McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9 A Basic View of Technical Analysis Technical Analysis

9-2Objective Understand the difference between Understand the difference between fundamental and technical analysis Appreciate how technical analysis is related to patterns of stock price movement Appreciate how technical analysis is related to patterns of stock price movement Explain the types of charting that are Explain the types of charting that are used in technical analysis Describe the use of key indicator series Describe the use of key indicator series in attempting to track the direction of the market

9-3 A Basic View of Technical Analysis Technical Analysis: The Use of Charting Technical Analysis: The Use of Charting Key Indicator Series Key Indicator Series

9-4 Technical Analysis Examines prior price and volume data and other market-related indicators to determine past trends believing they may help to forecast future trends Examines prior price and volume data and other market-related indicators to determine past trends believing they may help to forecast future trends Emphasis on charts and graphs of internal market data Emphasis on charts and graphs of internal market data Less emphasis on fundamental factors Less emphasis on fundamental factors Timing considerations and market imperfections Timing considerations and market imperfections

9-5 Technical Analysis Basic Assumptions 1.Market value determined solely by interaction of demand and supply 2.Although there are minor fluctuations in the market, stock prices tend to move in trends that persist for long periods 3.Reversals of trends are caused by shifts in demand and supply 4.Shifts in demand and supply can be detected sooner or later in charts 5.Many chart patterns tend to repeat themselves

9-6 Technical Analysis Most Significant Assumptions: The lag between the time a technical analyst perceives a change in the value of a security and when the investing public ultimately assesses this change provides a profit opportunity to the chartist

9-7 The Use of Charting Often linked to development of the Dow Theory in the late 1890s by Charles Dow Often linked to development of the Dow Theory in the late 1890s by Charles Dow Generally believed successful in signaling the market crash of 1929 Generally believed successful in signaling the market crash of 1929

9-8 Essential Elements of the Dow Theory 3 major movements in the market: 3 major movements in the market: 1.Daily fluctuations 2. Secondary movements two weeks to a month two weeks to a month 3. Primary trends long term long term May be bullish or bearish in nature May be bullish or bearish in nature

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9-10 Presentation of the Dow Theory: Example of use to analyze a trend Chart shows positive primary trend despite two secondary downward trends Chart shows positive primary trend despite two secondary downward trends Bullish primary trend is confirmed by the increases in the levels of secondary lows and highs Bullish primary trend is confirmed by the increases in the levels of secondary lows and highs Pattern assumed to persist long term but ultimately to end Pattern assumed to persist long term but ultimately to end

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9-12 Presentation of the Dow Theory: Market reversal and confirmation Ultimate end of a bullish trend detected by a new pattern: Recovery fails to exceed previous high (Abortive recovery) + Recovery fails to exceed previous high (Abortive recovery) + New low penetrates a previous low + New low penetrates a previous low + New pattern confirmed by subsequent movement in Dow Jones Transportation Average New pattern confirmed by subsequent movement in Dow Jones Transportation Average

9-13 Support and Resistance Levels Chartists attempt to define trading levels where price movements might face a challenge or barrier This assumes the existence of Support levels (lower ends of trading ranges) and Support levels (lower ends of trading ranges) and Resistance levels (upper ends of trading ranges) Resistance levels (upper ends of trading ranges)

9-14 Support and Resistance Levels A breakout above a resistance level or below a support level is assumed to be significant A breakout above a resistance level or below a support level is assumed to be significant suggests that stock is now trading in new rangesuggests that stock is now trading in new range suggests higher or lower trading values outside the previous range may be expectedsuggests higher or lower trading values outside the previous range may be expected

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9-16 Support and Resistance Levels Support may develop each time stock price falls to lower level as investors who previously passed up buying opportunity now act Resistance may develop when stock price rises to high side of normal trading range as investors take profit or try to get even after having bought at previous high

