1. Chapter 9
Technical Analysis, Market Efficiency, and Behavioral Finance

2. Market Price Behavior Learning Goals
Discuss the purpose of technical analysis and why market performance is important to stock valuation.
Describe approaches to technical analysis, such as the Dow Theory, moving averages, charting and indicators of the technical condition of the market.
Compute and use technical trading rules.
Explain the idea of random walks and efficient markets and note the challenges these theories hold for the stock valuation process.
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3. Market Price Behavior Learning Goals (cont’d)
Describe the weak, semi-strong, and strong versions of the efficient market hypothesis and explain what market anomalies are.
Demonstrate a basic appreciation of how psychological factors can affect investors’ decisions, and how behavioral finance presents a challenge to the concept of market efficiency.
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4. Technical Analysis
Before financial data/financial statements were required to be disclosed, investors could only watch the stock market itself to determine buy-or-sell decisions
Investors began keeping “charts” of stock market movements to look for patterns, or “formations” that indicated whether to buy or sell
Studies have shown that anywhere from 20% to 50% of the price behavior of a stock can be traced to overall market forces
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5. Technical Analysis (cont’d)
Technical Analysis is the study of the various forces at work in the marketplace and their affect on stock prices.
Focus is on trends in a business’ stock price and the overall stock market
Stock prices are a function of supply and demand for shares of stock
Used to get a general sense of where the stock market is going in the next few months
Several technical indicators may be used together
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6. Big Picture Technical Indicators
The Dow Theory
Market’s performance is based upon long-term price trend (primary trend) in overall market
Used to signal end of both bull and bear markets
An after-the-fact measure with no predictive power
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7. Figure 9.1 The Dow Theory in Operation
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8. Big Picture: Technical Indicators (cont’d)
Trading Action
Looks at minor trading characteristics in market over long periods of time
Assumes the market moves in cycles and these cycles repeat themselves
Trading rules are formed from patterns:
January indicator
Presidential election indicator
Super Bowl indicator
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9. Big Picture Technical Indicators (cont’d)
Confidence Index
Looks at ratio between yields on high-grade corporate bonds compared to low-grade corporate bonds
Optimism and pessimism about the future outlook is reflected in the bond yield spread
Trend of “smart money” is revealed in bond market before it shows up in stock market
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10. Market Technical Indicators
Market Volume
Pure supply and demand analysis for common stocks
Strong market when volume goes up
Weak market when volume goes down
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11. Market Technical Indicators (cont’d)
Breadth of the Market
Looks at number of stock prices that go up (advances) versus number of stock prices that go down (declines)
Strong market when advances outnumber declines
Weak market when declines outnumber advances
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12. Market Technical Indicators (cont’d)
Short Interest
Looks at number of stocks that have been sold short at any given time
Can give two different interpretations:
Measure of Future Demand for Stock
Strong market when short sales are high since guarantees future stock sales to cover the short positions
Measure of Present Market Optimism or Pessimism
Weak market when short sales are high since professional short sellers think stocks will decline
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13. Market Technical Indicators (cont’d)
Contrary Opinion and Odd-Lot Trading
Measures the volume of small traders
Assumes that small traders will do just the opposite of what should be done
Panic and sell when market is low
Speculate and buy when market is high
Bull market when odd-lot sales significantly outnumber odd-lot purchases
Bear market when odd-lot purchases significantly outnumber odd-lot sales
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14. Trading Rules and Measures
Advance-Decline Line
Measures the difference between stocks closing higher and stocks closing lower than previous day
Difference is plotted on graph to view trends
Used as signal to buy or sell stocks
Bull market when advances outnumber declines
Bear market when declines outnumber advances
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15. Trading Rules and Measures (cont’d)
New Highs–New Lows
Measures the difference between stocks reaching a 52-week high and stocks reaching a 52-week low
10-day moving average is plotted on graph to view trends
Used as signal to buy or sell stocks
Bull market when highs outnumber lows
Bear market when lows outnumber highs
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16. Trading Rules and Measures (cont’d)
The Trading Index (TRIN)
Combines advance-decline line with trading volume
Used as signal to buy or sell stocks
Bull market when TRIN values are lower
Bear market when TRIN values are higher
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17. Trading Rules and Measures (cont’d)
Mutual Fund Cash Ratio (MFCR)
Tracks cash position of mutual funds
High cash positions in mutual funds provides liquidity for future stocks purchases or protection from future mutual fund withdrawals
Bull market when MFCR values are higher
Bear market when MFCR values are lower
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18. Trading Rules and Measures (cont’d)
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
Bull market when OBV values are higher
Bear market when OBV values are lower
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19. Using Technical Analysis
Charting
Shows visual summary of stock activity over time
Easy to use and to understand
Use to spot developing trends
Major types
Bar Charts
Point-and-Figure Charts
Chart Formations
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20. Figure 9.3 A Stock Chart
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21. Using Technical Analysis (cont’d)
Bar Charts
Shows changes in stock price over period of time
