Lecture 10 Technical Analysis Investments Lecture 10 Technical Analysis

Technical vs. Fundamental Analysis Fundamentalist looks forward Technician looks backward Fundamentalist concerned with future earnings and dividends Technician is concerned little if at all with these Fundamentalist concerned with where the price is moving in the future Technician makes recommendations on the timing of purchases and sales Fundamental analysis designed to answer “What” Technical analysis designed to answer “When”

Technical Analysis Definition – Technical analysis is the study of internal stock exchange information. The word technical implies a study of the market itself and not of those external factors which are reflected in the market…all the relevant factors, whatever they may be, can be reduced to the volume of the stock exchange transactions and the level of share prices… (Rosenfeld) At odds with market efficiency – The methodology of technical analysis…rests upon the assumption that history tends to repeat itself in the stock exchange. If a certain pattern of activity has in the past produced certain results nine times out of ten, one can assume a strong likelihood of the same outcome whenever the pattern appears in the future. It should be emphasized, however, that a large part of the methodology of technical analysis lacks a strictly logical explanation.

Uses for Technical Analysis Analyzing the various forces in the market is used in different ways by different investors As only input necessary in their decision-making As another piece of information in making buy/sell decisions As a waste of time Study of price and volume data in an attempt to gain insight on where future prices (especially in the short-term) will be moving “Information is pretty thin stuff unless mixed with experience.” (Day, 1920)

History of Technical Analysis Early development Developed in the late 1800s by Charles Dow (editor of the WSJ) Developed theory to describe past price movements – this was a completely new way of analyzing markets Developed more by William Hamilton who used to predict movements in the market

History of Technical Analysis Analyzing market behavior goes back to 1800s No such thing as industry or firm analysis Some used charts to see what was going on in market overall – charts focused on price movements Movements made “formations” “formations indicated buy/sell decisions If stock price behavior is independent of market movements, then technical analysis is worthless. Studies of betas of stocks prices react to demand for securities and supply of funds As balance between supply and demand shifts, future prices will change Technical analysis is aimed at detecting this shift

Technical Analysis On what should stock prices be based? Fundamental characteristics of the firm? Investors expectations? The price of a stock at any one time represents a consensus view of the market of that stock’s current intrinsic value Rationality of investors – if investors are rational, then the use of fundamental analysis should at all times be directly related to the intrinsic value of firms Are investors perfectly rational with respect to investing? “I believe that the future is only the past again, entered through another gate.” (Sir Arthur Wing Pinero, 1893)

Underlying Assumptions Market value is determined solely by the interaction of supply and demand Supply and demand are governed by numerous factors both rational and irrational. Disregarding minor fluctuations in the market, stock prices tend to move in trends which persist for an appreciable length of time. Changes in trend are caused by shifts in demand and supply. These shifts no matter why they occur, can be detected sooner or later in the action of the market itself.

Framework for Technical Analysis Able to be applied to the aggregate market or individual stocks Uses graphs or charts and technical trading rules and indicators Price and volume are primary tools Believe that forces of supply and demand lead to certain patterns of price behavior Volume data used to gauge the general condition in the market and to help assess the trend Most evidence suggests that rising (falling) prices are usually associated with rising (falling) volume

Technical Analysis “It is futile to assign an intrinsic value to a stock certificate. One share of US Steel, for example, was worth $261 in the early fall of 1929, but you could buy it for only $22 in June 1932. By March 1937 it was selling for $126 and one year later for $38…This sort of thing, this wide divergence between presumed value and intrinsic value, is not the exception, it is the rule… (Damodaran) Transaction price is the settlement point that reflects both fundamental characteristics of firm and all other qualitative factors that affect investors dealings in the market

Technical Analysis Are investors rational? In studies of investments/portfolio management, we generally assume investors are rational. Behavioral finance is one area of research that addresses the legitimacy of this assumption Speculative bubbles Overreaction Implications of irrationality for technical analysis

Technical Analysis Computerized trading If we agree that prices are affected by factors that can not be quantified and are not always rational, we must accept that our decision-making on buying/selling is driven by these same factors. Trading rules and computerized trading can take away some of our irrationality. However remember that even if you establish specific rules that prevent you from being irrational, the computer is still “making decisions” in a market that is not always rational.

Technical Analysis Problems with accounting statements that make technical analysis feasible Lack a lot of information that security analysts need Firms can choose different ways to present certain numbers in accounting statements that make it difficult for analysts to compare across firms Large number of nonquantifiable variables not included in financial statements

Tools for Technical Analysis “A picture is worth a thousand words.” Bar charts Line charts Volume bar charts Candlestick Point and figure charts

Contrarian Indicators Observed behavior is that individuals tend to overreact to surprising news events Evidence that this behavior also occurs in the market (overweight new information and underweight older information) If markets overreact, then big changes in prices will be followed by price movements in the other direction. Questions about whether overreaction occurs

Sentiment Indicators Investment advisory opinions Mutual fund cash positions Put/call ratio Public short interest ratio

Support and Resistance Market price is consensus view of market on security’s intrinsic value Buyers are bullish on stock Sellers are bearish on stock Price movements indicate one side winning Support levels arise when consensus is price is at its bottom and will not fall further Buyers outnumber sellers Resistance levels when consensus is price is at its highest Sellers outnumber buyers

Support and Resistance Penetration of support/resistance occurs when supply/demand changes Volume / trader’s remorse Rationale for importance of support/resistance Institutional trading programs Self-fulfilling prophecy

Moving Averages Oldest tool of technical analysis Smooths out fluctuations in prices so that technical analyst can search for trends Simple moving average Average of price expectations over period of time during which moving average is calculated Comparison of security price to moving average Current price > ma  current expectations exceed average expectations over period ma calculated (bullish or buy signal)

Momentum Indicators Absolute breadth Advance/decline line Looks at volatility and price changes Direction of prices is unimportant =absolute value (advancing issues – declining issues) Advance/decline line Most popular measure of market breadth Line moves up when more stocks are advancing than declining “trouble looms when the generals lead and the troops refuse to follow” (Achelis) Numeric value of line is unimportant – slope and pattern are impt.

Relative Strength Ratios determined for firm or industry group Computed as price of stock relative to value of a market series (ie, S&P 500) Increasing ratio says stock outperforming market In a bear market, if the stock price falls by less than the decline in the market series, then techs believe that this stock will do well in the next bull market RSI first presented as a 14 day index Now 9 day and 25 day are popular