is considered as the
average of all future short term interest rates expected to prevail over the duration of
the shares’ life (Moolman & Du Toit 2005: 81).
The interest rate represents the discount rate in the denominator in equation 2.1. All
else being equal, an increase in the interest rate, results in a decrease in the price of
shares. The opposite is true for a decrease in interest rates (Asprem 1989: 598).
23
Van Rensburg (1995: 53) investigates the relationship between the JSE and the term
structure of interest rates. The term structure of interest rates refers to the yield to
maturity of bonds that display different terms to maturity. The term structure
influences the discount rate in the Gordon growth model. The measure used by Van
Rensburg (1995: 53) was the difference in yields between three month and ten year
default free bonds. He found a significant negative relationship between the
unexpected changes in the term structure and the ALSI.
2.5 CONCLUSION
In both developed and emerging markets, there have been times when share market
indices experienced substantial declines or crashes. These crashes ask the question
whether share prices reflect fundamental economic factors (Jefferis & Okeahalam
2000: 23). Share markets play the important role of pricing and allocating capital
within the economy in accordance with risk and expected return. This role is
particularly important in developing economies such as South Africa. If the share
market does not allocate financial capital efficiently to competing uses, then share
markets are unlikely to contribute to economic development.
It is thus important to improve the general understanding of the relationship between

the JSE and macroeconomic variable to see if the market is driven by fundamentals. If
so, share markets should be promoted for economic development.
The following chapter moves from theory to empirical analysis. A model is built,
taking into account the four variables discussed above, namely GDP growth, the
exchange rate, inflation expectations and the interest rate. These variables are
regressed against the ALSI. The results are critically analysed, using the appropriate
econometric methods, in order to determine whether share markets are indeed driven
by fundamentals.
24
CHAPTER THREE: AN EMPIRICAL ANALYSIS OF SHARE PRICE VALUATION
USING A FUNDAMENTAL ANALYSIS APPROACH
3.1 INTRODUCTION
Over the history of share market research, much concentration has been on the more
developed economy’s share markets while developing economy’s share markets, such
as South Africa’s Johannesburg Securities Exchange (JSE), has received less
attention. However, with the ending of apartheid in South Africa, the country has
become more attractive to portfolio investors (Jefferis & Okeahalam 2000: 28). This
increase in popularity is evident in the proliferation of research on the JSE in the
pursuing years.
According to Asprem (1989: 589) returns on shares have a complicated relationship to

macroeconomic variables. Chen, Roll and Ross (1986) recognised the spread between
long and short term interest rates, the expected and unexpected inflation rate,
industrial production, and the spread between high and low grade bonds, as
systematically affecting share returns. The link between share returns, real activity,
inflation and money was investigated by Fama (1981). Keim and Stambaugh (1986)
explored the relationship between share returns and the yield differential between low
grade bonds and Treasury bills, the ratio of the Standard and Poor’s composite index
to its previous long run level, and the level of small firms’ prices. The relationship
between share prices and exchange rates was found to be significant by Fang (2002).
A great deal of this empirical research was carried out with respect to international
and developed countries. Nonetheless, according to Moolman and Du Toit (2005: 77)
the most important studies that examine structural determinants of South Africa’s JSE
are those of Van Rensburg (1995) and Barr and Kantor (2002).
Van Rensburg (1995) estimates the simultaneous linear relationship between the JSE
and four macroeconomic factors, namely the unexpected changes in the term structure
of interest rates, unexpected returns on the New York Stock Exchange, unexpected
changes in inflation expectations and unexpected changes in the gold price. All four
variables were found to be statistically significant in explaining movements in share
prices. A further study by Van Rensburg (1998) used bivariate Granger causality tests
25
and correlations to investigate relationships between macroeconomic variables and
share prices. He tested factors affecting the discount rate and dividend in the Gordon
growth model and also tested international factors. Finally, Van Rensburg (1999) also
analysed macroeconomic relationships on the JSE All Share Index (ALSI), the
Industrial Index and Gold Index of the JSE. For all three indices, he found long term
interest rates, the gold and foreign reserve balance and the balance on current account
to be significant influences on share returns (Moolman & Du Toit 2005: 82).
Barr and Kantor (2002) identified the gold price, the short term interest rate, foreign
stock markets and local business confidence as factors that significantly influence
returns on the JSE (Barr and Kantor 2002: 53).
Lastly, Jefferis and Okeahalam (2000) carried out empirical research on several
Southern African markets. Variables investigated in the South African case consisted
of the real exchange rate, real GDP, long term interest rates and US interest rates.
Chapter three shifts from the theoretical premise established in chapter two, and has
an empirical focal point. A model is built using certain macroeconomic variables, as
mentioned above, in an attempt to explain movements in the ALSI.
3.2 DATA SOURCES USED
The data used for this dissertation is a quarterly data series, which was extracted
from the first quarter of 2000 to the second quarter of 2008. This resulted in 32 data
points. The majority of the data, for the independent variables, was from the
electronic database of the South African Reserve Bank. Data for the dependent
variable was supplied by the JSE. The dependent variable in this case is quarterly
index values of the ALSI. The variables are explained in more detail in the
following section.
26
3.2.1 Data Description
The following table presents a list of all the independent variables to be used in the
estimation procedure:
Table 3.1: Variables used in estimation
Independent Variable name Unit of Functional form

