technical analysis(3)

8/8/2019 Technical Analysis(3)

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Pamela L. Hall, Western Washington University

Francis & Ibbotson Chapter 26: Technical Analysis 11

Technical AnalysisTechnical Analysis

Chapter 26




BackgroundBackground

jMain approaches to valuing stocks include

± Risk-return analysis

± Fundamental analysis

± Technical analysis

jSome technicians use only technical analysis while

others use both fundamental and technical analysis

jTechnicians (AKA: chartists) focus on charts of

market prices and transactions statistics ± Think that these statistics will reveal all

jTechnicians study patterns in security prices




Theoretical FoundationTheoretical Foundation

jEdwards & Magee (1997) state the basicassumptions of technical analysis ± A security¶s market value is based on supply and

demand ± Supply and demand are based on both rational

and irrational factors

± Security prices tend to move in persistent trends

± Changes in trends occur due to shifts in supplyand demand

± Shifts in supply and demand can be detectedusing charts of market transactions

± Some chart patterns tend to repeat themselves





jTechnicians believe past patterns will recur

± Therefore can be predicted

jTechnical analysts estimate prices ± Whereas fundamental analysts estimate value

jTechnicians tend to ignore issues such as a

firm¶s riskiness and earnings growth

± Instead focus on barometers of supply anddemand





jTechnicians claim technical analysis is ± Easier

± Faster

± Can be applied simultaneously to more stocks thanfundamental analysis

jBut, does technical analysis work?

jTechnicians argue that when using fundamentalanalysis

± Must wait until market realizes a stock is undervalued ± Must rely on inadequate accounting statements

± It is hard work

± Must use ambiguous estimates of growth




The Dow TheoryThe Dow Theory

j Originated by Charles Dow

± Founder of the Dow Jones Company and editor of Wall Street

Journal

j Dow Theory presumes market moves in persistent bull and

bear trends ± Often used for market as a whole, but used for individual

securities also

j Types of movements defined by Dow theorists

± Primary trends (bull or bear market)

± Secondary trends (corrections)

Market collapses or upward surges lasting a few weeks or months

± Tertiary moves (little daily fluctuations)

Meaningless random wiggles but should be studied to determine if relate to a primary trend




The Dow TheoryThe Dow Theory

Most Dow theorists do not think a new primary trend has been confirmed until pattern of

ascending or descending tops occur in both industrial and transportation averages.




Testing the DOW TheoryTesting the DOW Theory

jBrown, Goetzmann & Kumar (BGK) testedDow theory using event study ± 255 WSJ editorials used as events

± Neural net estimation used to identify optimaltrading rules during 1902-1929

jResults indicate forecasts based on 4discernable patterns

± Recent downward trends in DJIA are sell signals ± DJIA falls from recent peaks are sell signals

± Recent upward trends in DJIA are buy signals

± Recoveries from recent declines in DJIA are buy

signals




Testing the DOW TheoryTesting the DOW Theory

jWhen a buy or neutral signal was detected, a

hypothetical portfolio is fully invested in

DJIA

jWhen a sell signal was detected, a

hypothetical portfolio is fully invested in

cash

± Tested from 1930-1997 Results indicate that some trend-predicting power

existed, but not enough to generate large excess returns




Bar ChartsBar Charts

jRepresent price (high, low, close) of

security over time

jVolume data is represented along bottom

± Second most important statistic to

technicians




Head and Shoulders FormationHead and Shoulders Formation

jA series of reversals

± Supposed to signal that a security¶s price has

reached a ceiling and is expected to decline in the

future




Head and Shoulders FormationHead and Shoulders Formation

Left shoulder²

heavy buying

increases priceto a peak before

lull in trading

pushes price

downward.

Head²a spurt of

buying activity

increases price to

new high. Then alull in trading

decreases prices

to below top of

left shoulder.

Right shoulder²amoderate rally

increases price

but not to a new

level equal to the

top of the head.

Confirmation

(breakout)²the

price falls belowthe neckline

which is a sell

signal.




Other PatternsOther Patterns

j Numerous patterns have been described bytechnicians, such as ± Triangles

± Pennants

± Flags

± Channels

± Rectangles

± Double tops ± Triple tops

± Wedge formations

± Diamonds




Charting Volume of Shares TradedCharting Volume of Shares Traded

jTechnicians argue volume measures

the intensity of investor¶s feelings

jVolume is studied in conjunction with prices

jTechnicians analyze resistance and

support levels along with volume




Support and Resistance LevelsSupport and Resistance Levels

jResistance level ± Ceiling (peak) above which

stock price is not expected to

go Supply of security is expected

to increase

jSupport level ± Floor (trough) below which

stock price is not expected todrop

Demand of security is expectedto increase




Support and Resistance LevelsSupport and Resistance Levels

jSuppose the following occurred

± Moderate surge in trading volume at Point

A ± Larger surge in trading volume at Point B

3 times greater than surge at Point A

± May surmise that some bullish new

information caused buying pressure atPoint B which overcame the previous

resistance at Point A




Congestion AreasCongestion Areas

jTechnicians are unable to offer reasons for

price actions like this

± Penetrating support line means sell

± Penetrating resistance line means buy

jStudies examining trading range breakouts find

that, after deducting commissions, return was

slightly larger than riskless interest rate




Congestion AreasCongestion Areas

Price fluctuates in

first congestion

area for a while.

