Analysis of Investments and Management of Portfolios by Keith C. Brown & Frank K. Reilly Chapter 15 Technical Analysis –Underlying Assumptions –Advantages of Technical Analysis –Challenges to Technical Analysis –Technical Trading Rules and Indicators –Technical Analysis of Foreign Markets –Technical Analysis of Bond Markets

15-2 The 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 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 Underlying Assumptions of Technical Analysis

15-3 Underlying Assumptions of Technical Analysis Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself See Exhibit 15.1 –It shows the process wherein new information causes a decrease in the equilibrium price for a security but the price adjustment is not rapid

15-4 Exhibit 15.1

15-5 Advantages of Technical Analysis Technical analysis is not heavily dependent on financial accounting statements. The technician contends that there are several major problems with accounting statements: –Lack information needed by security analysts –GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements from two firms –Non-quantifiable factors do not show up in financial statements

15-6 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 their prices as quickly Advantages of Technical Analysis

15-7 Challenges to Technical Analysis For Technical Analysis –Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends –The past may not be repeated –A successful rule will gain followers and become less successful –Rules require a great deal of subjective judgement

15-8 Technical Trading Rules & Indicators The Rationale –A typical stock price cycle for the market or a stock goes through a peak and trough as well as trends –By analyzing the trend patterns (rising trend, flat trend, declining trend) and the change in trend, a technical analyst would be able to decide what trade is needed (Exhibit 15.2) Trading Rules –Contrary-Opinion Rules –Follow the Smart Money –Momentum Indicators –Stock Price and Volume Techniques

15-9 Exhibit 15.2

15-10 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 troughs Technicians try to determine whether investors are strongly bullish or bearish and then trade in the opposite direction These positions have various indicators

15-11 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

15-12 Contrary-Opinion Rules OTC versus NYSE volume –If OTC volume increases relative to NYSE volume, sell since speculation increases at peaks Futures traders bullish on stock index futures –Sell when speculators are bullish

15-13 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, investors The Barron’s Confidence Index –Measures the yield spread between high-grade bonds and low grade bonds –Declining (increasing) yield spreads increase (decrease) this index, and are a bullish (bearish) indicator

15-14 Follow the Smart Money T-Bill - Eurodollar yield spread –Decreases 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

15-15 Momentum Indicators Breadth of market –Measures the number stock prices increased and the number of stock prices declined each day –Bullish if Advances outnumber declines –The advance–decline index is typically a cumulative index of net advances or net declines –See Exhibit 15.5 Stocks above their 200-day moving average –The market is considered to be overbought and subject to a negative correction when more than 80 percent of the stocks are trading above their 200-day moving average

15-16 Exhibit 15.5

15-17 Stock Price and Volume Techniques The Dow Theory –The oldest technical trading rule –Stock prices as moving in trends analogous to the movement of water –Three types of price movements over time Major trends are like tides in the ocean Intermediate trends resemble waves Short-run movements are like ripples –Exhibit 15.7 shows the typical bullish pattern

15-18 Exhibit 15.7

15-19 Stock Price and Volume Techniques Importance of Volume –Technicians watch volume changes along with price movements as an indicator of changes in supply and demand –The technician looks for a price increase on heavy volume relative to the stock’s normal trading volume as an indication of bullish activity –Conversely, a price decline with heavy volume is considered bearish

Stock Price and Volume Techniques On Balance Volume - Tracks the volume to price change relationship as a running total - Up-volume occurs when stock closes higher and is added to running total; down-volume occurs when stock closes lower and is subtracted from running total - Direction of indicator is more important than actual value - Used to confirm price trends - Bullish when OBV values are higher - Bearish when OBV values are lower

15-21 Stock Price and Volume Techniques Support and Resistance Levels –A support level is the price range at which the technician would expect a substantial increase in the demand for a stock –A resistance level is the price range at which the technician would expect an increase in the supply of stock and a price reversal –It is also possible to envision a rising trend of support and resistance levels for a stock

Stock Price and Volume Techniques The Trading Index (TRIN) - Combines price movement with trading volume - Used as signal to buy or sell stocks - Bullish when TRIN values are lower - Bearish when TRIN values are higher

15-23 Stock Price and Volume Techniques Moving Average Lines –MA lines are meant to reflect the overall trend for the price series –The shorter MA line (the 50-day versus 200-day) reflecting shorter trends –If prices reverse and break through the moving- average line from below accompanied by heavy trading volume, most technicians would consider this a positive change; and vice verse –If the 50-day MA line crosses the 200-day MA line from below on good volume, this would be a bullish indicator –See Exhibit 15.9

15-24 Exhibit 15.9

Stock Price Charting Charting - Shows visual summary of stock activity over time - Easy to use and to understand - Use to spot developing trends -Major types Line Chart Bar Chart Candlestick Chart Point-and-figure Charts

Line Chart 15-26

15-27 Bar Chart

15-28 Market Anomalies Calendar Effects –Stocks returns may be closely tied to the time of year or time of week –Questionable if really provide opportunity –Examples: January effect, weekend effect Small-Firm Effect –Size of a firm impacts stock returns –Small firms may offer higher returns than larger firms, even after adjusting for risk

15-29 Market Anomalies (cont’d) Earnings Announcements –Stock price adjustments may continue after earnings adjustments have been announced –Unusually good quarterly earnings reports may signal buying opportunity P/E Effect –Uses P/E ratio to value stocks –Low P/E stocks may outperform high P/E stocks, even after adjusting for risk

Investor Behavior and Security Prices Overconfidence Investors tend to be overconfident in their judgment, leading them to underestimate risks Biased Self-Attribution Investors tend to take credit for successes and blame others for failures Investors will follow information that supports their beliefs and disregard conflicting information

Investor Behavior and Security Prices (cont’d) Loss Aversion Investors dislike losses much more than gains Investors will hang on to losing stocks hoping they will bounce back Representativeness Investors tend to draw strong conclusions from small samples Investors tend to underestimate the effects of random chance

Investor Behavior and Security Prices (cont’d) Narrow Framing Investors tend to analyze a situation in isolation, while ignoring the larger context Belief Perseverance Investors tend to ignore information that conflicts with their existing beliefs

15-33 The Internet Investments Online