Often used to compare current stock price with moving average
When current price goes above or below a moving average, indicates significant price change
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22. Figure 9.4 A Bar Chart
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23. Using Technical Analysis (cont’d)
Point-and-Figure Charts
Only shows significant changes in stock price patterns
Up patterns are shown as an “X” and down patterns are shown as an “O”
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24. Figure 9.5 A Point-and-Figure Chart
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25. Using Technical Analysis
Chart Formations
Looking for patterns, or formations, that historically meant that stocks were going up or down
Buy when stocks break through a “line of resistance”
Sell when stocks break through a “line of support”
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26. Figure 9.6 Some Popular Chart Formations
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27. Using Technical Analysis (cont’d)
Moving Averages
Tracks data (usually stock price) as average value over time
Used to “smooth out” daily fluctuations and focus on underlying trends
Usually calculated over periods ranging from 10 to 200 days
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28. Figure 9.7 A 100-Day Moving Average Line
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29. Random Walks and Efficient Markets
Random Walk: the theory that stock price movements are unpredictable, so there is no way to know where prices are headed
Studies of stock price movements indicate that they do not move in neat patterns
This could be an indication that markets are highly efficient and respond quickly to changes in the current situation
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30. Random Walks and Efficient Markets (cont’d)
Efficient Market: a market in which securities reflect all possible information quickly and accurately
Efficient Market Hypothesis: markets have a large number of knowledgeable investors who react quickly to new information, causing securities prices to adjust quickly and accurately
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31. Random Walks and Efficient Markets (cont’d)
To have an efficient market, you must have:
Many knowledgeable investors active in analyzing and trading stocks
Information is widely available to all investors and is free/easy to obtain
Events, such as labor strikes or accidents, tend to happen randomly
Investors react quickly and accurately to new information, causing prices to adjust
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32. Levels of Efficient Markets
Weak Form
Past data on stock prices are of no use in predicting future stock price changes
Everything is random
Should simply use a “buy-and-hold” strategy
Semi-strong Form
Abnormally large profits cannot be consistently earned using public information
Any price anomalies are quickly found out and the stock market adjusts
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33. Levels of Efficient Markets (cont’d)
Strong Form
There is no information, public or private, that allows investors to consistently earn abnormally high returns
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34. Market Anomalies Calendar Effects Small-Firm Effect
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
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35. 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
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36. Technical vs. Fundamental: So Who is Right?
There is growing consensus that markets may not be perfectly efficient, but they may be at least reasonably efficient
Individual investor must determine which approach has merits for their investing decisions
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37. 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
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38. 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
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39. 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
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40. Behavioral Finance at Work in the Markets
Stock Return Predictability
It maybe profitable to buy underperforming stocks when they are out-of-favor
Momentum of stock prices up and down tends to continue over 6- to 12-month time horizons
Value stocks may outperform growth stocks
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41. Behavioral Finance at Work in the Markets (cont’d)
Investor Behavior
Investors who believe they have superior information tend to trade more, but earn lower returns
Investors tend to sell stocks that have risen in value rather than declined
Investors acting on emotions instead of facts may reduce market efficiency
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42. Behavioral Finance at Work in the Markets (cont’d)
Analyst Behavior
Analysts may be biased by “herding” behavior, where they tend to issue similar recommendations for stocks
Analysts may be overly optimistic about a favorite stock’s future
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43. Using Behavioral Finance to Improve Investment Results (Table 9.1)
Don’t hesitate to sell a losing stock
Don’t chase performance
Be humble and open-minded
Review the performance of your investment on a periodic basis
Don’t trade too much
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44. Chapter 9 Review Learning Goals
Discuss the purpose of technical analysis and why market performance is important to stock valuation.
Describe approaches to technical analysis, such as the Dow Theory, moving averages, charting and indicators of the technical condition of the market.
Compute and use technical trading rules.
Explain the idea of random walks and efficient markets and note the challenges these theories hold for the stock valuation process.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

45. Chapter 9 Review (cont’d)
Learning Goals (cont’d)
Describe the weak, semi-strong, and strong versions of the efficient market hypothesis and explain what market anomalies are.
Demonstrate a basic appreciation of how psychological factors can affect investors’ decisions, and how behavioral finance presents a challenge to the concept of market efficiency.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

46. Chapter 9
Additional Chapter Art

47. Figure 9.2 Some Market Statistics
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48. Table 9.1 Using Behavioral Finance to Improve Investment Results
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