Chapter Nine A Basic View of Technical Analysis

A Basic View of Technical Analysis and Market Efficiency n n n Technical Analysis: The Use of Charting Key Indicator Series Efficient Market Hypothesis Weak Form of the Efficient Market Hypothesis Semistrong Form of the Efficient Market Hypothesis Strong Form of the Efficient Market Hypothesis 2

The Technical Approach to Investment Timing n n A gap exists between the practices of brokerage houses and Wall Street (charting and other technical analyses) and the beliefs held in the academic community (such as in the efficient market hypothesis) Since a consensus does not exist, it may pay to consider many schools of thought in valuing a security 3

Technical Analysis n n n Examines prior price and volume data and other market-related indicators to determine past trends hoping this will help forecast future trends Emphasis on charts and graphs of internal market data Less emphasis on fundamental factors 4

Technical Analysis n n Belief that the discovery of fundamental information may not lead to profitable trading because of timing considerations and market imperfections Market Imperfections: ability of the market to adjust rapidly to the supply of new information in valuing a security 5

Technical Analysis n Efficient Market Hypothesis: “All securities are correctly priced at any point in time” • Implies neither fundamental analysis nor technical analysis work to profitably predict security valuation 6

Technical Analysis assumes: 1. Market value is determined solely by the interaction of demand supply 2. Although there are minor fluctuations in the market, stock prices tend to move in trends that persist for long periods Continued 7

Technical Analysis assumes: 3. Reversals in trends are caused by shifts in demand supply 4. Shifts in demand supply can be detected sooner or later in charts 5. Many chart patterns tend to repeat themselves 8

Technical Analysis Most Significant Assumptions: n n Stock prices move in trends that persist for long periods These trends can be detected in charts Thus past trends in market movements can be used to forecast or understand the future. The lag between the time a technical analyst perceives a change in the value of a security and when the investing public ultimately assesses this change provides a profit opportunity to the chartist 9

Technical Analysis Tools to project future market movements n Charting n Key indicator series 10

Technical Analysis Use of Charting n n Often linked to development of the Dow Theory in the late 1890 s by Charles Dow Generally believed successful in signaling the market crash of 1929 11

Essential Elements of the Dow Theory There are 3 major movements in the market: 1. Daily fluctuations 2. Secondary movements (two weeks to a month) 3. Primary trends (long term) n May be bullish or bearish in nature n Daily fluctuations and secondary movements only important to extent they reflect on the persistence of the long term primary trend 12

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Presentation of the Dow Theory: Example of use to analyze a trend n n n Chart shows positive primary trend despite two secondary downward trends Bullish primary trend is confirmed by the increases in the levels of secondary lows and highs Pattern assumed to persist long term but ultimately to end 14

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Presentation of the Dow Theory: Market reversal and confirmation Ultimate end of a bullish trend detected by a new pattern: n Recovery fails to exceed previous high (Abortive recovery) + n New low penetrates a previous low + n New pattern confirmed by subsequent movement in Dow Jones Transportation Average 16

Support and Resistance Levels Chartists attempt to define trading levels where price movements might face a challenge or barrier This assumes the existence of n Support levels (lower ends of trading ranges) and n Resistance levels (upper ends of trading ranges) 17

Support and Resistance Levels n n A breakout above a resistance level or below a support level is assumed to be significant in suggesting that a stock is now trading in a new range and A breakout suggests higher or lower trading values outside the previous range may now be expected 18

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Support and Resistance Levels • Support may develop each time a stock price falls to a lower level as investors who previously passed up a buying opportunity now act • Resistance may develop when a stock price rises to the high side of the normal trading range as investors take a profit or try to get even after having bought at a previous high 20

Support and Resistance Levels • Support – at a sufficiently low price, the quantity demanded of a security increases keeping the price from falling further • Resistance – at a sufficiently high price, the quantity supplied of a security increases keeping the price from rising further Note that the analyst is looking just at the patterns here and is not really concerned with any fundamentals behind them 21

