FIN 320 Prof. Jim Mallett

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CHAPTER 9
A Basic View of Technical Analysis and Market
Efficiency
FIN 320 Prof. Jim Mallett
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Learning Objectives

• Understand the difference between fundamental and
  technical analysis.
• Understand how technical analysis is related to
  patterns of stock price movement.
• Explain the types of charting that are used in
  technical analysis.
• Describe the use of key indicator series in
  attempting to track the direction of the market.
• Explain the efficient market hypothesis and the
  various forms it can take.
• Relate the efficient market hypothesis to
  fundamental and technical analysis.

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Technical Analysis

• Technicians examine prior price and volume data
  to determine past trends in the belief that they
  will help forecast future ones.
• Fundamental Analysis uses expectations of
  economic conditions and company information to
  value an asset (stock).
• Technical analysis relies on charts and graphs of
  internal market data.
• Technicians believe that even when important
  fundamental information is uncovered, it may not
  lead to profitable trading because of timing
  considerations and market imperfections.

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Assumptions ofTechnical Analysis

• Market value is determined solely by the
  interaction of supply and demand.
• It is assumed that there are minor fluctuations
  in the market and stock prices tend to move in
  trends that persist for long periods of time.
• Reversals of trends are caused by shifts in
  demand and supply.
• Shifts in demand and supply can be detected
  sooner or later in charts.
• Many chart patterns tend to repeat themselves.

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The Use of Charting

• Charles Dow, editor of the Wall Street Journal
  (WSJ) developed the charting technique in the
  late 1890s.
• The Dow Theory
• There are three major movements in the market
• Daily fluctuations.
• Secondary movements - covering two weeks to a
  month and are only important to the extent they
  reflect on the long-term primary trend in the
  market.
• Primary trends which are either bullish or
  bearish in nature.
• Analysts should not be confused by secondary
  movement.
• New pattern of movement by the DJIA must be
  confirmed by DJTA.

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Presentation ofthe Dow Theory
(Figure 9-1)
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Support and Resistance Levels

• Support is a new price level at which new demand
  comes into the market.
• Resistance is a new price level at which supply
  of the stock increases.

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Types of Charts

• A bar chart shows the high and low price for a
  stock with a horizontal dash to indicate closing
  price.
• A point and figure chart emphasizes significant
  price changes and the reversal of significant
  price changes.

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Contrary Opinion Rule

• Short Sales Position indicates that a large
  aggregate number of short sellers is a bullish
  signal.
• It is measured by the ratio of total short sales
  positions on an exchange to average daily
  exchange volume for the month.
• A normal ratio is between 2.0 (bearish) and 5.0
  (bullish). The ratio is published daily in the
  WSJ.
• Also known as short interest ratio
• Around the 20th of each month, WSJ reports on
  total short sale figures.

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Contrary Opinion Rule

• Investment Advisory Recommendations.
• Investors Intelligence developed the Index of
  Bearish Sentiment which suggests that when 60 or
  more of the advisory services are bearish, you
  should expect an upturn and when only 15 or less
  are bearish you should expect a decline.
• Published in the Market Laboratory - Economic
  Indicators section of Barrons.

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Contrary Opinion Rule

• Put/Call Ratio tells you to do the opposite of
  what option traders are doing because their
  speculation is ill conceived.
• The ratio is normally around 0.60.
• 0.70 or higher 4 Pessimism by option traders 4
  Buy Signal
• 0.40 or lower 4 Optimism by option traders 4
  Sell Signal
• Ratio can be found in the Market Week - Options
  section of Barrons

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Overall Market Rules

• Breadth of the market indicator attempts to
  measure what a broad range of securities is doing
  as opposed to merely examining a market average.
• The technician compares the advance - declines
  with the movement of a market average to
  determine if there is a divergence between the
  two.
• Advances and declines move in the opposite
  direction of market averages at a market peak or
  bottom.

Net Advances or Declines
Breadth Index
Number of Issues Traded
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Efficient Market Hypothesis

• An efficient market is one in which new
  information is very rapidly processed so that
  securities are properly priced at any given time.
• Premise of an Efficient Market Hypothesis -
• A large number of independent profit maximizing
  participants, concerned with analysis and
  valuation of securities.
• Information travels in a random independent
  fashion.
• There is almost instantaneous adjustment to new
  information. Consequently, no stock price can be
  in disequilibrium or improperly priced for very
  long.
• Prices are an unbiased reflection of all
  currently available information. No one
  investor can consistently outperform the market.

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Weak Form of EfficientMarket Hypothesis

• Weak-form of EMH suggests that there is no
  relationship between past and future prices and
  trading volumes of securities.
• Prices are presumed independent over time. There
  is nothing to be gained from studying past data.
• Tests of independence have examined the degree of
  correlation between stock prices over time and
  found the correlation to be consistently small
  (-.10 4 .10) and not statistically
  significant.

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Weak Form of EfficientMarket Hypothesis
(continued)

• Trading Rule Test
• Example If a stock moves up by 2 (or 10) or
  more, the rule might be to buy it. This
  supposedly represents a breakout and should be
  bullish.
• Can a trading rule beat a naïve buy-and-hold
  approach?
• Empirical research finds that in a limited
  number of cases, trading rules may produce
  slightly positive returns, but after commissions
  and risk are considered, the results are neutral
  and sometimes negative.
• Implications for Technical Analysis
• Prices move independently over time, past trends
  cannot be used to predict the future and that
  charting and technical analysis may have limited
  value.

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Semistrong Form of theEfficient Market
Hypothesis

• Semi-Strong form of EMH maintains that all public
  information is already impounded in the value of
  a security and therefore one cannot use
  fundamental analysis to determine whether a stock
  is undervalued or overvalued.
• There is no learning lag in the distribution of
  public information.
• Investors cannot earn superior returns by trading
  on public information about stock splits, earning
  reports, asset sales, capital restructuring, etc
• Tests of semi-strong form of EMH are generally
  based on risk adjusted returns.
• Research shows that market is generally efficient
  in semistrong form.

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Implications of Semi-Strong FormEMH for
Fundamental Analysis

• It is very difficult (but not impossible) to earn
  abnormal returns.
• Although many would suggest that fundamental
  analysis may not lead to superior profits in an
  efficient market, it is fundamental analysis
  itself that makes the market efficient.
• Portfolio managers should decide on the desirable
  level of risk for their clients and maintain that
  level of risk by periodically rebalancing the
  portfolio, while minimizing the costs associated
  with liquidity, transactions and taxes.
• Tests on the performance of mutual funds managers
  have consistently indicated that they are not
  able to beat the market averages over the long
  term.

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Market Anomolies

• Evidence against semi-strong form EMH
• Low P/E stock consistently provide higher returns
  than high P/E stocks.
• Small firms tend to provide higher returns than
  large firms, after adjusting for risk.
• Stock market returns are higher in January than
  rest of the year.

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Strong Form of theEfficient Market Hypothesis

• Strong form of EMH states that stock prices
  reflect not only public information but all
  information. It goes beyond the concept of an
  efficient market to one that is perfect.
• Assumption No group of investors has
  monopolistic access to information.
• Results of research do not support strong form of
  EMH.
• Studies report that specialists average return on
  capital exceeds 100.
• Insiders consistently achieve higher returns than
  would be expected in a perfect capital market.