CHAPTER 19 Behavioral Finance and Technical Analysis

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Behavioral Finance  Traditional theory ignores some aspects of personal behavior  Behavioral finance tries to incorporate personal behavior to extend corporate finance  Behavioral finance is a developing area

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior  Cooperation and Altruism  Bidding and the Winner’s Curse  Endowment Effect, Status Quo Bias and Loss Aversion  Mental Accounts

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Asset Returns and Behavioral Explanations  Calendar effects  Cash dividends  Overreaction and mean reversion  Controversial explanations from behavioral finance –Closed-end fund pricing –Excess volatility in stock prices

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. High Low Close Price Days Sample Price Chart

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. oooooo oooooooooo oooo oooooooooo oooo oooo Congestion areas Sell Point and Figure Chart Price xxxxxxxx xxxxxx xxxx xxxx xxxx x

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Sentiment Indicators Trin Statistics # Advancing / # Declining Volume Advancing / Volume Declining # Declining / Volume Declining # Advancing / Volume Advancing If Trin > 1.0 bearish signal

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Sentiment Indicators  Put / Call Ratio –Historical value 65% –When higher than 65% a signal occurs  Bearish view  Bullish view  Mutual Fund Cash Position –Cash levels are low - bearish sign –Cash levels are high - bullish sign

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Sentiment Indicators Odd - Lot Trading  Ratio of odd-lot purchases to odd-lot sales  When ratio exceeds 1.0, bearish sign  Contrarian logic - small investors are the last to buy in bull markets

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Flow of Funds Indicators  Short Interest - total number of shares that are sold short –When short sales are high a signal occurs –Bullish interpretation –Bearish interpretation  Credit Balances in Brokerage Accounts –Investor leave balances when they plan to invest in the future –When levels are high a bullish sign

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Structure Indicators Moving Averages  Average price over some historical period (5 weeks or 200 days)  When current price crosses the average a trading signal occurs  Bullish signal when the current price rises above the moving average  Bearish sign when the current price falls below the moving average

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Structure Indicators Breadth  The extent to which movements in a broad index are reflected widely in movements of individual stocks  Spread between advancing stocks and declining stocks  Also used in industry indexes

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Value Line System  Widely followed with some evidence of superior performance  Value Line System is predominately a technical system –Earnings momentum –Relative stock prices –Ratios of moving averages

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Value Line System  Paper vs actual performance indicates that the system is difficult to implement –Value Line Fund has not shown superior performance –High turnover costs are associated with the strategy  Evidence shows prices react quickly to reported ranking changes