Support and Resistance Levels • Breakout – the security price moves out of the previous trading range (breaching the resistance or support level) suggesting a new consensus and new trading levels 22

Volume The volume of trading supporting a given market movement is considered significant n n A stock price (or the general market) making a new high on heavy trading volume is viewed as bullish A stock price (or the general market) making a new low on heavy trading volume is viewed as very bearish Continued 23

Volume The volume of trading supporting a given market movement is considered significant cont. n A stock price (or the general market) making a new high or low on light trading volume may indicate a temporary move likely to be reversed 24

Types of Charts n n n Line charts (like the previous ones shown here to visualize market patterns) Bar charts Point and figure charts 25

Types of Charts: Bar Charts On November 12 th, this stock traded between a high of $41 and a low of $38 and closed at $40 a share Bar chart showing the high and low prices of a stock during trading days in November with a horizontal dash along the line to indicate the closing price 26

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Chart Evaluations Market technicians carefully evaluate charts – looking for what they perceive to be significant patterns of movement 28

Chart Evaluations Thus in the Figure 9 -4 bar chart, the pattern might be interpreted as the “head-and-shoulders” one (note the head in the middle) with a lower penetration of the neckline to the right indicating a sell signal Chart Representation of a Market Bottom 29

Chart Representations 30

Chart Representations 31

Types of Charts: Point and Figure Chart (PFC) • Emphasizes significant price changes and the reversal of significant price changes • Has no time dimension • Chartists carefully read PFCs to observe market patterns: support, resistance, breakouts, congestion, and so on. 32

Types of Charts: Point and Figure Chart In Figure 9 -7, assume stock price starts at $30. Only moves of $2 or more are plotted Advances x Declines o Reversals from advance to a decline & vice versa calls for a shift in columns 33

Types of Charts: Point and Figure Chart Thus: The stock price initially goes from $30 to $42 and then shifts columns in its subsequent decline to $36 before moving up again in column 3. A similar pattern persists throughout the chart. 34

Charts Trendline, published through a division of Standard & Poor’s § Provides excellent charting information on a variety of securities traded on the major exchanges § Is available at many libraries and brokerage houses 35

Charts § The problem in reading charts has always been to analyze patterns in such a fashion that they truly predict stock market movements before they unfold. § To justify this effort, one must assume there are discernible trends over the long term. 36

Key Indicator Series A number of technical indicator series may be watched for bearish ( )and bullish ( ) trends • Contrary opinion rules • Smart money rules • Overall market indicators 37

Contrary Opinion Rules Suggest observing unsuccessful market behavior and choosing a contrary position: n Odd-lot Theory n Short Sales Position n Investment Advisory Recommendations n Put-Call Ratio 38

Contrary Opinion Rules: Odd-Lot Theory n n An odd-lot trade is one of less than 100 shares — only small investors tend to engage in odd-lot transactions This theory suggests watching what the small investor is doing and then do the opposite The weekly Barron’s reports odd-lot trading on a daily basis in its “Market Laboratory – Stocks” section It is easy to construct a ratio of odd-lot purchases to odd-lot sales 39

Contrary Opinion Rules: Odd-Lot Theory Cont. As shown in Figure 9 -8, the odd-lot trader is on the correct path as the market is going up (net selling position) but becomes a net buyer preceding a fall in the market 40

Contrary Opinion Rules: Odd-Lot Theory Cont. n n The odd-lot trader is also presumed to be a strong seller right before the bottom of a bear market A corollary to the odd-lot theory says that Monday odd-lot trades are particularly suspect 41

Contrary Opinion Rules: Odd-Lot Theory Cont. n n The theory actually suggests the small trader does all right most of the time but badly misses on key market turns While the odd-lot theory appeared to have some validity in the 1950 s and 1960 s, it was not particularly valuable in more recent decades. However, odd-lot traders outguessed many professional traders in the mid-1970 s and late 1980 s as well as in October 1997 and in the fall of 2003 42

