1. Lecture 10 Technical Analysis
Investments
Lecture 10
Technical Analysis

2. 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”

3. 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.

4. 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)

5. 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

6. 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

7. 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)

8. 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.

9. 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

10. 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 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

11. 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

12. 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.

13. 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

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

15. 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

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

17. 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

18. 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

19. 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)

20. 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.

21. 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