Variable Measurement
InfExp Inflation % Linear
Expectations
Exchange Real Effective % Linear
Exchange Rate
GDPGrowth Gross Domestic % Linear
Product Growth
IntRate Prime Overdraft % Linear
Interest Rate
Source: www.resbank.co.za
The dependent variable is the ALSI. The top 99 per cent of all companies are included
in the ALSI and the remaining 1 per cent forms the FTSE/JSE Africa Fledgling Index.
The ALSI is further divided into the FTSE/JSE Africa Top 40 Index containing the
forty highest ranking companies, the FTSE/JSE Africa Mid Cap Index containing the
sixty highest ranking companies outside the top forty, and the FTSE/JSE Small Cap
Index containing the remaining companies (Forssman 2005). The ALSI is ranked by
full market capitalization (shares in issue multiplied by price). The weighting of a
constituent in the index is Free Float Market Cap weighted (free float multiplied by
shares in issue multiplied by price). Free float is the number of shares that are freely
tradable among investors.
Inflation expectations considered here are for one year ahead in relation to the
reference quarter when the expectations were surveyed. In each instance, the annual
average CPIX inflation rate for the calendar year which is expected by the participants
is asked.
The exchange rate is the real effective exchange rate. This is a weighted average
exchange rate against the most important currencies, it is measured in percentage
changes of averages.
27
Gross domestic product (GDP) growth is growth in GDP for one term. GDP is
compared with the preceding period. Quarterly changes reflect annual rates based on
seasonally adjusted data
The prime overdraft rate, is the lowest rate at which a clearing bank will lend money
to its clients on overdraft. Competition forces all banks to set the same prime rate.
3.2.2 The Econometric Method of Estimation
Regression analysis is used by economists to make quantitative estimates of economic

relationships that previously have been completely theoretical (Studenmund 2006: 6).
The lifeblood of regression analysis is estimation of the coefficients of econometric
models with a technique called Ordinary Least Squares (OLS) (Studenmund 2006:
35). It is very rare that one independent variable explains all the variation in a
dependent variable, thus multivariate regression models (models with more than one
independent variable) are employed. The general multivariate regression model with
K independent variables is represented by equation 3.1:
Y i=β 0 + β 1 X 1 i+ β 2 X 2 i +…+ β k X ki +∈i ....................................................... (3.1)
Where i indicates the observation number, therefore, X 1 i indicates the ith observation
of independent variable X 1 , while X 2 i indicates the ith observation of another
independent variable X 2 . In this model, Y is referred to as the dependent variable and
∈ is the stochastic error term that is added to the model to account for all the variation
in the model not explained by the independent variables. The coefficients β in a
multivariate regression model are often called partial regression coefficients. The
word “partial” implies that researchers are able to distinguish the impact of one
variable on the dependent variable from that of other independent variables. The
intercept is given by β 0 (Studenmund 2006: 41).
The above gives some insight into the statistical theory used in this dissertation. The
subsequent section will present the model used in this study.
3.3 AN EMPIRICAL APPROACH TO SHARE VALUATION USING