9-17 Support and Resistance Levels Support – at a sufficiently low price, the quantity demanded of a security increases keeping the price from falling furtherSupport – at a sufficiently low price, the quantity demanded of a security increases keeping the price from falling further Resistance – at a sufficiently high price, the quantity supplied of a security increases keeping the price from rising furtherResistance – at a sufficiently high price, the quantity supplied of a security increases keeping the price from rising further Note that the analyst is looking just at the patterns here and is not really concerned with any fundamentals behind them

9-18 Support and Resistance Levels Breakout – the security price moves out of the previous trading range (breaching the resistance or support level) suggesting a new consensus and new trading levelsBreakout – the security price moves out of the previous trading range (breaching the resistance or support level) suggesting a new consensus and new trading levels

9-19 Volume The volume of trading supporting a given market movement is considered significant A stock price making a new high on heavy trading volume is viewed as bullish A stock price making a new high on heavy trading volume is viewed as bullish A stock price making a new low on heavy trading volume is viewed as very bearish A stock price making a new low on heavy trading volume is viewed as very bearish

9-20 Volume The volume of trading supporting a given market movement is considered significant cont. A stock price making a new high or low on light trading volume may indicate a temporary move likely to be reversed A stock price making a new high or low on light trading volume may indicate a temporary move likely to be reversed

9-21 Types of Charts Line charts Line charts Bar charts Bar charts Point and figure charts Point and figure charts

9-22 Types of Charts: Bar Charts Bar chart showing the high and low prices of a stock during trading days in November with a horizontal dash along the line to indicate the closing price On November 12th, this stock traded between a high of $41 and a low of $38 and closed at $40 a share

9-23 Bar Chart of Market Average

9-24 Chart Evaluations – Market technicians carefully evaluate charts – looking for what they perceive to be significant patterns of movement

9-25 Thus in the Figure 9-4 bar chart, the pattern might be interpreted as the “head-and-shoulders” one (note the head in the middle) with a lower penetration of the neckline to the right indicating a sell signal Chart Evaluations Chart Representation of a Market Bottom

9-26 Chart Representations

9-27 Chart Representations

9-28 Types of Charts: Point and Figure Chart (PFC) Point and Figure Chart (PFC) Emphasizes significant price changes and the reversal of significant price changesEmphasizes significant price changes and the reversal of significant price changes Has no time dimensionHas no time dimension Chartists carefully read PFCs to observe market patterns: support, resistance, breakouts, congestion, etc.Chartists carefully read PFCs to observe market patterns: support, resistance, breakouts, congestion, etc.

9-29 Types of Charts: Point and Figure Chart Point and Figure Chart In Figure 9-7, assume stock price starts at $30. Only moves of $2 or more are plotted Advances  x Declines  o Reversals from advance to a decline & vice versa calls for a shift in columns

9-30 Types of Charts: Point and Figure Chart Point and Figure Chart Thus: The stock price initially goes from $30 to $42 and then shifts columns in its subsequent decline to $36 before moving up again in column 3. A similar pattern persists throughout the chart.

9-31 Charts Trendline, published through a division of Standard & Poor’s  Provides excellent charting information on a variety of securities traded on the major exchanges  Is available at many libraries and brokerage houses

9-32 Charts  The problem in reading charts:  Analyzing patterns in such a fashion that they truly predict stock market movements before they unfold.

9-33 Key Indicator Series A number of technical indicator series may be watched for bearish ( )and bullish ( ) trends Contrary opinion rulesContrary opinion rules Smart money rulesSmart money rules Overall market indicatorsOverall market indicators

9-34 Contrary Opinion Rules Observe unsuccessful market behavior and choose a contrary position: Odd-lot Theory Odd-lot Theory Short Sales Position Short Sales Position Investment Advisory Recommendations Investment Advisory Recommendations Put-Call Ratio Put-Call Ratio

9-35 Contrary Opinion Rules: Odd-Lot Theory Odd-lot trade Odd-lot trade Less than 100 sharesLess than 100 shares Small investorsSmall investors Theory suggests watching what small investor is doing, then do opposite Theory suggests watching what small investor is doing, then do opposite Barron’s reports odd-lot trading in Barron’s reports odd-lot trading in Barron’s Barron’s “Market Laboratory – Stocks” section“Market Laboratory – Stocks” section Construct a ratio of odd-lot purchases to odd-lot sales Construct a ratio of odd-lot purchases to odd-lot sales