Contrary Opinion Rules: Short Sales Position A rule based on the volume of short sales in the market [A short sale represents the selling of a security you do not own with the anticipation of purchasing the security in the future to cover your short position] The contrary opinion stems from two sources: n n Short seller are sometimes emotional and may overreact to the market, and more importantly There is now a built-in demand for stocks that have been sold short by investors who will have to repurchase shares to cover their short positions 43

Contrary Opinion Rules: Short Sales Position Cont. n n When the number of short sellers is large (i. e. , they are bearish), this is thought to be a bullish signal Daily short sale totals for the NYSE are reported in the Wall Street Journal as well as midmonth figures for the two major exchanges and securities traded on those exchanges 44

Contrary Opinion Rules: Short Sales Position Cont. n Technical analysts compute a ratio of total short sales positions on an exchange to average daily exchange volume for the month • Normal ratio is between 2. 0 and 3. 0 • A ratio of 2. 5 indicates current short sales are equal to 2 ½ times the day’s average trading volume 45

Contrary Opinion Rules: Short Sales Position Cont. § As the ratio (called the short interest ratio) approaches the higher end of the normal range, this would be considered bullish § Use of the ratio has produced mixed results 46

Contrary Opinion Rules: Investment Advisory Recommendations A further contrary opinion rule: Watch the predictions of investment advisory services and do the opposite n Investors Intelligence has formalized this into an Index of Bearish Sentiment: When 60% or more of advisory services are bearish, expect a market upturn When only 15% or fewer are 47

Contrary Opinion Rules: Investment Advisory Recommendations Cont. In Figure 9 -9, a summary of bullish and bearish sentiments from the “Market Laboratory—Economic Indicators” section of Barron’s, the AAII Index (American Assoc. of Individual Investors Index) shows the percentage of bears in the 15% range suggesting a possible sell under contrary opinion rules 48

Contrary Opinion Rules: Put-Call Ratio ILL-CONCEIVED speculation in the options market suggests that a “put-call” ratio may tell you to do the opposite of what option traders are doing n Puts and calls represent options to buy or sell stock over a specified period of time at a given price: • A put is an option to sell • A call is an option to buy n Put-call ratio data is found in the “Market Week – Options” section of Barron’s 49

Contrary Opinion Rules: Put-Call Ratio Cont. n n The ratio of put (sell) to call (buy) options is normally about 0. 60 – there are generally fewer traders of put options than call options When the ratio gets up to 0. 65 to 0. 70 or higher, this indicates increasing pessimism by option traders and the contrary rules suggests a buy signal Continued 50

Contrary Opinion Rules: Put-Call Ratio Cont. When the ratio goes down to 0. 40, decreasing pessimism (increasing optimism) may indicate that it is time to sell if you are a contrarian n The put-call ratio has a better than average record for calling market turns. n 51

Smart Money Rules Market technicians have long attempted to track the pattern of sophisticated traders in the hope that they might provide unusual insight into the future: n Theories related to bond market traders (e. g. , Barron’s Confidence Index), and n Theories related to stock market specialists (e. g. , short sales by specialists) 52

Smart Money Rules: Barron’s Confidence Index Barron’s = Confidence Index Yield on 10 top-grade corporate bonds x 100 Yield on 40 intermediate-grade bonds 53

Smart Money Rules: Barron’s Confidence Index Cont. § This index is used to observe the trading pattern of investors in the bond market on the premise that they are more sophisticated than stock traders and pick up trends more quickly § The theory suggests that a person who can figure out what bond traders are doing today may be able to determine what stock market investors will be doing in the near future 54

Smart Money Rules: Barron’s Confidence Index Cont. § As top-grade bonds pay smaller yields than intermediate-grade bonds, the Confidence Index is always below 100% § Normal trading range is between 80 and 96 55 Continued

Smart Money Rules: Barron’s Confidence Index n n n Cont. If bond investors are bullish about future economic prosperity, they are rather indifferent between holding topgrade and intermediate-grade bonds the yield differences between the two categories will be relatively small Confidence Index near 96 56

