Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 16

Underlying Assumptions of Technical Analysis 1. The market value of any good or service is determined solely by the interaction of supply and demand 2. Supply and demand are governed by numerous factors, both rational and irrational

Underlying Assumptions of Technical Analysis 3. 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 4. 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 Not heavily dependent on financial accounting statements Problems with accounting statements: 1. Lack information needed by security analysts 2. GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements from two firms 3. Non-quantifiable factors do not show up in financial statements (psychological and other)

Advantages of Technical Analysis Fundamental analysts must process new information and quickly determine a new intrinsic value. Technical analysts have to recognize movements to new equilibria Technicians trade when a move to a new equilibrium is underway. Fundamental analysts find undervalued securities that may not adjust their prices as quickly

Challenges to Technical Analysis Assumptions of Technical Analysis Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends Technical Trading rules The past may not be repeated Patterns may become self-fulfilling prophecies A successful rule will gain followers and become less successful Rules require a great deal of subjective judgement

Technical Trading Rules and Indicators Stock cycles typically go through peaks and troughs Typical stock price cycles show a rising trend channel, a flat trend channel, a declining trend channel, and indications of when to trade

Typical Stock Market Cycle Stock Price Exhibit 16.2

Typical Stock Market Cycle Stock Price Exhibit 16.2 Declining Trend Channel Peak Flat Trend Channel Sell Point Rising Trend Channel Declining Trend Channel Buy Point Buy Point Trough Trough

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

Contrary-Opinion Rules Mutual fund cash positions: A high cash ratio (10-11%) means “time to buy”. A low cash ratio (4-5%) means time to sell. Credit balances in brokerage accounts: Decline in credit balances means lower purchasing power Investment advisory opinions: If most analysts are bearish, the trough in near

Contrary-Opinion Rules OTC versus NYSE volume: High OTC/NYSE volume ratio means more speculative activity (overbought market) Chicago Board Options Exchange (CBOE) put/call ratio: A ratio of 0.6 is considered bullish, 0.4 is considered bearish Futures traders bullish on stock index futures: Based on a survey

Follow the Smart Money The Barron’s Confidence Index: Ratio of yield on top-grade bonds over yield of average bonds (high ratio  bullish) T-Bill - Eurodollar yield spread: Spread falls at times of crisis Short sales by specialists Debit balances in brokerage accounts (margin debt)

Other Market Indicators Breadth of market Advance-decline Diffusion index Short interest (bullish when close to 5.0, bearish when close to 3.0) Stocks above their 200-day moving average Block uptick-downtick ratio

Stock Price and Volume Techniques The Dow theory – oldest technical trading rule 1. Major trends are like tides in the ocean 2. Intermediate trends resemble waves 3. Short-run movements are like ripples Importance of volume Ratio of upside-downside volume Support and resistance levels Moving average lines

Stock Price and Volume Techniques Relative-strength (RS) ratios For individual stocks and industry groups Bar charting Multiple indicator charts Point-and-figure charts Overall feel from a consensus of numerous technical indicators