FUNDAMENTAL ANALYSIS
28
3.3.1 Model Structure
As mentioned before, Asprem (1989: 589) states that share prices have a complicated
relationship to macroeconomic variables. There is no generally accepted asset pricing
model that explicitly takes economic variables into account. However, this
econometric model is specified in equation 3.2, and attempts to explain this complex
relationship:
ALSI=bo +b1 InfExp+ b2 Exchange +b3 GDPGrowth+b 4 IntRate+ ∈t .. (3.2)
The variables considered are the ALSI, inflation expectations for one year ahead
(InfExp), the real effective exchange rate (Exchange), gross domestic product growth
for one term (GDPGrowth), and the prime overdraft interest rate (IntRate). The
stochastic error term ∈t is added to represent all possible variables omitted from the
model as well as random errors from the estimation process. Economic theory predicts
a positive relationship between share prices and real activity (represented by
GDPGrowth) as additional real activity results in higher earnings and therefore higher
prices. Theory also suggests a negative relationship between share prices and inflation
expectations, since higher inflation expectations bring about higher interest rate
expectations, and with forward looking monetary policy, this generally suppresses
share market performance. Higher interest rates lead to above average short term
inflows, thus improving the performance on share markets. However, theory is
inconclusive on the relationship between share prices and the exchange rate – a
negative or positive relationship could exist, due to the point of view taken. From an
export orientated firm’s perspective, depreciation in currency will have positive
effects on share prices. However, depreciation from an investor’s viewpoint will have
a negative effect on share prices.
3.3.2 Presentation and Analysis
The model specified in equation (3.2) is regressed using Eviews and the results are
displayed in table 3.2 below:
Table 3.2: Regression output of equation 3.2

29
Dependent Variable: ALSI
Method: Least Squares
Date: 11/22/08 Time: 09:38
Sample(adjusted): 2000:3 2008:2
Included observations: 32 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
C 10616.57 12758.39 0.832124 0.4126
INFEXP -7745.243 2470.989 -3.134471 0.0041
EXCHANGE -410.8546 252.2541 -1.628733 0.1150
GDPGROWTH 1360.849 985.2728 1.381190 0.1785
INTRATE 3678.538 1423.635 2.583905 0.0155
R-squared 0.364679 Mean dependent var 15396.41
Adjusted R-squared 0.270557 S.D. dependent var 7897.919
S.E. of regression 6745.410 Akaike info criterion 20.61371
Sum squared resid 1.23E+09 Schwarz criterion 20.84273
Log likelihood -324.8194 F-statistic 3.874546
Durbin-Watson stat 0.618148 Prob(F-statistic) 0.012971
The estimated equation is given below:
ALSI=10616.57−7745.24 InfExp−410.85 Exchange+ 1360.85GDPGrowth+3678.54 IntRate