Smart Money Rules: Barron’s Confidence Index Cont’d § 10 Top Grade Bonds yielding 8. 4% while 40 Intermediate Grade Bonds yield 9. 1%: 8. 4% Barron’s Confidence Index = x 100 = 92% 9. 1% § Investors become quite concerned about the economy’s future health and will invest in lowerquality bond issues only at a sufficiently high yield differential to justify the risk – the gap widens: 8. 9% Barron’s Confidence Index = x 100 = 83% 10. 7% 57

Smart Money Rules: Barron’s Confidence Index Cont’d § Market technicians assume there a few months of lead time between what happens to the Confidence Index and what happens to the economy and stock market § The Confidence Index has a mixed record of predicting future events § This mixed record may partly be due to the fact that the supply of new bond issues can influence yields as much as investor attitudes (demand) 58

Smart Money Rules: Short Sales By Specialists n n Because of the uniquely close position of specialists to the action on Wall Street, market technicians ascribe unusual importance to their decisions Frequently monitored is the ratio of specialists’ short sales to the total amount of short sales 59

Smart Money Rules: Short Sales By Specialists n n n The normal ratio of specialists’ short sales to the total amount of short sales on an exchange is about 45% If the ratio goes above 50%, technicians interpret this as a bearish signal If the ratio falls below 40%, technicians consider this bullish 60

Overall Market Rules n Breadth of the Market Attempts to measure what a broad range of securities are doing compared to a market average • Advance-declines are often compared with movement of a popular market average • n Cash Position of Mutual Funds • Indicates their buying potential • Is generally representative of the purchasing potential of other large institutional investors 61

Overall Market Rules n Breadth of the Market • Compare advance-declines: The number of stock prices which are rising compared to those declining relative to movements in a stock market average as a potential signal of a turning point in the market 62 Continued

Overall Market Rules n Breadth of the Market • Cont’d E. g. , if the Dow-Jones Industrial Average (DJIA) is rising while the number of daily declines consistently exceeds the number of daily advances, this might signal the end of a bull market. Why? Although conservative investors are investing in blue-chip stocks, there is a lack of a broad-based confidence in the market 63

Overall Market Rules n Breadth of the Market Cont. In Table 9 -1, future weakness in the market is signaled by a strength in the DJIA that is not reflected in the advance-decline data 64

Overall Market Rules n Breadth of the Market Cont. When the DJIA is going down but advanced consistently lead declines, the market may be posed for recovery n Weighted averages calculated of daily advances/declines are also used n Daily data on the DJIA and advancing & declining issues may be found in the “Stock Market Data Bank” section of the Wall Street Journal n 65

Overall Market Rules n Breadth of the Market Cont. n Comparisons may provide insights but also false signals – care in interpretation should include a look at a wide range of variables n Decimalization of stock prices in 2001 may have caused the advance-decline measure to lose some of its usefulness as an advance or decline of only a penny is all that is now needed to make the list n (You could, with effort, make up your own measures) 66

Overall Market Rules n Cash Position of Mutual Funds § Between 5 - 20% as a percent of total assets § At the lower end of this range, mutual funds appear to be fully invested and can provide little in the way of additional purchasing power § As their cash position goes to 15% or higher, this might represent significant purchasing power that might help trigger a market upturn § While the overall premise is valid, problems arise in identifying significant cash positions for mutual funds in a given market cycle 67

The real world of investing n Behavioral finance • Based on cognitive psychology • Suggests individuals may view or “frame” economically equivalent events differently if presented in different contexts even after adjusting for risk and other rational considerations • What is viewed by an individual as a rational choice in a context may seem irrational to an outside observer 68

The real world of investing n Behavioral finance continued: • A poor or a favorable personal experience with a particular investment may color an individual’s attitude toward choices among alternatives including that investment even if they are economically equivalent • Financial behaviorists suggest people overreact to both good and bad news n This “may well portray the high tech fervor and debacle of the last decade” 69

The real world of investing n Behavioral finance suggests: • Focus less on computing expected values, standard deviations, and betas • Spend more time examining the “irrational” human being making investment decisions 70

