Week 6

Technical Analysis

Technical Analysis Attempt to exploit recurring and predictable patterns in

stock prices to generate abnormal trading profits. Stock market moves in trends which are determined by the

changing attitudes of investors to a variety of economic, monetary, political and psychological forces.

Identify changes in trends at an early stage; and Maintain an investment until a reversal of that trend is indicated.

Technicians believe: Shifts in market fundamentals can be discerned before the

impact is fully reflected in prices. Fundamentals can be perturbed by irrational factors. When there is a shift in market fundamentals, price

adjustment to a new equilibrium is gradual, leading recognizable trend.

Technical Analysis The presumptions in technical analysis are not consistent

with EMH. Exploitable trends in stock prices would be the evidence

against EMH, as they would indicate profit opportunities that market participants had left unexploited.

The notion of evolving patterns is consistent with almost but not-quite efficient markets. There are patterns in stock prices that can be exploited, but

once investors identify and attempt to profit from these patterns, their trading activities affect prices, thereby altering prices.

The patterns that characterize the stock prices will be constantly evolving, and only the best analysts who can identify new patterns earliest will be rewarded.

Charting: The Dow Theory A technique that attempts to discern long- and short-term

trends in stock market prices. Two indicators used

DJIA: Key indicator of underlying trends DJTA: Indicator for confirming or rejecting the signal

Three forces that simultaneously affect stock prices Primary trend: Long-term movements of prices (several

month to several years) Secondary or intermediate trends: Short-term deviations of

prices from the underlying trend line, which are eliminated via corrections toward trend values.

Tertiary or minor trends: Daily fluctuations of little importance.

Charting: The Dow Theory Support and resistance levels in stock prices

Support level: A value below which a stock or stock index is relatively unlikely to fall.

Resistance level: A value above which a stock or stock index is difficult to rise.

Support and resistance levels are determined by the recent history of stock prices.

Piercing the resistance level is a bullish signal. Piercing the support level is a bearish signal. Technicians see these levels as resulting from common

psychological investor traits. The contradictory signal between DJIA and DJTA

(nonconfirmation by DJTA) is a warning sign.

Charting: The Dow TheoryEMH and the Dow theory

The EMH holds that if any pattern is exploitable, many investors attempt to profit from such predictability, which would ultimately move prices and cause trading strategy to self-destruct.

Recent variations on the Dow theory The Elliott wave theory: Stock prices can be

described by a set of wave patterns – By interpreting the long- and short-term cycles, one can predict broad movements.

The theory of Kondratieff waves: Macroeconomy (stock market) moves in broad waves lasting between 48 and 60 years.

Charting: Other Techniques Point and figure chart

Simply trace significant upward or downward movements in stock prices without regard to their timing.

It is customary to require reasonably substantial price changes before marking pluses or minuses.

Sell (buy) signals are generated when the stock price penetrates previous lows (highs).

Candlestick chart The box with the vertical line drawn through it allows to

ascertain the open and close price for the day, as well as the high and low price.

If the price increases during the day, the box is shaded. The chart conveys a considerable amount of information

about recent stock price history.

Charting: Warning Unfortunately, it is possible to perceive patterns that

really do not exist. The simulated data from a random number generator

(patternless by construction) can display the pattern that is very similar to a pattern in the real stock prices.

Data mining After the fact, you can always find patterns and trading rules

that would have generated big profits: If you test enough rules, some will have worked in the past.

Unfortunately, picking a theory that would have worked after the fact carries no guarantee of future success.

In evaluating trading rules, you should always ask whether the rule would have seemed reasonable before you looked at the data.

Technical Indicators

Sentiment Indicators Measure the expectations of various groups of investors,

for example, mutual fund managers, corporate insiders, or NYSE specialists.

Flow of funds indicators Measure the potential for various investor groups to buy

or sell stocks in order to predict the price pressure from those actions.

Market structure indicators Monitor price trends and cycles. Examples: Charting techniques.

Sentiment Indicators Trin Statistic

Market volume can measure the strength of a market rise or fall: Market advances (reversals) are considered more bullish (bearish) when associated with increased trading volume.

Trin = Number Advancing / Number Declining

Volume Advancing / Volume Declining

= Volume Declining / Number Declining

Volume Advancing / Number Advancing

= Average Volume in Declining Issues

Average Volume in Advancing Issues Ratios above 1.0 are considered bearish because the falling

stocks would have higher average volume than advancing stocks, indicating net selling pressure.