..................................................................................................... (3.3)
Equation (3.3) indicates that a one percentage point increase in inflation expectations
decreases the ALSI by 7745.24 points; a one percentage point increase in the
exchange rate (i.e depreciation) leads to a 410.85 point decrease in the ALSI; a one
percentage point increase in the GDP growth rate increases the ALSI by 1360.85
points; and a one percentage point increase in the interest rate increases the ALSI by
3678.54 points.
All coefficients conform to the expected signs. However, the only coefficients that
are statistically significant at the 5 per cent level are b 1 and b 4 . Further aspects will be
scrutinised before accepting this initial result.
3.3.3 The Overall Fit of the Estimated Model
The R-squared indicates that 36% of the variation in the ALSI is explained by
inflation expectations, the exchange rate, GDP growth and the interest rate. A more
accurate measure is the adjusted R–squared as it takes into account the sample size
and the number of independent variables. The adjusted R-squared shows that the
models explanatory power drops to 27%. That is a 9% downward adjustment from the
30
original R-squared measure. The following section examines equation (3.3)’s
violations of the classical model.
3.3.4 Violations of the Classical Linear Regression Model
In order for OLS to be the best estimator available for regression models the
following classical assumptions must be met (Studenmund 2006: 89):
I. The regression model is linear, is correctly specified, and has an additive error
term;
II. The error term has a zero population mean;
III. All explanatory variables are uncorrelated with the error term;
IV. Observations of the error term are uncorrelated with each other (no serial
correlation);
V. The error term has a constant variance (no heteroskedasticity);
VI. No explanatory variable is a perfect linear function of any other explanatory

variable(s) (no perfect multicollinearity);
VII. The error term is normally distributed.
This lays down the criteria to be met by the model so that the OLS estimates are the
best, linear, unbiased estimators.
The next section deals with violations of the classical model of econometrics in the
form of multicollinearity, serial correlation and heteroskedasticity. Corrections will
be made where necessary.
Multicollinearity
Perfect multicollinearity is the violation of Classical Assumption (VI) that no

independent variable is a perfect linear function of one or more other independent
variables. Perfect multicollinearity is a rare phenomenon; however, harsh imperfect
multicollinearity can cause several problems. The more correlated two or more
independent variables are, the trickier it is to accurately estimate the coefficients of
the true model (Studenmund 2006: 245). Thus, multicollinearity reveals itself through
31
low t-statistics. This is due to the chief consequence of multicollinearity, that is, the
variance and the standard errors of the estimates will increase (Studenmund 2006:
251).
The variance inflation factor (VIF) is a means of exposing the severity of

multicollinearity. The VIF is an index of how much multicollinearity has increased
the variance of an estimated coefficient. A VIF is calculated for each independent
variable using EViews. There is no table of formal critical VIF values, however, the
widely accepted rule is that if the VIF of a coefficient is greater than five, then severe
multicollinearity is considered to exist (Studenmund 2006: 259).
Table 3.3: Unadjusted R-squares and VIFs of independent variables
Variable R2 VIF
InfExp 0.815 5.41
Exchange 0.159 1.19
GDPGrowth 0.348 1.53
IntRate 0.835 1
Table 3.3 gives the unadjusted R-squares and VIFs of each independent variable.
Using the rule given by Studenmund (2006: 259), only inflation expectations appears
to show severe multicollinearity. Since inflation expectations are statistically
significant at the 5 per cent level with a p-value of 0.0041, it is not dropped from the
equation. All other variables show no severe multicollinearity. Therefore, the
estimated equation is not altered for multicollinearity.
Serial Correlation
Serial correlation is a violation of Classical Assumption (IV). The theory assumes that
observations of the error term are uncorrelated with each other. Serial correlation can
exist in any research study in which the order of the observations has some
significance. Therefore, it often occurs in time series data. In effect, serial correlation
entails that the value of the error term from one time period depends in some
systematic way on the value of the error term in other time periods (Studenmund
2006: 313). The Durbin-Watson d test is the most commonly used test for serial
32
correlation. If serial correlation is detected using this test, the generalised least squares
technique is used to reduce it or remove it.
(a) First order serial correlation coefficient
First order serial correlation is the most usual form of serial correlation that is
assumed. This is where the current value of the error term is a function of the previous
value of the error term:
∈t= ρ∈t −1+u t...................................................................................................... (3.4)
Where, ∈ is the error term of the equation; ρ is “rho”, the first-order autocorrelation
coefficient (this variable indicates the strength of the serial correlation if it equals zero
then there is no serial correlation); and u is a classical error term (Studenmund 2006:
314).
Table 3.4, below, shows this functional form regressed for the residuals in equation
(3.3).
Table 3.4: The first-order serial correlation coefficient
Dependent Variable: E
Date: 11/26/08 Time: 10:52
C 663.0859 884.7689 0.749445 0.4596
E(-1) 0.768737 0.168137 4.572077 0.0001
33
The coefficient of the variable E(-1) represents rho ( ρ). In this case, the value of ρ is
positive and significant, confirming first order serial correlation. However, this is not
a test of serial correlation but is important for the Durbin-Watson d test described
below.
(b) Durbin-Watson d test
The Durbin-Watson d statistic is used to establish if there is first order serial