Efficient Market Hypothesis (EMH) n n n New information is very rapidly processed so that securities are properly priced at any given time The large number of profit-maximizing participants concerned with analysis and valuation of securities promotes this Any relevant news is likely to be absorbed and acted upon very rapidly by these profit-maximizing individuals 71

Efficient Market Hypothesis n n No stock price can be in disequilibrium or improperly priced for long Instantaneous adjustment to new information Information travels in a random, independent fashion Prices are an unbiased reflection of all currently available information 72

Efficient Market Hypothesis The Efficient Market Hypothesis (EMH) is stated and tested in three forms: 1. The weak form 2. The semi-strong form 3. The strong form 73

Weak Form of the EMH n n n No relationship between past and future prices of securities Prices of securities are presumed to be independent over time Because EMH maintains that current prices reflect all available information, and information travels in a random fashion, it is assumed that little or nothing is to be gained from studying past stock prices 74

Weak Form EMH n n Has been tested in two ways: • Tests of independence • Trading rule tests Both tests seem to uphold the weak form of the EMH: • Security prices do appear to be independent over time or move in the pattern of a random walk 75

Weak Form EMH § Tests imply prices move independently over time § Past trends cannot be used easily to predict the future § Charting/technical analysis may have limited value § No exceptional returns can be earned by using investment strategies based on historical stock prices or other financial data 76

Tests of Independence n n The serial correlation between stock prices over time has been consistently small and not statistically significant – they follow a “martingale” “Securities are priced in an unbiased fashion at any given time” – the only factor that affects stock prices is the introduction of previously unknown news or information 77

Tests of Independence n A further test based on the frequency and extent of runs in stock price data – sequences of two or more price changes in the same direction – also tends to indicate that stock price movements are independent over time (+ + - + - + - - - +) Price changes run over time 78

Trading Rule Tests n n Try to determine whether a given trading rule based on past price data, volume, and so forth, can be used to beat a naïve buy-and-hold approach Simulates conditions under which a given trading rule is used to determine if superior returns were produced after considering transaction costs and the risks involved 79

Trading Rule Tests n Stock price moves up 5% or more, “buy” • Assumes this represents a “breakout” and should be considered bullish n n If price drops 5%, “sell” This is a follow-the-market-trend strategy rather than a buy low-sell high strategy Since stock prices move randomly, such rules do not consistently achieve exceptional results 80

Implications for Technical Analysis n n Any trading rule that relies on historical data and information will be of little value Security prices do appear to be independent over time, or, more specifically, move in the pattern of a random walk 81

Semistrong Form EMH n n All public information is already impounded into the value of a security There is no learning lag in the dissemination of public information • This may depend upon the size of the firm which issued the stock and the attention being paid to it by analysts and others in the marketplace 82

Semistrong Form of EMH n Tests of this form of the EMH attempt to see if investors acting on the basis of newly released public information are able to earn superior returns adjusting for risk and transaction costs 83

Semistrong Form of EMH Assume a stock goes up 15% and the stock is 20% riskier than the market. Assume the overall market rises by 10%. On a risk-adjusted basis, the stock would need to go up in excess of 12% [10% mkt return x 1. 2 risk factor] to beat the market. Since the stock rose by more than 12%, it is said to have beaten the market on a risk-adjusted basis. 84

Semistrong Form of EMH n n Tests examining the effects of such events as stock splits, stock dividends, and changes in accounting policy indicate that the market is generally efficient in a semistrong sense. Almost all the market impact of a stock split appears to occur before the public announcement. Little is gained from acting on the announcement 85

Semistrong Form of EMH n Investors are assumed to not only digest information very quickly, but also to be able to see through mere changes in accounting information that do not have economic consequences • Changing depreciation schedules for financial reporting (but not tax purposes) makes earnings per share look higher but provides no economic benefit to the firm and research shows it has no positive impact on valuation 86