Sentiment Indicators Odd-Lot Trading

An odd lot is a transaction of fewer than 100 shares. Odd-lot traders are almost always small individual traders. The odd-lot theory

Small investors tend to miss key market turning points, typically buying stocks a bull market has already run its course and selling too late into a bear market.

When odd-lot traders are widely buying, you should sell and vice versa.

The ratio of odd-lot purchases to sales which is above 1.0 indicates the bearish market because small traders are net buyers.

Sentiment Indicators Confidence Index

Presumption: Actions of bond traders reveal trends that will emerge soon in the stock market.

The ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds: Always below 100%.

The higher values are bullish signal because default premium on lower rated bonds will be smaller when bond traders are optimistic about the economy.

Put/Call Ratio The ratio of outstanding put options to outstanding call

options: Typically, about 65%. Deviations of the ratio from historical norm can be a signal

of market sentiment and predictive of market movements.

Sentiment Indicators Put/Call Ratio

Increase in the ratio as Bearish: Growing interest in puts as a hedge against market declines.

Contrarian investors would consider an increase in the ratio as a signal of a buy opportunity, as they believe that a good time to buy is when the rest of the market is bearish.

Mutual Fund Cash Positions Presumption: Mutual funds act incorrectly before a market

turning points – Become more bullish and hold lower cash position (fully invested) when the market is at, or near, a peak.

The percentage of cash held in mutual fund portfolios is one common measure of sentiment: This percentage moves in the opposite direction of the stock market.

Flow of Funds Indicators Short Interest

Total number of shares currently sold short in the market. High levels of short interest can be interpreted as bullish,

some as bearish. Bullish: All short sales must be covered, suggesting short

interest represents latent future demand for the stocks. Bearish: Short sellers tend to be larger, more sophisticated

investors, and increased short interest reflects bearish sentiment of those investors.

Credit Balances in Brokerage Accounts Investors with brokerage accounts often leave balances

when they plan to invest in the near future. Credit balances may be viewed as measuring the potential

for new stock purchases: High balances - Bullish sign.

Market Structure Indicators Moving Averages

Moving average of a stock index is the average level of index over a given interval of time.

52-week moving average: Each week, the moving average is recomputed using index values of most recent 52-week.

After a period in which prices have generally been falling, the moving average will be above the current price (the moving average averages in the older and higher prices).

When the current price breaks through the moving average line from below: A bullish sign – A shift from a falling trend (with prices below the moving average) to a rising trend (with prices above the moving average).

When the current price breaks through the moving average line from above: A bearish sign.

Market Structure Indicators Breadth

A measure of the extent to which movement in a market index is reflected widely in the price movements of all the stocks in the market.

The most common measure: Spread between the number of stocks that advance and decline in price.

If advances outnumber decline by a wide margin, the market is viewed as being stronger.

Some analysts cumulate breadth data each day. The cumulative breadth for each day = That day’s net

advances (or declines) + Previous day’s total. The direction of cumulative breadth is used to identify

broad market trends.

Market Structure Indicators Relative Strength

A measure of the extent to which a security has outper-formed or underperformed either the market as a whole or its particular industry.

The most common measure: Ratio of the price of the security to a price index for the industry.

A rising ratio implies the stock has been outper-forming the rest of industry.

If relative strength can be assumed to persist over time, this would be a signal to buy stock.

The relative strength of an industry relative to the whole market can be computed for tracking the ratio of the industry price index to the market price index.

Value Line System Value Line System is widely followed by investors and

displays the evidence of superior performance. Value Line ranks stocks on a timeliness scale of one (best

buy; expected to perform the best) to five (sell; expected to perform the worst).

The evidence shows that the different groups perform just as the rankings predict.

Value Line System is predominately a technical system. The ranking procedure has three components: relative

earnings momentum, earnings surprise, and value index. Points assigned for each factor determine the stock’s overall

ranking. Value Line System is difficult to implement in market:

Underperformance of Value line’s mutual fund.

Technical Analysis in Efficient Markets Self-destructing Patterns

The idea behind the technical analysis is inconsistent with EMH.

The real test of EMH: Whether a technical rule that seems to work will continue to work in the future (that, is become reflected in stock prices) once it becomes widely recognized: Self-destructing.

Market dynamic: Search for profitable trading rules Destruction Another search for yet-discovered rules.

Modern View of Technical Analysis Prices reveal and reflect information and become useful to

traders. This view can reconcile technical analysis with the usual

assumption of rational traders participating in efficient markets.