correlation in the error term of the equation by investigating the residuals of a specific
estimation of that equation (Studenmund 2006: 325). The typical hypotheses are:
H 0 : ρ≤ 0 ................................................................................................................ (3.5)
H A : ρ>0 ................................................................................................................ (3.6)
Here, the null hypothesis is no serial correlation and the alternate hypothesis is
positive serial correlation. The Durbin-Watson d statistic is 0.618 as indicated by table
3.2. Also indicated by table 3.2 is that 32 observations are included in the regression.
Therefore using the number of observations and number of explanatory variables, and
reading the critical values of the Durbin –Watson test statistics, the lower and upper
limit is 1.18 and 1.73 respectively. Therefore the Durbin-Watson d statistic lies below
the lower limit and the null hypothesis may be rejected at the 5 per cent level of
significance. Thus there is positive serial correlation and the generalized least squares
(GLS) method will be used as a remedy.
(c) Generalized least squares
The GLS equation is estimated using the AR(1) method, the results are displayed in
table 3.5 below.
Table 3.5: Generalized least squares AR(1) method
Dependent Variable: ALSI

Date: 11/26/08 Time: 14:57
Convergence achieved after 74 iterations
C 474418.0 8783324. 0.054013 0.9574
34
INFEXP -252.3288 472.2942 -0.534262 0.5979
EXCHANGE 45.76945 29.80164 1.535803 0.1371
GDPGROWTH 175.4081 129.1097 1.358598 0.1864
INTRATE -38.28460 251.1317 -0.152448 0.8801
AR(1) 0.998396 0.030736 32.48279 0.0000
Sum squared resid 26847636 Schwarz criterion 17.17422
Inverted AR Roots 1.00
The equation is re-estimated as:
ALSI=474418.03−252.33 InfExp+45.77 Exchange +175.41 GDPGrowth
−38.28 IntRate ...................................................................................................... (3.7)
[ AR ( 1 )=0.9983956357]
The coefficients b 2 and b 4 have changed signs. The change in b 2 indicates the
uncertainty with regard to the theory relating to exchange rates. The negative sign of
the coefficient b 4 now conforms to the theory of the Gordon growth model and shows
the negative relationship between share prices and interest rates. All coefficients
reduce significantly in magnitude. The p-values show that all variables are not
statistically significant at the 5 per cent level. However, the adjusted R-squared of the
model has increased dramatically from 27 per cent to 98 per cent. The Durbin-Watson
d statistic has increased from 0.62 to 0.95, showing that serial correlation may still be
present.
Heteroskedasticity
Heteroskedasticity is the violation of Classical Assumption (V). The assumption

asserts that the observations of the error term are drawn from a distribution that has a
constant variance. This assumption of constant variances for different observations of
the error term is not often observed in real world scenarios. Heteroskedacticity is
more likely to be found in cross-sectional data than time series data (Studenmund
2006: 346). Tests for heteroskedacticity include the Park test and White test. The
latter will be used in this dissertation.
35
(a) Testing for Heteroskedasticity: The White Test
Table 3.6: White heteroskedasticity results
White Heteroskedasticity Test:

