Chapter 13 TECHNICAL ANALYSIS

Chapter 13 Questions How does technical analysis differ from fundamental analysis? What are the underlying assumptions of technical analysis? What major assumption causes a difference between technical analysis and the efficient market hypothesis? What are the major advantages of technical analysis compared to fundamental analysis?

Chapter 13 Questions What are the major challenges to technical analysis and its rules? What is the logic for the major contrary-opinion rules used by technicians? What are some of the significant rules used by technicians who want to “follow the smart money,” and what is the logic of those rules? What are the breadth of market measures and what are they intended to indicate?

Chapter 13 Questions What are the three types of price movements postulated in the Dow Theory, and how are they used by a technician? Why is the volume of trading important and how do technicians use it? What are support and resistance levels and how are they used by technicians?

Chapter 13 Questions How do technicians use moving-average lines to detect major changes in trends? What is the rationale behind the relative-strength line for an industry or a stock? How are bar charts different from point-and-figure charts? What are some uses of technical analysis in foreign security markets? How is technical analysis used when analyzing bond markets?

Technical Analysis vs. Fundamental Analysis Technical analysis involves the development of trading rules based on past price and volume data for individual stocks and the overall stock market. Fundamental analysis involves economic, industry, and company analysis that lead to valuation estimates for companies, which can then be compared to market prices to aid in investment decisions.

Technical Analysis To “non-believers,” technical analysis can sound like a lot of focus-pocus!

Underlying Assumptions of Technical Analysis Trading via technical analysis involve a number of assumptions about markets 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

Underlying Assumptions of Technical Analysis Technical analysis assumptions: 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 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 Unlike fundamental analysis, technical analysis is not heavily dependent on financial accounting statements Problems with accounting statements: Lack information needed by security analysts GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements between firms Many psychological and other non-quantifiable factors do not show up in financial statements

Advantages of Technical Analysis 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 to “correct” prices as quickly

Challenges to Technical Analysis Challenges to basic assumptions Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends Challenges to technical trading rules Rules that worked in the past may not be repeated Patterns may become self-fulfilling prophecies A successful rule will gain followers and become less successful Rules all require subjective judgement

Technical Trading Rules and Indicators Stock cycles typically go through a peak and trough For instance, consider the following stock price graph over time, and then consider how a technical analyst would interpret the chart

Typical Stock Market Cycle Stock Price

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

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

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

Contrary-Opinion Rules OTC versus NYSE volume If OTC volume increases relative to NYSE volume, sell since speculation increases at peaks Chicago Board Options Exchange (CBOE) put/call ratio Buy when option purchasers are bearish (when the put/call ratio increases) Futures traders bullish on stock index futures Sell when speculators are bullish

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 a large cross section of bonds Declining (increasing) yield spreads increase (decrease) this index, and are a bullish (bearish) indicator

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

Momentum Indicators These indicators are meant to gauge overall market sentiment Breadth of market Advance-decline (number of advancing minus the number of declining issues) Stocks above their 200-day moving average Technicians use moving averages to compute general trends, and evaluate current stock prices relative to those trends

Stock Price and Volume Techniques The Dow theory Major trends are like tides in the ocean Intermediate trends resemble waves Short-run movements are like ripples Key is to identify the nature of a current price movement Importance of volume Ratio of upside-downside volume Price movements are not very important unless they are “confirmed” by volume

Stock Price and Volume Techniques Support and resistance levels Support level: the level that a price is unlikely to decline below; when price reaches the support level, demand surges for the stock Resistance level: the level that a price is unlikely to rise above; when price reaches the resistance level, we observe selling or “profit taking” Movements below (bearish) and above (bullish) this range provide indicators

Stock Price and Volume Techniques Moving average lines Moving average prices are calculated and track for several different time periods When the shorter-term moving average line is consistently above the longer-term line, it is considered a bullish signal

Stock Price and Volume Techniques Relative-strength (RS) ratios For individual stocks and industry groups Measure relative price changes across different stocks or industries Other Indicators Bar charting Multiple indicator charts Point-and-figure charts Idea is to get an overall feel from numerous technical indicators

Technical Analysis of Foreign Markets Some foreign market data is more limited than U.S. market data Greater reliance on stock and volume data Merrill Lynch publishes various indicators for several countries Technical analysis of foreign exchange rates Traders look for trends in exchange rates that could give rise to profit opportunities

Technical Analysis of Bond Markets Many of the same indicators and trading rules can be applied to bond markets Generally not possible to get bond market volume data