Technical Analysis

1
Technical Analysis

• Chapter 26

2
Background

• Main approaches to valuing stocks include
• Risk-return analysis
• Fundamental analysis
• Technical analysis
• Some technicians use only technical analysis
  while others use both fundamental and technical
  analysis
• Technicians (AKA chartists) focus on charts of
  market prices and transactions statistics
• Think that these statistics will reveal all
• Technicians study patterns in security prices

3
Theoretical Foundation

• Edwards Magee (1997) state the basic
  assumptions of technical analysis
• A securitys market value is based on supply and
  demand
• Supply and demand are based on both rational and
  irrational factors
• Security prices tend to move in persistent trends
• Changes in trends occur due to shifts in supply
  and demand
• Shifts in supply and demand can be detected using
  charts of market transactions
• Some chart patterns tend to repeat themselves

4
Theoretical Foundation

• Technicians believe past patterns will recur
• Therefore can be predicted
• Technical analysts estimate prices
• Whereas fundamental analysts estimate value
• Technicians tend to ignore issues such as a
  firms riskiness and earnings growth
• Instead focus on barometers of supply and demand

5
Theoretical Foundation

• Technicians claim technical analysis is
• Easier
• Faster
• Can be applied simultaneously to more stocks than
  fundamental analysis
• But, does technical analysis work?
• Technicians argue that when using fundamental
  analysis
• Must wait until market realizes a stock is
  undervalued
• Must rely on inadequate accounting statements
• It is hard work
• Must use ambiguous estimates of growth

6
The Dow Theory

• Originated by Charles Dow
• Founder of the Dow Jones Company and editor of
  Wall Street Journal
• Dow Theory presumes market moves in persistent
  bull and bear trends
• Often used for market as a whole, but used for
  individual securities also
• Types of movements defined by Dow theorists
• Primary trends (bull or bear market)
• Secondary trends (corrections)
• Market collapses or upward surges lasting a few
  weeks or months
• Tertiary moves (little daily fluctuations)
• Meaningless random wiggles but should be studied
  to determine if relate to a primary trend

7
The Dow Theory
Most Dow theorists do not think a new primary
trend has been confirmed until pattern of
ascending or descending tops occur in both
industrial and transportation averages.
8
Testing the DOW Theory

• Brown, Goetzmann Kumar (BGK) tested Dow theory
  using event study
• 255 WSJ editorials used as events
• Neural net estimation used to identify optimal
  trading rules during 1902-1929
• Results indicate forecasts based on 4 discernable
  patterns
• Recent downward trends in DJIA are sell signals
• DJIA falls from recent peaks are sell signals
• Recent upward trends in DJIA are buy signals
• Recoveries from recent declines in DJIA are buy
  signals

9
Testing the DOW Theory

• When a buy or neutral signal was detected, a
  hypothetical portfolio is fully invested in DJIA
• When a sell signal was detected, a hypothetical
  portfolio is fully invested in cash
• Tested from 1930-1997
• Results indicate that some trend-predicting power
  existed, but not enough to generate large excess
  returns

10
Bar Charts

• Represent price (high, low, close) of security
  over time
• Volume data is represented along bottom
• Second most important statistic to technicians

11
Head and Shoulders Formation

• A series of reversals
• Supposed to signal that a securitys price has
  reached a ceiling and is expected to decline in
  the future

12
Head and Shoulders Formation
Heada spurt of buying activity increases price
to new high. Then a lull in trading decreases
prices to below top of left shoulder.
Confirmation (breakout)the price falls below the
neckline which is a sell signal.
Left shoulderheavy buying increases price to a
peak before lull in trading pushes price downward.
Right shouldera moderate rally increases price
but not to a new level equal to the top of the
head.
13
Other Patterns

• Numerous patterns have been described by
  technicians, such as
• Triangles
• Pennants
• Flags
• Channels
• Rectangles
• Double tops
• Triple tops
• Wedge formations
• Diamonds

14
Charting Volume of Shares Traded

• Technicians argue volume measures the intensity
  of investors feelings
• Volume is studied in conjunction with prices
• Technicians analyze resistance and support levels
  along with volume

15
Support and Resistance Levels

• Resistance level
• Ceiling (peak) above which stock price is not
  expected to go
• Supply of security is expected to increase
• Support level
• Floor (trough) below which stock price is not
  expected to drop
• Demand of security is expected to increase

16
Support and Resistance Levels

• Suppose the following occurred
• Moderate surge in trading volume at Point A
• Larger surge in trading volume at Point B
• 3 times greater than surge at Point A
• May surmise that some bullish new information
  caused buying pressure at Point B which overcame
  the previous resistance at Point A