F-statistic 1.698085 Probability 0.149121
Obs*R-squared 18.65790 Probability 0.178437
Test Equation:
Dependent Variable: RESID^2
Date: 11/26/08 Time: 16:57
Sample: 2000:3 2008:2
Included observations: 32
C 2.65E+09 1.44E+09 1.839862 0.0833
INFEXP -1.20E+09 3.86E+08 -3.104620 0.0064
INFEXP^2 77911246 60579271 1.286104 0.2156
INFEXP*EXCHANGE 153350.8 6786077. 0.022598 0.9822
INFEXP*GDPGROW 81007631 26517614 3.054861 0.0072
TH
INFEXP*INTRATE -13392751 58529419 -0.228821 0.8217
EXCHANGE 47807019 47878242 0.998512 0.3320
EXCHANGE^2 28716.78 682760.6 0.042060 0.9669
EXCHANGE*GDPGR -2224612. 3637875. -0.611514 0.5490
OWTH
EXCHANGE*INTRAT -3460873. 4613380. -0.750182 0.4634
E
GDPGROWTH -3.80E+08 2.10E+08 -1.808611 0.0882
GDPGROWTH^2 13369940 9345185. 1.430677 0.1706
GDPGROWTH*INTR -19188864 12058046 -1.591374 0.1299
ATE
INTRATE 2.88E+08 2.06E+08 1.398091 0.1801
INTRATE^2 -3385866. 17255032 -0.196225 0.8468
R-squared 0.583059 Mean dependent var 38391090
Adjusted R-squared 0.239697 S.D. dependent var 70410037
S.E. of regression 61394299 Akaike info criterion 39.00851
The hypotheses are stated as follows:
H 0 : No Heteroskedasticity
H A : Heteroskedasticity is present
The null hypothesis is only rejected if the test statistic is greater than the critical value
obtained from the Chi-square distribution tables.
36
The results of the white test are displayed in table 3.6 above. The Obs*R-squared
value of 18.66 is the White’s test statistic. It is computed as the number of
observations time the R2 from the test regression. The test statistic has a chi-square
distribution with degrees of freedom equal to the number of slope coefficients in table
3.6. Thus, with 14 degrees of freedom, the critical chi-square value is 23.7 at the 5 per
cent level of significance. Since the test statistic of 18.66 is less than the critical value
of 23.7, the null hypothesis cannot be rejected, and it is thus concluded that no
heteroskedasticity is present.
3.4 CONCLUSION
Theory suggests that the four variables considered in this dissertation should relate to
the ALSI as follows. Higher inflation expectations, according to the Gordon growth
model, should lead to a higher discount rate and thus current share prices
should drop. Theory on the exchange rate was inconclusive (remembering though that
not much research has been done in this area). The portfolio balance model suggests
that a currency depreciation will have a negative effect on share prices. However,
looking at the effect of a currency depreciation on domestic industries, share prices
could rise. Real activity, represented by GDP growth, should have a positive
relationship with the ALSI. Increased GDP should be reflected by higher earnings and
thus higher share prices. Lastly, using the Gordon growth model again, higher
interest rates increase the discount rate and thus share prices should decrease.
Short term inflows, however, from perceived higher returns, associated with higher
interest rates can increase share prices.
In the initial regression (table 3.2) all coefficients obeyed these relationships, except
for the coefficient of the interest rate variable. The overall fit of this regression was
not that impressive, with only 27 per cent explanatory power, according to the
adjusted R-squared.
The model was tested for multicollinearity, serial correlation and heteroskedasticity to
see if it conformed to the assumptions of the classical model. With respect to
multicollinearity, only inflation expectations showed severe multicollinearity, with a
VIF of 5.4. Since inflation expectations were statistically significant, no remedial
action was taken. Using the Durbin-Watson d test, positive serial correlation was
found. Therefore the GLS AR(1) method was run to solve the serial correlation.
37
However, the signs of the exchange rate variable and the interest rate variable
changed signs. Also the p-values for all the variables in table 3.5 show that the
coefficients are insignificant at the 5 per cent level. In an attempt to correct for this
serial correlation, the ALSI was lagged by one period and inflation expectations for
one year ahead was replaced by current inflation expectations. This new equation still
gave disappointing results when the GLS AR(1) method was run, with the outcome of
insignificant coefficients. Therefore the initial regression was kept. According to the
White Test, the initial model showed no heteroskedasticity.
CHAPTER 4: CONCLUSION
4.1 INTRODUCTION
The first chapter introduced the topic of research with a preliminary literature review.
The literature review gave an outline of the two models used for predictive purposes,
namely technical and fundamental analysis. Fundamental Analysis was expounded by
the macroeconomic factors that were considered, specifically real activity, exchange
38
rates, inflation expectations and the interest rate. The problem statement indicated that
