Investments

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Investments

• Lecture 10
• Technical Analysis

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Technical vs. Fundamental Analysis

• Fundamentalist looks forward
• Technician looks backward
• Fundamentalist concerned with future earnings and
  dividends
• Technician is concerned little if at all with
  these
• Fundamentalist concerned with where the price is
  moving in the future
• Technician makes recommendations on the timing of
  purchases and sales
• Fundamental analysis designed to answer What
• Technical analysis designed to answer When

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Technical Analysis

• Definition
• Technical analysis is the study of internal stock
  exchange information. The word technical implies
  a study of the market itself and not of those
  external factors which are reflected in the
  marketall the relevant factors, whatever they
  may be, can be reduced to the volume of the stock
  exchange transactions and the level of share
  prices (Rosenfeld)
• At odds with market efficiency
• The methodology of technical analysisrests upon
  the assumption that history tends to repeat
  itself in the stock exchange. If a certain
  pattern of activity has in the past produced
  certain results nine times out of ten, one can
  assume a strong likelihood of the same outcome
  whenever the pattern appears in the future. It
  should be emphasized, however, that a large part
  of the methodology of technical analysis lacks a
  strictly logical explanation.

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Uses for Technical Analysis

• Analyzing the various forces in the market is
  used in different ways by different investors
• As only input necessary in their decision-making
• As another piece of information in making
  buy/sell decisions
• As a waste of time
• Study of price and volume data in an attempt to
  gain insight on where future prices (especially
  in the short-term) will be moving
• Information is pretty thin stuff unless mixed
  with experience. (Day, 1920)

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History of Technical Analysis

• Early development
• Developed in the late 1800s by Charles Dow
  (editor of the WSJ)
• Developed theory to describe past price movements
  this was a completely new way of analyzing
  markets
• Developed more by William Hamilton who used to
  predict movements in the market

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History of Technical Analysis

• Analyzing market behavior goes back to 1800s
• No such thing as industry or firm analysis
• Some used charts to see what was going on in
  market overall charts focused on price
  movements
• Movements made formations
• formations indicated buy/sell decisions
• If stock price behavior is independent of market
  movements, then technical analysis is worthless.
• Studies of betas of stocks
• prices react to demand for securities and supply
  of funds
• As balance between supply and demand shifts,
  future prices will change
• Technical analysis is aimed at detecting this
  shift

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Technical Analysis

• On what should stock prices be based?
• Fundamental characteristics of the firm?
• Investors expectations?
• The price of a stock at any one time represents a
  consensus view of the market of that stocks
  current intrinsic value
• Rationality of investors if investors are
  rational, then the use of fundamental analysis
  should at all times be directly related to the
  intrinsic value of firms
• Are investors perfectly rational with respect to
  investing?
• I believe that the future is only the past
  again, entered through another gate. (Sir
  Arthur Wing Pinero, 1893)

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Underlying Assumptions

• Market value is determined solely by the
  interaction of supply and demand
• Supply and demand are governed by numerous
  factors both rational and irrational.
• Disregarding minor fluctuations in the market,
  stock prices tend to move in trends which persist
  for an appreciable length of time.
• Changes in trend are caused by shifts in demand
  and supply. These shifts no matter why they
  occur, can be detected sooner or later in the
  action of the market itself.

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Framework for Technical Analysis

• Able to be applied to the aggregate market or
  individual stocks
• Uses graphs or charts and technical trading rules
  and indicators
• Price and volume are primary tools
• Believe that forces of supply and demand lead to
  certain patterns of price behavior
• Volume data used to gauge the general condition
  in the market and to help assess the trend
• Most evidence suggests that rising (falling)
  prices are usually associated with rising
  (falling) volume

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Technical Analysis

• It is futile to assign an intrinsic value to a
  stock certificate. One share of US Steel, for
  example, was worth 261 in the early fall of
  1929, but you could buy it for only 22 in June
  1932. By March 1937 it was selling for 126 and
  one year later for 38This sort of thing, this
  wide divergence between presumed value and
  intrinsic value, is not the exception, it is the
  rule (Damodaran)
• Transaction price is the settlement point that
  reflects both fundamental characteristics of firm
  and all other qualitative factors that affect
  investors dealings in the market

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Technical Analysis

• Are investors rational?
• In studies of investments/portfolio management,
  we generally assume investors are rational.
• Behavioral finance is one area of research that
  addresses the legitimacy of this assumption
• Speculative bubbles
• Overreaction
• Implications of irrationality for technical
  analysis

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Technical Analysis

• Computerized trading
• If we agree that prices are affected by factors
  that can not be quantified and are not always
  rational, we must accept that our decision-making
  on buying/selling is driven by these same
  factors.
• Trading rules and computerized trading can take
  away some of our irrationality.
• However remember that even if you establish
  specific rules that prevent you from being
  irrational, the computer is still making
  decisions in a market that is not always
  rational.

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Technical Analysis

• Problems with accounting statements that make
  technical analysis feasible
• Lack a lot of information that security analysts
  need
• Firms can choose different ways to present
  certain numbers in accounting statements that
  make it difficult for analysts to compare across
  firms
• Large number of nonquantifiable variables not
  included in financial statements

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Tools for Technical Analysis

• A picture is worth a thousand words.
• Bar charts
• Line charts
• Volume bar charts
• Candlestick
• Point and figure charts

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Contrarian Indicators

• Observed behavior is that individuals tend to
  overreact to surprising news events
• Evidence that this behavior also occurs in the
  market (overweight new information and
  underweight older information)
• If markets overreact, then big changes in prices
  will be followed by price movements in the other
  direction.
• Questions about whether overreaction occurs

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Sentiment Indicators

• Investment advisory opinions
• Mutual fund cash positions
• Put/call ratio
• Public short interest ratio

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Support and Resistance

• Market price is consensus view of market on
  securitys intrinsic value
• Buyers are bullish on stock
• Sellers are bearish on stock
• Price movements indicate one side winning
• Support levels arise when consensus is price is
  at its bottom and will not fall further
• Buyers outnumber sellers
• Resistance levels when consensus is price is at
  its highest
• Sellers outnumber buyers

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Support and Resistance

• Penetration of support/resistance occurs when
  supply/demand changes
• Volume / traders remorse
• Rationale for importance of support/resistance
• Institutional trading programs
• Self-fulfilling prophecy

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Moving Averages

• Oldest tool of technical analysis
• Smooths out fluctuations in prices so that
  technical analyst can search for trends
• Simple moving average
• Average of price expectations over period of time
  during which moving average is calculated
• Comparison of security price to moving average
• Current price gt ma ? current expectations exceed
  average expectations over period ma calculated
  (bullish or buy signal)

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Momentum Indicators

• Absolute breadth
• Looks at volatility and price changes
• Direction of prices is unimportant
• absolute value (advancing issues declining
  issues)
• Advance/decline line
• Most popular measure of market breadth
• Line moves up when more stocks are advancing than
  declining
• trouble looms when the generals lead and the
  troops refuse to follow (Achelis)
• Numeric value of line is unimportant slope and
  pattern are impt.

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Relative Strength

• Ratios determined for firm or industry group
• Computed as price of stock relative to value of a
  market series (ie, SP 500)
• Increasing ratio says stock outperforming market
• In a bear market, if the stock price falls by
  less than the decline in the market series, then
  techs believe that this stock will do well in the
  next bull market
• RSI first presented as a 14 day index
• Now 9 day and 25 day are popular