Fin2802: Investments Spring, 2010 Dragon Tang

1. Lectures 11&12 Behavioral Finance and Technical Analysis February 23&25, 2010 Readings: Chapter 12 Practice Problem Sets: 1,2,4,10, 11 Fin2802: InvestmentsSpring, 2010Dragon Tang Chapter 12: Behavioral Finance and Technical Analysis

2. Where Are We? How? Securities Markets Institutions Trading Delegated investment Why? Market efficiency Historical performance What? Stock Bond Evaluation International Chapter 12: Behavioral Finance and Technical Analysis

3. Where Are We? How? Securities Markets Institutions Trading Delegated investment Why? Market efficiency Historical performance What? Stock Bond Evaluation International So What? Chapter 12: Behavioral Finance and Technical Analysis

4. Behavioral Finance and Technical Analysis • Objectives: • Understand the principles of behavioral finance. • Identify reasons why technical analysis may be profitable. • Use the Dow theory to identify situations that technicians would characterize as buy or sell opportunities. • Use indicators such as volume, breadth, short interest, or confidence indexes to measure the "technical condition" of the market. • Explain why most of technical analysis is at odds with an efficiently functioning stock market. Chapter 12: Behavioral Finance and Technical Analysis

5. Traditional theories (e.g., CAPM) assume rational investors Systematic behavioral biases (anomalies) have been observed Behavioral finance tries to incorporate some aspect of investors’ behavior and explain those anomalies using psychological principles It is a developing and important area Companies exploiting behavioral biases: Lakonishok, Shleifer and Vishny (LSV) Dimensional Fund Advisors (DFA) Fuller and Thaler Asset Management Case-Shiller-Weiss Behavioral Finance Chapter 12: Behavioral Finance and Technical Analysis

6. Cooperation and Altruism Bidding and the Winner’s Curse Endowment Effect, Status Quo Bias and Loss Aversion Mental Accounts Individual Behavior Chapter 12: Behavioral Finance and Technical Analysis

7. Figure 12-1 Loss Aversion Preference Function Chapter 12: Behavioral Finance and Technical Analysis

8. Calendar Effects Cash Dividends Overreaction and Mean Reversion Controversial explanations from behavioral finance Closed-end fund discount puzzle Excess volatility in stock prices Loss aversion Asset Returns and Behavioral Explanations Chapter 12: Behavioral Finance and Technical Analysis

9. Fundamental Risk Implementation Costs Model Risk Siamese Twin Companies Equity Carve-outs Closed-End Funds Limits to Arbitrage Chapter 12: Behavioral Finance and Technical Analysis

10. Figure 12.2 Pricing of Royal Dutch Relative to Shell (Deviation from Parity) Chapter 12: Behavioral Finance and Technical Analysis

11. Technical Analysis • Attempts to exploit stock price patterns for profit. • Assumes prices adjust slowly to their true equilibrium values Chapter 12: Behavioral Finance and Technical Analysis

12. Technical Analysis and EMH • Technical analysis clashes with the EMH hypothesis. • EMH predicts rapid adjustment of prices with the onset of new information. • Evidence for the success of technical analysis is poor. Chapter 12: Behavioral Finance and Technical Analysis

13. Charting: The analysis of “charts” of stock price and volume with the hope of finding patterns to exploit in the markets. The Dow Theory Point and Figure Chart Elliott Wave Theory Technical Indicators Sentiment Indicators:Market Volume (Trin Statistic); Odd-lot Trading; Confidence Index; Put/Call Ratio; Mutual Fund Cash Position Flow of Funds:Short Interest; Credit balances in brokerage accounts Market Structure:Moving Averages; Breadth; Relative Strength; Technical Analysis Tool-kit Chapter 12: Behavioral Finance and Technical Analysis

14. Charting: The Dow Theory The Dow Theory: • Uses price and volume trends to predict stock prices. • Identifies primary, secondary, and tertiary trends. • Predicts support and resistance price levels. Chapter 12: Behavioral Finance and Technical Analysis

15. Figure 19-2 Dow Theory Trends Chapter 12: Behavioral Finance and Technical Analysis

16. Figure 19-3 Dow Jones Industrial Averages in 1988 Chapter 12: Behavioral Finance and Technical Analysis

17. Charting: Elliott Wave Theory Elliott Wave Theory: • Stock prices can be described by a set of wave patterns • Long-term and short-term wave cycles are superimposed on each other • By interpreting the cycles, one can predict broad movements Chapter 12: Behavioral Finance and Technical Analysis

