CHAPTER 19

1. CHAPTER 19 Technical Analysis

2. Technical Analysis • Technical analysis is a security analysis technique that claims the ability to forecast the future direction of prices through the study of past market data, primarily price and volume.In its purest form, technical analysis considers only the actual price and volume behavior of the market or instrument. Technical analysts, sometimes called "chartists", may employ models and trading rules based on price and volume transformations

3. Technical Analysis • Technical analysis stands in distinction to fundamental analysis. Technical analysis "ignores" the actual nature of the company, market, currency or commodity and is based solely on "the charts," that is to say price and volume information, whereas fundamental analysis does look at the actual facts of the company, market, currency or commodity. • Any large brokerage, trading group, or financial institution will typically have both a technical analysis and fundamental analysis team

4. Technical Analysis • Technical analysis is widely used among traders and financial professionals, and is particularly widely used by active day traders, market makers, and pit traders. • In the 1960s and 1970s it was widely discredited by academic mathematics, but 56 of 95 modern studies found it produces positive results • Academics such as Eugene Fama say the evidence for technical analysis is sparse and is inconsistent with the weak form of the efficient market hypothesis • Users hold that even if technical analysis cannot predict the future, it helps to identify trading opportunities.

5. Underlying Assumptions of Technical Analysis • The market value of any good or service 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, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time

6. Underlying Assumptions of Technical Analysis • Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself • See Exhibit 15.1 • It shows the process wherein new information causes a decrease in the equilibrium price for a security but the price adjustment is not rapid

7. Exhibit 15.1

8. Advantages of Technical Analysis • Technical analysis is not heavily dependent on financial accounting statements. The technician contends that there are several major problems with accounting statements: • Lack information needed by security analysts • GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements from two firms • Non-quantifiable factors do not show up in financial statements

9. 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

10. Challenges to Technical Analysis • For Assumptions of Technical Analysis • Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends • For 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

11. Technical Analysis Rationale • A typical stock price cycle for the market or a stock goes through a peak and trough as well as trends • By analyzing the trend patterns (rising trend, flat trend, declining trend) and the change in trend, a technical analyst would be able to decide what trade is needed (Exhibit 15.2)

12. Exhibit 15.2

13. Dow Theory • The primary trend is the long-term movement of prices, lasting from several months to several years • Secondary trend or intermediate trends are caused by short-term deviations of prices from primary trend. These deviations are eliminated via corrections when prices revert back to trend values • Tertiary or minor trends are daily fluctuations of little importance

14. Figure 9.3 Dow Theory Trends

15. Dow Theory Trends

16. Dow Theory: Signals and Identification of Trends An upward trend in Dow theory is a series of successively higher peaks and higher troughs.

17. Dow Theory: Signals and Identification of Trends A downward trend is a series of successively lower peaks and lower troughs.

18. Dow Theory: Signals and Identification of Trends Upward trend reversal: A reversal in the primary trend is signaled when the market is unable to create another successive peak and trough in the direction of the primary trend. For an uptrend, a reversal would be signaled by an inability to reach a new high followed by the inability to reach a higher low. In this situation, the market has gone from a period of successively higher highs and lows to successively lower highs and lows, which are the components of a downward primary trend

19. Dow Theory: Signals and Identification of Trends The reversal of a downward primary trend occurs when the market no longer falls to lower lows and highs. This happens when the market establishes a peak that is higher than the previous peak followed by a trough that is higher than the previous trough, which are the components of an upward trend.

20. Point-and-Figure Charts • Identifies price levels that support or resist price changes • Breaking support or resistance levels are buy and sell signals.

21. Figure 9.5 Point and Figure Chart

22. Figure 9.6 Point and Figure Chart for Atlantic Richfield

23. Buy and Sell Indicators

24. Moving averages • Average price over some historical period (5 weeks or 200 days) • When current price crosses the average a trading signal occurs • Bullish signal when the current price rises above the moving average • Bearish sign when the current price falls below the moving average

25. Moving averages

26. Figure 9.7 Share Price and 50-Day Moving Average for Apple Computer

27. Figure 14.3 Dow Jones Industrial Average and a Six-Month Moving Average

28. Breadth • The extent to which movements in a broad index are reflected widely in movements of individual stocks • Spread between advancing stocks and declining stocks • Also used in industry indexes

29. Breadth

30. Table 9.2 Breadth

31. Sentiment Indicators • Trin Statistics: • Trin > 1: bearish • Trin < 1: bullish • Relative strength • Measures the extent to which a security has outperformed or underperformed either the market or its industry

32. Sentiment Indicators • Confidence index • Ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds • Put/call ratio • Call options give investors the right to buy at a fixed exercise price and a put is the right to sell at a fixed exercise price • Change in ratio can be given a bullish or bearish interpretation

33. Sentiment Indicators • Short Interest - total number of shares that are sold short • When short sales are high a signal occurs • Bullish interpretation • Bearish interpretation

34. A Warning • Although the ability to discern apparent patterns with stock market prices is irresistible—it is also possible to perceive patterns that may not exist

35. Figure 9.10 Actual and Simulated Levels for Stock Market Prices of 52 Weeks

36. Figure 9.11 Actual and Simulated Changes in Weekly Stock Prices for 52 Weeks