Chapter 16

TECHNICAL ANALYSIS

Chapter 16 Questions

How does technical analysis differ from fundamental analysis?What are the underlying assumptions of technical analysis?What major assumption causes a difference between technical analysis and the efficient market hypothesis?What are the major advantages of technical analysis compared to fundamental analysis?

Chapter 16 Questions

What are the major challenges to technical analysis and its rules?What is the logic for the major contrary-opinion rules used by technicians?What are some of the significant rules used by technicians who want to follow the smart money, and what is the logic of those rules?What are the breadth of market measures and what are they intended to indicate?

Chapter 16 Questions

What are the types of price movements postulated in the Dow Theory, and how are they used by a technician?

Why is the volume of trading important and how do technicians it in their analysis?

What are support and resistance levels, when do they occur, and how are they used by technicians?

Chapter 16 Questions

What is the purpose of moving average lines and how do technicians use them to detect major changes in trends?What is the rationale behind the relative-strength line for an industry or a stock?How are bar charts different from point-and-figure charts?What are some uses of technical analysis in foreign security markets?How is technical analysis used when analyzing bond markets?

Technical Analysis vs. Fundamental Analysis

Technical analysis involves the development of trading rules based on past price and volume data for individual stocks and the overall stock market.

Fundamental analysis involves economic, industry, and company analysis that lead to valuation estimates for companies, which can then be compared to market prices to aid in investment decisions.

Technical Analysis

To “non-believers,” technical analysis can sound like a lot of focus-pocus!

Underlying Assumptions of Technical Analysis

Trading via technical analysis involve a number of assumptions about marketsThe market value of any good or service is

determined solely by the interaction of supply and demand

Supply and demand are governed by numerous factors, both rational and irrational

Underlying Assumptions of Technical Analysis

Technical analysis assumptions: Disregarding minor fluctuations, the prices for

individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time

Prevailing trends change in reaction to shifts in supply and demand relationships and these shifts can be detected in the action of the market

Advantages of Technical Analysis

Unlike fundamental analysis, technical analysis is not heavily dependent on financial accounting statementsProblems with accounting statements:

Lack information needed by security analystsGAAP allows firms to select reporting

procedures, resulting in difficulty comparing statements between firms

Many psychological and other non-quantifiable factors do not show up in financial statements

Advantages of Technical Analysis

Fundamental analyst must process new information and quickly determine a new intrinsic value, but technical analyst merely has to recognize a movement to a new equilibrium

Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds undervalued securities that may not adjust to “correct” prices as quickly

Challenges to Technical Analysis

Challenges to basic assumptions Empirical tests of Efficient Market Hypothesis

(EMH) show that prices do not move in trends

Challenges to technical trading rules Rules that worked in the past may not be repeated Patterns may become self-fulfilling prophecies A successful rule will gain followers and become

less successful Rules all require subjective judgement

Technical Trading Rules and Indicators

Stock cycles typically go through a peak and trough

For instance, consider the following stock price graph over time, and then consider how a technical analyst would interpret the chart

Typical Stock Market Cycle Stock Price

Typical Stock Market Cycle Stock Price

Declining Trend

Channel

Trough

Buy Point

Rising Trend Channel

Flat Trend Channel

Sell Point

Peak

Declining Trend

Channel TroughBuy Point

Contrary-Opinion Rules

Many analysts rely on rules developed from the premise that the majority of investors are wrong as the market approaches peaks and troughsTechnicians try to determine whether investors are strongly bullish or bearish and then trade in the opposite directionThese positions have various indicators

Contrary-Opinion Rules

Mutual fund cash positions Buy when the mutual fund cash position is high,

sell when low Assumes that mutual fund managers are poor

judges of market turning points

Credit balances in brokerage accounts Buy when credit balances increase, sell when

credit balances fall

Investment advisory opinions Buy when advisory firms become more bearish

Contrary-Opinion Rules

OTC versus NYSE volume If OTC volume increases relative to NYSE volume,

sell since speculation increases at peaks

Chicago Board Options Exchange (CBOE) put/call ratio Buy when option purchasers are bearish (when

the put/call ratio increases)

Futures traders bullish on stock index futures Sell when speculators are bullish

Follow the Smart Money

While contrary-opinion rules assume that most investors are not smart, these indicators seek to follow the path of sophisticated, and assumed smart, investorsThe Barron’s Confidence Index Measures the yield spread between high-grade

bonds and a large cross section of bonds Declining (increasing) yield spreads increase

(decrease) this index, and are a bullish (bearish) indicator

Follow the Smart Money

T-Bill - Eurodollar yield spreadDecreases in this spread indicates greater

confidence, and is a bullish indicator

Debit balances in brokerage accounts Such balances represent buying on

margin, which is assumed to be done by largely sophisticated investors

Increases are a bullish signal

Other Market Indicators

These indicators are meant to gauge overall market sentimentBreadth of market Advance-decline (number of advancing minus the

number of declining issues)

Short interest Cumulative number of shares sold short in

uncovered positions Actually a bullish indicator, as it indicates potential

demand

Other Market Indicators

Stocks above their 200-day moving average Technicians use moving averages to compute

general trends, and evaluate current stock prices relative to those trends

Block uptick-downtick ratio Gauges institutional investor sentiment by looking

at the proportion of block trades that resulted in an uptick (buy) or a downtick (sell)

Stock Price and Volume Techniques

The Dow theory1. Major trends are like tides in the ocean2. Intermediate trends resemble waves3. Short-run movements are like ripples Key is to identify the nature of a current price

movement

Importance of volume Ratio of upside-downside volume Price movements are not very important unless

they are “confirmed” by volume

Stock Price and Volume Techniques

Support and resistance levels Support level: the level that a price is unlikely to

decline below; when price reaches the support level, demand surges for the stock

Resistance level: the level that a price is unlikely to rise above; when price reaches the resistance level, we observe selling or “profit taking”

Movements below (bearish) and above (bullish) this range provide indicators

Stock Price and Volume Techniques

Moving average lines Moving average prices are calculated and

track for several different time periods When the shorter-term moving average

line is consistently above the longer-term line, it is considered a bullish signal

Stock Price and Volume Techniques

Relative-strength (RS) ratios For individual stocks and industry groups Measure relative price changes across different

stocks or industries

Other Indicators Bar charting Multiple indicator charts Point-and-figure charts

Idea is to get an overall feel from numerous technical indicators

Technical Analysis of Foreign Markets

Some foreign market data is more limited than U.S. market data Greater reliance on stock and volume data

Merrill Lynch publishes various indicators for several countries

Technical analysis of foreign exchange rates Traders look for trends in exchange rates that

could give rise to profit opportunities

Technical Analysis of Bond Markets

Many of the same indicators and trading rules can be applied to bond markets

Generally not possible to get bond market volume data