TECHNICAL ANALYSIS

TECHNICAL ANALYSIS CHAPTER NINE Practical Investment Management Robert A. Strong

Outline • Charting • The Underlying Logic • Types of Charts • Other Chart Annotations • Technical Indicators • Indicators with Economic Justification • Indicators of the Witchcraft Variety

Outline • Old Puzzles and New Developments • Fibonacci Numbers • Dow Theory • Kondratev Wave Theory • Chaos Theory • Neural Networks • The Future of Technical Analysis

Charting: The Underlying Logic • The technical analyst believes that charts can be used to predict changes in supply and demand and investor behavior. • Market participants seldom wait for things to completely unfold. They try to anticipate events rather than merely react to them.

Charting: Types of Charts • The technical analyst uses many types of charts: • line charts • bar charts • point and figure charts • candlestick charts

Linear Scale Line Chart Insert Figure 9-1 here.

Logarithmic Y-Axis Line Chart Insert Figure 9-2 here.

Bar Chart Insert Figure 9-3 here.

Point and Figure Chart Insert Figure 9-4 here.

Candlestick Chart

Charting: Other Chart Annotations Chartists believe investors remember missed opportunities and look for them to return. • support level • resistance level • congestion area • breakout

Charting: Other Chart Annotations Insert Figure 9-6 here.

Technical Indicators • These statistics, either calculated or directly observed, are alleged to have a relationship with the future direction of the overall stock market or with an individual security. • Indicators with economic justification are based on economic activities that are measurable and observable. • Indicators of the witchcraft variety have no logical connections between the measurements and what the measurements purport to show.

Indicators with Economic Justification • The higher the short interest figure, the larger is the potential demand for the shares.

Short Interest Insert Table 9-1 here.

Indicators with Economic Justification • Increased margin buying has historically been associated with rising markets.

Margin Loans

Indicators with Economic Justification • Cash held by mutual funds represents potential demand for stock.

Mutual Fund Cash Position Insert Figure 9-8 (Mutual Fund Cash Position Rule) here.

Mutual Fund Cash Position

Indicators with Economic Justification • When the confidence index gets closer to 1.0, investors are more likely to be bullish about the economy, and therefore about corporate earnings.

Confidence Index Insert Figure 9-10 here.

Indicators with Economic Justification • An advance-decline line is a graphical representation of the net advances over a period of time.

Advance-Decline Line Insert Figure 9-11 (Market Breadth) here.

Indicators with Economic Justification • A high relative strength ratio, such as a high relative PE, means that investors are willing to pay more for the past earnings of a company than average.

Relative Strength Ratio Insert Table 9-3 here.

Indicators with Economic Justification • Advocates of moving averages in stock selection believe that changes in the slope of the line are important. • Market indicators can help present data in a more intuitive way and may suggest areas for further investigation. However, they cannot always predict the future movements of a stock or of the overall market.

Indicators of the Witchcraft Variety • The super bowl indicator states that the stock market will advance the following year if the super bowl football game is won by a team from the original National Football League.

The Super Bowl Indicator

Indicators of the Witchcraft Variety • Increased sunspot activity every eleven years leads to better weather for an improved harvest, leading in turn to a stronger economy, and finally to higher stock prices. • Hemline indicator : As shorter dresses for women become the fashion, the market advances, and vice versa.

Fibonacci Numbers 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, ... Old Puzzles and New Developments • Fibonacci numbers occur frequently and inexplicably in nature. • 1.618, the golden mean of the numbers, is used to calculate the Fibonacci ratios. • Many Fibonacci advocates in the investment business use the first two ratios, 0.382 and 0.618, to “compute the retracement levels of a previous move.”

Old Puzzles and New Developments Dow Theory • The Dow theory holds that there are three components in the movement of stock prices: • The primary trend is the long-term direction of the market and is the most important. • The secondary trend refers to a temporary reversal in the primary trend. • Daily fluctuations in the stock price are meaningless and contain no useful information.

Old Puzzles and New Developments Insert Figure 9-12 (The Dow Theory) here.

Old Puzzles and New Developments • The Kondratev wave theory states there is a 50-60 year business cycle. • The Chaos theory sees systematic behavior amidst apparent randomness. • A neural network is a trading system in which a forecasting model is trained to find a desired output from past trading data.

Old Puzzles and New Developments Insert Figure 9-13 (Investment-Style Topography) here.

The Future of Technical Analysis • Technical analysis has persisted for more than 100 years, and it is not likely to disappear from the investment scene anytime soon. • Improved quantitative methods coupled with improved behavioral research will continue to generate ideas for analysts to test.

Review • Charting • The Underlying Logic • Types of Charts • Other Chart Annotations • Technical Indicators • Indicators with Economic Justification • Indicators of the Witchcraft Variety

Review • Old Puzzles and New Developments • Fibonacci Numbers • Dow Theory • Kondratev Wave Theory • Chaos Theory • Neural Networks • The Future of Technical Analysis

TECHNICAL ANALYSIS