a complicated relationship exists between share prices and macroeconomic factors,
and that research in this area for the Johannesburg Securities Exchange (JSE) was
limited. The objective of the study was to investigate the connection between the
performance of the All Share Index (ALSI) and the four macroeconomic variables and
to develop a model to explain these connections.
The second chapter was a theoretical examination of the two approaches to share
price valuation. Despite the efficient market hypothesis (EMH), the two models,
mentioned above, dominate the literature on share price valuation. Technical analysis
is a very vast subject, with many techniques been developed over the years of share
market research. In the dissertation this model was shortened to a discussion on
patterns on price charts and trend following methods. Fundamental analysis was then
explained, with a discussion on value, the macroeconomy and industry, and
equity. The fundamental model was used in the dissertation focusing only on the
four variables mentioned above.
Chapter two concluded with the question of whether shares reflect fundamental
economic factors. Subsequently, chapter three attempts to answer this question and to
find a better understanding of the correlations that exist between the macroeconomic
variables investigated and the ALSI.
4.2 GENERAL FINDINGS
The empirical analysis of chapter three was not as significant as expected. Asprem
(1989: 589) declared that no commonly accepted pricing model exists that only
takes macroeconomic variables into account. This declaration was investigated with
respect to the JSE, and it seems as though this is still the case.
A linear multivariate regression model was built using the ALSI as the dependent
variable and inflation expectations, the real effective exchange rate, GDP growth and
the prime overdraft rate as independent variables. The coefficients of inflation
expectations and the interest rate were the only variables that were statistically
significant at the 5 per cent level. According to the adjusted R-squared, all the
variables explained only 27 per cent of the variation in the ALSI. The model was
constructed to obey the classical linear regression model, thus it was checked for
39
multicollinearity, serial correlation and heteroskedasticity. A remedy was only sought
for serial correlation by estimating the generalized least squares (GLS) equation using
the AR (1) method. However, this did not adequately solve the problem of serial
correlation.
Another equation was regressed, lagging the ALSI for one period and substituting
inflation expectations for one year ahead with current inflation expectations. This was
done to see if better results could be found; in spite of this the results were no more
promising than the initial regression, and thus are not included here.
4.3 CONCLUDING REMARKS
The empirical analysis carried out in this dissertation encountered two major
difficulties. Firstly, not enough data could be found for inflation expectations,
therefore EViews included only 32 observations after adjusting the endpoints. It is
generally accepted that the more sample observations one has, the more reliable ones
estimates can be. Secondly, serial correlation could not be solved regardless of the
efforts made, as mentioned above. This dissertation thus concludes that only inflation
expectations for one year ahead and the interest rate are statistically significant in
explaining the variation in the ALSI. The presence of serial correlation, however,
caused the ordinary least squares (OLS) estimates of the standard errors to be biased,
leading to unreliable hypothesis testing (Studenmund 2006: 324). Given the
unreliable and biased results obtained, it is difficult to determine whether any of the
hypotheses stated in chapter one are true.
Increased real activity did lead to an increase in the ALSI, however this result was
insignificant in the initial model. A depreciation in the exchange rate did lead to better
performance on the ALSI, however, this result was also found to be insignificant (see
table 3.2). The interest rate showed a positive relationship with the ALSI, which
highlighted the importance of international investors in South Africa. Short term
inflows increased, leading to a better performing ALSI. This result was significant,
however, this was prior to correcting for serial correlation. Lastly, inflation
expectations had an expected negative relationship with the ALSI. This result was
also significant, but once again, did not account for possible serial correlation.
40
In conclusion, further research should be carried out in order to identify significant
variables that help explain the performance of the ALSI, under the fundamental
approach to share price valuation.
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45