Price rises through $50 resistance

level²old resistance level

becomes new support level.




Selling Climaxes and Speculative BlowoffsSelling Climaxes and Speculative Blowoffs

jWhen supply and demand are out of balance

(price is moving) volume is watched closely

± Market is bullish when high volume is combined

with a rising price

± Market is bearish with high volume and falling

prices

jFalling prices and high volume are

considered bullish if a selling climax occurs




Selling Climaxes and Speculative BlowoffsSelling Climaxes and Speculative Blowoffs

jIf one believes the end of bear market is near and high volume occurs ± Means last of bearish investors are liquidating

their holdings Clears the way for bullish investors to start bidding up

price

jA speculative blowoff marks the end of a bull market ± High volume pushes prices to peak

Exhausts bullish speculators enthusiasm, enabling bearish market to begin

± A bull dies with a bang, not a whimper




The Confidence IndexThe Confidence Index

jRatio of high-grade bond yields to low-grade bond yields ± Reveals how willing investors are to take risks

As investors grow more confident about economy, shiftfrom higher-grade bonds to lower-grade bonds (higher yields)

± Increases prices of low-grade bonds which leads tolower yields which leads to an increase in confidenceindex

jBarron¶s Confidence Index (BCI) ± Ratio of average yield from Barron¶s of 10 high-

grade bonds over average yield of Dow Jones 40 bond index




Interpreting the IndexInterpreting the Index

jHas an upper limit of 1 ± Yields on high-quality bonds will always be lower than

yields on low-quality bonds

± Yield spread narrows during economic boom

Confidence index rises

± Technicians predict stock market will rise

jBCI was at historically high levels (and rising) prior to stock market crash of October 19, 1987

jConfidence index is positively correlated to stock market over a complete business cycle ± However, sometimes it is a leading indicator, sometimes a

lagging one




Moving Average AnalysisMoving Average Analysis

jMoving averages are used to provide a smoothreference point for ± Individual securities

± Market indices

± Commodity prices

± Interest rates

± Foreign exchange rates

jSome use a 150-day (30 week) moving average

± Changes each day Most recent day is added and oldest day is dropped

± Following calculation is performed

» M150DAPt = (1/150)(Valuet + Valuet-1 + « Valuet-149)





jMoving averages computed over short time framesfollow daily prices more closely ± More volatile than longer-term moving averages

jTechnicians analyze difference between daily priceand moving average ± If daily prices penetrate moving average line it is a signal to

take action

If daily price moves down through a moving average, pricefails to rise for many months

± Sell signal If daily prices are above moving average but difference is

narrowing

± Signals end of bull market may be near





jMoving average analysts recommend buying stock if

± Moving average line flattens and stock price moves up through moving averageline

± Price of stock falls (temporarily) belowmoving average line that is rising

± Stock price is above moving average line,falls, turns around and rises again without penetrating moving average line





jMoving average analysts recommend sellingstock if ± Moving average line flattens and stock price

drops down through moving average line ± Stock price temporarily rises above a declining

moving average line

± Stock price falls through moving average line andturns around only to fall again without

penetrating above moving average line

jStrategy is more successful if movingaverage is calculated over a longer timeframe





jCan subscribe to chart delivery service

jCan buy years of historical daily prices

and draw own chartsjCan simulate trading by managing

hypothetical trades




Empirical Tests of Moving Average Rules andEmpirical Tests of Moving Average Rules and

Congestion AreasCongestion AreasjBrock, Lakonishok and LeBaron

(1992) and Bessembinder and Chan(1998) test moving average tradingrules

± Provide significant forecast power over DJIA

Found sample periods in which movingaverage trading rule earned significant profits

Found many sample periods in whichsignificant losses occurred




Patterns and ProceduresPatterns and Procedures

j New patterns can be perceived at will

jSimilarities between technical analysis

and Rorschach ink blot test ± Intelligent technicians with good

imagination can perceive many different

meaningful patterns




The Bottom LineThe Bottom Line

jTechnical tools are used to detect price patterns

jTechnical analysis assumes shifts in supply and

demand occur gradually over time

jPrice change pattern is extrapolated to predict future price changes

jMany financial economists believe technical analysis

cannot predict market prices

± Believe security prices are a random walk Occur in reaction to random arrival of new information

± Believe a series of similar independent changes in prices

are coincidence

technical analysis(3)

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