17
Congestion Areas

• Technicians are unable to offer reasons for price
  actions like this
• Penetrating support line means sell
• Penetrating resistance line means buy
• Studies examining trading range breakouts find
  that, after deducting commissions, return was
  slightly larger than riskless interest rate

18
Congestion Areas
Price rises through 50 resistance levelold
resistance level becomes new support level.
Price fluctuates in first congestion area for a
while.
19
Selling Climaxes and Speculative Blowoffs

• When supply and demand are out of balance (price
  is moving) volume is watched closely
• Market is bullish when high volume is combined
  with a rising price
• Market is bearish with high volume and falling
  prices
• Falling prices and high volume are considered
  bullish if a selling climax occurs

20
Selling Climaxes and Speculative Blowoffs

• If one believes the end of bear market is near
  and high volume occurs
• Means last of bearish investors are liquidating
  their holdings
• Clears the way for bullish investors to start
  bidding up price
• A speculative blowoff marks the end of a bull
  market
• High volume pushes prices to peak
• Exhausts bullish speculators enthusiasm, enabling
  bearish market to begin
• A bull dies with a bang, not a whimper

21
The Confidence Index

• Ratio of high-grade bond yields to low-grade bond
  yields
• Reveals how willing investors are to take risks
• As investors grow more confident about economy,
  shift from higher-grade bonds to lower-grade
  bonds (higher yields)
• Increases prices of low-grade bonds which leads
  to lower yields which leads to an increase in
  confidence index
• Barrons Confidence Index (BCI)
• Ratio of average yield from Barrons of 10
  high-grade bonds over average yield of Dow Jones
  40 bond index

22
Interpreting the Index

• Has an upper limit of 1
• Yields on high-quality bonds will always be lower
  than yields on low-quality bonds
• Yield spread narrows during economic boom
• Confidence index rises
• Technicians predict stock market will rise
• BCI was at historically high levels (and rising)
  prior to stock market crash of October 19, 1987
• Confidence index is positively correlated to
  stock market over a complete business cycle
• However, sometimes it is a leading indicator,
  sometimes a lagging one

23
Moving Average Analysis

• Moving averages are used to provide a smooth
  reference point for
• Individual securities
• Market indices
• Commodity prices
• Interest rates
• Foreign exchange rates
• Some use a 150-day (30 week) moving average
• Changes each day
• Most recent day is added and oldest day is
  dropped
• Following calculation is performed
• M150DAPt (1/150)(Valuet Valuet-1
  Valuet-149)

24
Moving Average Analysis

• Moving averages computed over short time frames
  follow daily prices more closely
• More volatile than longer-term moving averages
• Technicians analyze difference between daily
  price and moving average
• If daily prices penetrate moving average line it
  is a signal to take action
• If daily price moves down through a moving
  average, price fails to rise for many months
• Sell signal
• If daily prices are above moving average but
  difference is narrowing
• Signals end of bull market may be near

25
Moving Average Analysis

• Moving average analysts recommend buying stock if
  
• Moving average line flattens and stock price
  moves up through moving average line
• Price of stock falls (temporarily) below moving
  average line that is rising
• Stock price is above moving average line, falls,
  turns around and rises again without penetrating
  moving average line

26
Moving Average Analysis

• Moving average analysts recommend selling stock
  if
• Moving average line flattens and stock price
  drops down through moving average line
• Stock price temporarily rises above a declining
  moving average line
• Stock price falls through moving average line and
  turns around only to fall again without
  penetrating above moving average line
• Strategy is more successful if moving average is
  calculated over a longer time frame

27
Moving Average Analysis

• Can subscribe to chart delivery service
• Can buy years of historical daily prices and draw
  own charts
• Can simulate trading by managing hypothetical
  trades

28
Empirical Tests of Moving Average Rules and
Congestion Areas

• Brock, Lakonishok and LeBaron (1992) and
  Bessembinder and Chan (1998) test moving average
  trading rules
• Provide significant forecast power over DJIA
• Found sample periods in which moving average
  trading rule earned significant profits
• Found many sample periods in which significant
  losses occurred

29
Patterns and Procedures

• New patterns can be perceived at will
• Similarities between technical analysis and
  Rorschach ink blot test
• Intelligent technicians with good imagination can
  perceive many different meaningful patterns

30
The Bottom Line

• Technical tools are used to detect price patterns
• Technical analysis assumes shifts in supply and
  demand occur gradually over time
• Price change pattern is extrapolated to predict
  future price changes
• Many financial economists believe technical
  analysis cannot predict market prices
• Believe security prices are a random walk
• Occur in reaction to random arrival of new
  information
• Believe a series of similar independent changes
  in prices are coincidence