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AN ECONOMIC ANALYSIS

OF FACTORS AFFECTING SOUTH AFRICAN EQUITY RETURNS

Submitted in partial fulfilment of the requirements for the degree of

Baccalaureus Commercii Honores (Economics)

IN THE FACULTY OF BUSINESS AND ECONOMIC SCIENCES

AT THE NELSON MANDELA METROPOLITAN UNIVERSITY

Supervisor Mrs. D. Du Preez

This relationship, however, between certain macroeconomic variables and share

The dissertation takes on a fundamental approach instead of a technical one to share

Further research should thus be undertaken in order to identify possible significant

Table 2.1: Comparison of industry profitability ratios in South Africa

Figure 2.1:Bar chart and Point-and-figure chart 12

CHAPTER ONE: INTRODUCTION

CHAPTER TWO: ALTERNATIVE APPROACHES TO SHARE

CHAPTER THREE: AN EMPIRICAL ANALYSIS OF SHARE PRICE

CHAPTER FOUR: CONCLUSION

1.1 INTRODUCTION AND PRELIMINARY LITERATURE REVIEW

Notwithstanding the unpredictable nature of share prices, economists and those

1.2 MODELS USED FOR PREDICTION PURPOSES

1.2.1 Technical Analysis

1.2.2 Fundamental Analysis

In fundamental analysis, investors believe the market is 90 percent logical and 10

1.2.3 Fundamental Analysis Research

Asset prices are often thought to react to fluctuations in macroeconomic variables.

1.3 THE MACRO-ENVIRONMENT

Based on work done by Asprem (1989), the macroeconomic variables considered in

1.3.1 Real Activity

The perceptions of investor’s on future dividends must be responsive to changes in

1.3.2 Exchange Rates

A depreciation of a currency improves the competitive position of domestic

1.3.3 Inflation Expectations

1.3.4 Interest Rate

1.4 PROBLEM STATEMENT

This complex linkage of macroeconomic variables when related to shares on the

(a) Primary objective:

(b) Secondary objective:

1.6 RESEARCH HYPOTHESES

The following hypotheses will be tested:

 An expected depreciation in the exchange rate places domestic firms in a greater

 Higher inflation expectations will have a negative impact on the ALSI.

1.7 RESESEARCH METHODOLOGY

(a) Historical method:

(b) Analytical method:

This involves the drawing up of an econometric model to establish statistical

2.2 THE THEORY UNDERLYING THE EFFICIENT MARKET HYPOTHESIS

2.2.1 The Fair Game Model

2.2.2 The Submartingale Model

2.2.3 The Random Walk Model

2.2.4 The Forms of EMH

2.3 ALTERNATIVE APPROACHES TO SHARE PRICE VALUATION

Patterns on Price Charts

Trend Following Methods

A great deal of technical analysis is the identification of trends in market prices.

2.3.2 Fundamental Analysis

The alternative method to share price valuation is fundamental analysis. Fundamental

Macroeconomic and Industry Analysis

Table 2.1: Comparison of industry profitability ratios in South Africa (2004 –

Industry Profitability ratio

Figure 2.5: Industry cyclicality (from Bodie et al., 2008)

b) Price earnings ratios

D 1=E 1(1−b)....................................................................................................... (2.2)

g=ROE ×b.......................................................................................................... (2.3)

A focus on fundamental analysis, using macroeconomic variables, is embarked on,

2.4 A FUNDAMENTAL ANALYSIS OF SHARE PRICE VALUATION IN SOUTH