Semistrong Form of EMH • Mere accounting changes related to inventory policy, reserve accounts, exchange transactions, and other items that appear to have no economic benefits do not appear to deceive investors • The effect on stocks of such changes thus may be neutral or even negative 87

Implications for Fundamental Analysis n n One cannot use fundamental analysis to determine whether a stock is undervalued or overvalued The collective wisdom of the marketplace in which everyone is trying desperately to come out ahead will dominate any individual’s judgment on the value of a stock 88

Implications for Fundamental Analysis Cont. n Ironically, although many suggest that fundamental analysis may not lead to superior profits, it is fundamental analysis itself that makes the market efficient: Because everyone is doing fundamental analysis, there is little in the way of unabsorbed or undigested information. One extra person doing fundamental analysis is unlikely to achieve superior insight 89

Implications for Fundamental Analysis, Cont’d n Anomalies or deviations from the basic proposition that the market is efficient still do occur. • E. g. , stocks with low price/earnings ratios consistently provide better returns than stocks with high price/earnings ratios. Perhaps fewer institutional investors in smaller firms make for a less-efficient market and superior potential opportunities 90

Strong Form of EMH Stock prices fully reflect all information, whether public or otherwise n Requires that no group of investors have a monopoly on access to any information Perfect markets exist where all information is available to everyone at the same time (full transparency) No group of investors can be expected to show superior risk-adjusted returns under any circumstances n 91

Strong Form of EMH n Major test results of this form of the EMH do not support it • Specialists on security exchanges have been able to earn superior rates of return on invested capital. The “book” they keep on unfilled limit orders appears to provide monopolistic access to information. • Corporate insiders consistently earn higher returns than would be expected in a perfect capital market 92

Strong Form of EMH • Although there is evidence to not accept the strong form of the EMH, the range of participants with access to superior information is not large • Those who act illegally with insider information may initially achieve higher returns from their special access to information, but the price of their actions (forfeiture of gains, payment of fines, jail time) may be high 93

WEBSITE COMMENT www. bigcharts. com Provides data, charts and technical indicators, free cbs. marketwatch. com Market news and data ww. quicken. com Contains some technical analytical data and charts www. stockworm. com Has technical charts 94

WEBSITE COMMENT www. stockcharts. com Provides free technical charts and education on technical analysis www. investopedia. com Provides a searchable database 95

Summary n n While fundamental analysis deals with financial analysis and determinants of valuation, technical analysis is based on the study of past price and volume data as well as associated market trends to predict future price movements. Technical analysis relies heavily on charting and the use of key market indicators to make forecasts. 96

Summary n n n Technical Analysis also observes support and resistance levels in the market as well as data on volume. Line, bar, and point & figure graphs are used to spot turns in the market Market technicians also follow a number of key indicator series to predict the stock market – contrary opinion indicators, smart money indicators, and general market indicators. 97

Summary n Although arguments have traditionally been made about the relative importance of fundamental and technical analysis, current attention is directed to the efficient market hypothesis and its implications for all types of analysis. 98

Summary n The efficient market hypothesis maintains that the market adjusts very rapidly to the supply of new information, and, because of this, securities tend to be correctly priced at any given time (or rapidly approaching this equilibrium value). 99

Summary n The efficient market hypothesis has been stated and tested in three different forms: 1. The weak form states that there is no relationship between past and future prices (they are independent over time). 2. The semistrong form suggests all public information is currently impounded in the price of a stock. 3. The strong form suggests all information, public or otherwise, is included in the value of a security. 100

Summary n Research tends to support the weak form of the efficient market hypothesis which causes many researcher to seriously question the overall value of technical analysis. However, many Wall Streeters vigorously debate this position 101

Summary n The semistrong form is also reasonably supported by research and this fact would tend to question the value of fundamental analysis by the individual investor. (It is the collective wisdom of all fundamental analysis that leads to the efficient market hypothesis in the first place). There are some contradictions to the semistrong form and much research is aimed at supplying additional such data. 102

Summary n The strong form of the efficient market hypothesis is not generally accepted. 103