CHAPTER 16 TECHNICAL ANALYSIS

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CHAPTER 16TECHNICAL ANALYSIS
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Chapter Summary

• Objective To examine the basic principles of
  technical analysis and show how they relate to
  the efficient market hypothesis.
• Charting
• Technical indicators

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Technical Analysis

• Fundamental analysis (chap 15)
• Looks at the fundamentals of the stock to get a
  calculated price.
• If actual market price gt calculated price, then
  the stock should be sold.
• Technical analysis An attempt to exploit
  recurring and predictable patterns in stock
  prices to make money through timing the market

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Technical analysis

• Technicians beliefs
• Shifts in market fundamentals can be discerned
  before their impact is fully reflected in prices
• Market fundamentals can be perturbed by
  irrational factors
• These presumptions are in contradiction with the
  weak form of the EMH

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Definitions

• BULL MARKET market increasing
• BEAR MARKET market decreasing

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Technical indicators - orientation

• Technicians are
• Contrarian everyone else is dumb so do the
  opposite
• Follow the smart money most investors are
  sophisticated so copy them

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Technical Indicators

• 3 types of indicators
• Market structure indicators
• Sentiment indicators
• Flow of funds indicators

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Technical Indicators

• Market structure Indicators
• Monitor price trends and cycles then find
  patterns
• Sentiment Indicators
• Measures the expectations of various groups of
  investors
• Flow of Funds Indicators
• Predicts price inc/dec by measuring the tendency
  of investors to buy/sell stocks bec. when large
  groups buy/sell, then prices will move

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I. MARKET STRUCTURE INDICATORS

• Dow Theory
• Point and Figure Charts
• Candlestick Charts
• Moving averages
• Breadth
• Relative Strength

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Charting the Dow Theory

• Uses Dow Jones Industrial Average (DJIA) and Dow
  Jones Transportation Average (DJTA)
• DJIA signifies underlying trends and DJTA
  confirms/rejects the signal

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Dow Theory

• Primary trend
• LT movements of stock
• Secondary or intermediate trends
• Caused by ST deviations from underlying trend
• Tertiary or minor trends
• Support and resistance levels
• Support value below which mkt is unlikely to
  fall
• Resistance value above which mkt is unlikely to
  rise
• When DJIA moves above resistance ? signals BULL
  MARKET
• When DJTA moves above it ? confirms signal

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Dow Jones Industrial Average
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Dow Theory
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Other Charting Techniques

• Point and figure charts
• The figure has no time dimension
• It traces significant upward or downward moves in
  stock prices
• Candlestick charts
• Used to summarize price data
• Aid in identification of trends

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Point and figure chart
Sell signal When stock penetrates previous low
If price inc/dec by 2, mark X
Buy signal When stock penetrates previous high
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Candlestick chart
Daily high
If price is increasing, shade box
Open or close
Open or close
Daily low
Example stockta.com or yahoo-finance
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Yahoo finance IBM stock
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Moving averages
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Breadth

• Breadth
• stocks advancing - stocks declining
• If breadth is increasing ? bull market

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Relative strength

• Relative strength
• The ratio of the price of the security to a price
  index for the industry
• ie. Measures the extent to which a security has
  outperformed or underperformed the market or its
  industry
• P2/P1 for stock X
• Index2/Index1

If relative strength persists over time ? buy
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II. Sentiment Indicators

• Trin statistic
• Odd-lot trading (contrarian)
• Confidence index
• Put/call ratio (contrarian)
• Mutual fund cash positions (contrarian)

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Trin statistic
Measures the expectations of groups of investors

• Trin statistic

or
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Trin statistic

• If Trin lt1 ? signals Bull market
• If Trin lt 1 ? signals bear market
• Statistics are published in Wall St Journal

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Odd-Lot Trading

• Small investors tend to miss market turns
• ie. They buy after increases have already
  occurred
• Small investors buy in odd lots

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Confidence Index

• CI Avg yield on top 10 corporate bonds
• Avg yield on 10 intermediate grade bonds
• High CI ? bull signal
• Low CI ? bear signal

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Put/Call ratio

• Put option to sell
• Call option to buy
• IF outstanding puts ? signals bear mkt
• outstanding calls

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Mutual fund cash positions

• Most mutual funds are held by small investors who
  are more likely to buy when mkt
• The cash held in mutual fund portfolios is a
  measure of investor sentiment
• As cash ? signals investors feel mkt
• But they are usually wrong so contrarians will
  buy

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III FLOW OF FUNDS INDICATORS

• Some are contrarian, some are smart money
• Short Interest
• Credit Balances in Brokerage accounts

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Short interest

• shares of stock sold short and not covered
• Can be interpreted in different ways

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Credit balances in brokerage accounts (contrarian)

• Investors will leave credit balances when they
  plan to invest in the future
• As balance increases, they feel mkt will dec in
  future so they will buy
• If you are contrarian, this signals bull market

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Can Technical Analysis Work?

• Self-destructing patterns
• Once a useful technical rule is discovered, it
  ought to be invalidated once the mass of traders
  attempts to exploit it