Technical Analysis

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Chapter 16Technical Analysis
Chapter 16
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Chapter 16Technical Analysis

• Questions to be answered
• How does technical analysis differ from
  fundamental analysis?
• What are the underlying assumptions of technical
  analysis?
• What major assumption causes a difference between
  technical analysis and the efficient market
  hypothesis?

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Chapter 16Technical Analysis

• What are the major advantages of technical
  analysis compared to fundamental analysis?
• What are the major challenges to the assumptions
  of technical analysis and its rules?
• What is the logic for the major contrary opinion
  rules used by technicians?

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Chapter 16Technical Analysis

• What are some of the significant rules used by
  technicians who want to follow the smart money
  and what is the logic of those rules?
• What are the breadth of market measures and what
  are they intended to indicate?
• What are the types of price movements postulated
  in the Dow Theory and how are they used by a
  technician?

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Chapter 16Technical Analysis

• Why do technicians consider the volume of trading
  important and how do they use it in their
  analysis?
• What are support and resistance levels, how are
  they identified, and how are they used by
  technicians?
• What is the purpose of moving average lines and
  how does the technician use one or several of
  them to detect major changes in trends?

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Chapter 16Technical Analysis

• What is the rationale behind the relative
  strength line for an industry or a stock and how
  is it interpreted?
• How are bar charts different from
  point-and-figure charts?
• What are some uses of technical analysis in
  foreign security markets?
• How is technical analysis used when analyzing
  bond markets?

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Underlying Assumptions of Technical Analysis

• 1. The market value of any good or service is
  determined solely by the interaction of supply
  and demand
• 2. Supply and demand are governed by numerous
  factors, both rational and irrational

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Underlying Assumptions of Technical Analysis

• 3. Disregarding minor fluctuations, the prices
  for individual securities and the overall value
  of the market tend to move in trends, which
  persist for appreciable lengths of time
• 4. Prevailing trends change in reaction to shifts
  in supply and demand relationships and these
  shifts can be detected in the action of the market

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Advantages of Technical Analysis

• Not heavily dependent on financial accounting
  statements
• Problems with accounting statements
• 1. Lack information needed by security analysts
• 2. GAAP allows firms to select reporting
  procedures, resulting in difficulty comparing
  statements from two firms
• 3. Non-quantifiable factors do not show up in
  financial statements

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Advantages of Technical Analysis

• Fundamental analyst must process new information
  and quickly determine a new intrinsic value, but
  technical analyst merely has to recognize a
  movement to a new equilibrium
• Technicians trade when a move to a new
  equilibrium is underway but a fundamental analyst
  finds undervalued securities that may not adjust
  their prices as quickly

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Challenges to Technical Analysis

• Assumptions of Technical Analysis
• Empirical tests of Efficient Market Hypothesis
  (EMH) show that prices do not move in trends
• Technical Trading rules
• The past may not be repeated
• Patterns may become self-fulfilling prophecies
• A successful rule will gain followers and become
  less successful
• Rules require a great deal of subjective judgement

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Technical Trading Rules and Indicators

• Stock cycles typically go through a peak and
  trough
• Analyze the following chart of a typical stock
  price cycle and we will show a rising trend
  channel, a flat trend channel, a declining trend
  channel, and indications of when a technical
  analyst would want to trade

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Typical Stock Market Cycle
Stock Price
Exhibit 16.2
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Typical Stock Market Cycle
Stock Price
Exhibit 16.2
Declining Trend Channel
Peak
Flat Trend Channel
Sell Point
Rising Trend Channel
Declining Trend Channel
Buy Point
Buy Point
Trough
Trough
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Contrary-Opinion

• Many analysts rely on rules developed from the
  premise that the majority of investors are wrong
  as the market approaches peaks and troughs
• Technicians try to determine whether investors
  are strongly bullish or bearish and then trade in
  the opposite direction
• These positions have various indicators

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Contrary-Opinion Rules

• Mutual fund cash positions
• Credit balances in brokerage accounts
• Investment advisory opinions
• OTC versus NYSE volume
• Chicago Board Options Exchange (CBOE) put/call
  ratio
• Futures traders bullish on stock index futures

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Follow the Smart Money

• Indicators showing behavior of sophisticated
  investors
• The Barrons Confidence Index
• T-Bill - Eurodollar yield spread
• Short sales by specialists
• Debit balances in brokerage accounts (margin debt)

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Other Market Indicators

• Breadth of market
• Advance-decline
• Diffusion index
• Short interest
• Stocks above their 200-day moving average
• Block uptick-downtick ratio

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Stock Price and Volume Techniques

• The Dow theory oldest technical trading rule
• 1. Major trends are like tides in the ocean
• 2. Intermediate trends resemble waves
• 3. Short-run movements are like ripples
• Importance of volume
• Ratio of upside-downside volume
• Support and resistance levels
• Moving average lines

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Stock Price and Volume Techniques

• Relative-strength (RS) ratios
• For individual stocks and industry groups
• Bar charting
• Multiple indicator charts
• Point-and-figure charts
• Overall feel from a consensus of numerous
  technical indicators

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Technical Analysis of Foreign Markets

• Foreign stock market series
• Technical analysis of foreign exchange rates
• Technical analysis of bond markets

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The InternetInvestments Online

• www.mta-usa.org
• www.bigcharts.com
• www.dailystocks.com
• www.investools.com
• www.stockmaster.com
• www.dbc.com

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• End of Chapter 21
• Technical Analysis

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Future topicsChapter 17

• Equity Portfolio Management Strategies