CHAPTER 9 Technical Analysis

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Technical Analysis Technical analysis attempts to predict changes in prices by identifying trends or patterns in market price, volume, or other market indicators. Technical analysis is often referred to as “charting,” but charting is only one type of technical analysis. 2

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Technical Analysis Technical analysis will not will not benefit investors in an efficient market (even if it is only weak-form efficient). If a market is weak-form efficient, security prices fully reflect all market information. 3

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Technical Analysis Charting Market structure Sentiment 4

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Charting One form of charting is referred to as the Dow Theory. It attempts to identify “primary trends,” “intermediate trends” and “minor trends.” 5

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Charting: Dow Theory Primary trends are long-term, lasting several months or longer and are the most important. Secondary trends are short-term deviations from the primary trend, lasting a few days or a few weeks. Minor trends are daily fluctuations 6

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 9.3 Dow Theory Trends 7

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Charting: Dow Theory Technical analysts attempt to identify primary trends early enough to participate. The problem is that it is difficult to distinguish between the three trends (except after the fact). 8

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Charting: Dow Theory The Dow Theory also looks for “support levels” and “resistance levels.” ◦A support level is a price below which the market should not go. ◦A resistance level is a price above which the market should not go. 9

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Structure Another category of technical analysis is referred to market structure. It includes: ◦Moving average ◦Breadth indicators:  Advances – declines  Closing tick 10

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Structure Indicators 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 11

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 9.7 Share Price and 50-Day Moving Average for Apple Computer 12

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Table 9.2 Breadth 13

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Sentiment Indicators Yet another form of technical analysis is based on investor sentiment. There are many indicators of investor sentiment. One problem: many sentiment indicators can be interpreted as either bullish or bearish. 14

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Sentiment Indicators Odd - Lot Trading Ratio of odd-lot purchases to odd-lot sales When ratio exceeds 1.0, it means odd lot investors are buying more than they are selling. This is a bearish signal (contrarian): small investors are usually wrong 15

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Sentiment Indicators Trin Statistic:

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Technical Indicators Short Interest - total number of shares that are sold short ◦When short sales are high a signal occurs:  Bearish interpretation: investors sell short if they believe stock prices will fall. Most short sellers are sophisticated, knowledgeable investors.  Bullish interpretation: short positions have to be covered & represent future buying. 17

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Technical Indicators The Super Bowl January performance of stock market 18