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

2. 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

3. 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

4. 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)

5. 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

6. 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

7. 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

8. Typical Stock Market Cycle
Stock Price
Exhibit 16.2

9. 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

10. 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

11. 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

12. 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

13. 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)

14. 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

15. 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

16. 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