18. Figure 19-4 Point and Figure Chart for Table 19-2 Chapter 12: Behavioral Finance and Technical Analysis

19. Table 19-2 Stock Price History Chapter 12: Behavioral Finance and Technical Analysis

20. Figure 19-5 Point and Figure Chart for Atlantic Richfield Chapter 12: Behavioral Finance and Technical Analysis

21. Figure 19-6 Candlestick Chart Chapter 12: Behavioral Finance and Technical Analysis

22. Charting: A Warning A Warning: • Seeing patterns that don’t exists • After the fact, one can always find patterns and trading rules that would have generated enormous profits • What has worked in the past may not work in the future. Chapter 12: Behavioral Finance and Technical Analysis

23. Figure 19-7 Actual and Simulated Stock Prices for 52 Weeks Chapter 12: Behavioral Finance and Technical Analysis

24. Figure 19-8 Actual and Simulated Changes in Weekly Stock Prices for 52 Weeks Chapter 12: Behavioral Finance and Technical Analysis

25. Technical Indicators: Sentiment Indicators • Market Volume:Higher volume gives strong confirmation to price trend. • Trin>1: Bear Market; Trin<1: Bull Market • Odd-lot Trading(less than 100 shares): Small investors tend to miss key market turning points. • - Odd-lot buying heavy Þ investors should be bearish. • - Odd-lot selling heavy Þ investors should be bullish. Chapter 12: Behavioral Finance and Technical Analysis

26. Confidence Index: Closer to 100% Þ investors should be bullish Away from 100% Þ investors should be bearish. Put/Call Ratio: Ratio normally hovers around 65%. Rising ratio Þ investors should be bearish? Rising ratio Þ investors should be bullish? Mutual Fund Cash Positions More cash Þ bearish? Technical Indicators: Sentiment Indicators Chapter 12: Behavioral Finance and Technical Analysis

27. Technical Indicators: Flows of Funds • Short Interest: The volume of short selling • High volume Þ investors should be bearish. • Low volume Þ investors should be bullish. • or • High volume Þ investors should be bullish. • Low volume Þ investors should be bearish. • Credit Balances in Brokerage Accounts • High balanceÞ bullish Chapter 12: Behavioral Finance and Technical Analysis

28. 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 Market Structure Indicators Chapter 12: Behavioral Finance and Technical Analysis

29. Technical Indicators: Market Structure Moving Average: Average over a given interval, continuously updated. Price Price And M.A. Bullish Signal Bearish Signal Moving Average Time Averaging interval Chapter 12: Behavioral Finance and Technical Analysis

30. Figure 19-10 Moving Average for Microsoft Chapter 12: Behavioral Finance and Technical Analysis

31. Figure 19-11 Moving Averages Chapter 12: Behavioral Finance and Technical Analysis

32. Technical Indicators: Market Structure • Breadth: The spread between the number of advancing issues and the number of declining issues. • Advances > declines Þbullish • Advances < declines Þbearish • Relative Strength: • or • Persistent Rising ratio Þ bullish. • Persistent Falling ratio Þ bearish. “Momentum” Strategies Chapter 12: Behavioral Finance and Technical Analysis

33. Figure 19-12 Cumulative Difference in Returns of Previously Best and Worst Ranking Stocks in Subsequent Months Chapter 12: Behavioral Finance and Technical Analysis

34. Widely followed with some evidence of superior performance Value Line System is predominately a technical system Earnings momentum Relative stock prices Ratios of moving averages Value Line System Chapter 12: Behavioral Finance and Technical Analysis

35. Figure 19-13 Record of Value Line Ranking for Timeliness (without adjustment for change in rankings) 1965-1990 Chapter 12: Behavioral Finance and Technical Analysis

36. Paper vs actual performance indicates that the system is difficult to implement Value Line Fund has not shown superior performance High turnover costs are associated with the strategy Evidence shows prices react quickly to reported ranking changes Value Line System Chapter 12: Behavioral Finance and Technical Analysis

37. Technical Analysis and Market Efficiency • Reaction time and length of trends • EMH Þ new information is quickly reflected in prices. • Technical analysis Þ long-lived trends play out slowly and predictably. • A useful technical rule would be invalidated once the mass of traders attempt to exploit it (self-destructing Patterns) Chapter 12: Behavioral Finance and Technical Analysis

38. A New View of Technical Analysis EMH: Public information is available to all; Price reflect all available information Study by Brown and Jennings (RFS, 1989): • Many investors have private information • Sequence of past price can be useful in the inference of information held by other traders • Prices reveal as well as reflectinformation Chapter 12: Behavioral Finance and Technical Analysis

39. Summary • Principles of behavioral finance, individual behavior, behavioral explanations • Technical analysis is the search for recurring patterns in stock prices; Technical analysis assumes prices adjust slowly • Charting: The Dow Theory • Point and Figure Charts • Elliott Wave Theory • Technical Indicators: Sentiment Indicators • Flow of Funds • Market Structure • New theories of information dissemination Chapter 12: Behavioral Finance and Technical Analysis