9-36 Contrary Opinion Rules: Odd-Lot Theory Cont. As shown in Figure 9-8, the odd-lot trader is on the correct path as the market is going up (net selling position) but becomes a net buyer preceding a fall in the market

9-37 Contrary Opinion Rules: Odd-Lot Theory Cont. The odd-lot trader is also presumed to be a strong seller right before the bottom of a bear market The odd-lot trader is also presumed to be a strong seller right before the bottom of a bear market Odd-lot trades on Mondays are particularly suspect Odd-lot trades on Mondays are particularly suspect

9-38 Contrary Opinion Rules: Short Sales Position A rule based on the volume of short sales in the market A short sale represents the selling of a security you do not own with the anticipation of purchasing the security in the future at a lower price

9-39 Contrary Opinion Rules: Short Sales Position Short seller are sometimes emotional and may overreact to the market Short seller are sometimes emotional and may overreact to the market Built-in demand for stocks that have been sold short by investors Built-in demand for stocks that have been sold short by investors They have to repurchase shares to cover their short positionsThey have to repurchase shares to cover their short positions

9-40 Contrary Opinion Rules: Short Sales Position Cont. Short sale totals reported in the Wall Street Journal Short sale totals reported in the Wall Street JournalWall Street JournalWall Street Journal When the number of short sellers is large (i.e., they are bearish), this is thought to be a bullish signal When the number of short sellers is large (i.e., they are bearish), this is thought to be a bullish signal

9-41 Contrary Opinion Rules: Short Sales Position Cont. Compute the ratio of total short sales positions on an exchange to average daily exchange volume for the month Compute the ratio of total short sales positions on an exchange to average daily exchange volume for the month Normal ratio is between 2.0 and 3.0Normal ratio is between 2.0 and 3.0 A ratio of 2.5 indicates current short sales are equal to 2 ½ times the day’s average trading volumeA ratio of 2.5 indicates current short sales are equal to 2 ½ times the day’s average trading volume

9-42 Contrary Opinion Rules: Short Sales Position Cont.  As the ratio (called the short interest ratio) approaches the higher end of the normal range, this would be considered bullish  Use of ratio has produced mixed results

9-43 Contrary Opinion Rules: Investment Advisory Recommendations Watch the predictions of investment advisory services and do the opposite Investors Intelligence has formalized this into an Index of Bearish Sentiment: Investors Intelligence has formalized this into an Index of Bearish Sentiment: When 60% or more of advisory services are bearish, expect a market upturnWhen 60% or more of advisory services are bearish, expect a market upturn When only 15% or fewer are bearish,When only 15% or fewer are bearish, expect a decline in the market

9-44 Contrary Opinion Rules: Investment Advisory Recommendations Cont. In Figure 9-9, a summary of bullish and bearish sentiments from the “Market Laboratory—Economic Indicators” section of Barron’s, the AAII Index (American Assoc. of Individual Investors Index) shows the percentage of bears in the 15% range suggesting a possible sell under contrary opinion rules Barron’s

9-45 Contrary Opinion Rules: Put-Call Ratio Watch the “put-call” ratio and do the opposite of what option traders are doing Puts and calls represent options to buy or sell stock over a specified period of time at a given price: Puts and calls represent options to buy or sell stock over a specified period of time at a given price: A put is an option to sellA put is an option to sell A call is an option to buyA call is an option to buy

9-46 Contrary Opinion Rules: Put-Call Ratio Cont. The ratio of put (sell) to call (buy) options The ratio of put (sell) to call (buy) options Normally about 0.60Normally about 0.60 Fewer traders of put options than call optionsFewer traders of put options than call options When ratio gets up to 0.65 to 0.70 or higher When ratio gets up to 0.65 to 0.70 or higher Indicates increasing pessimism by option traders and contrary rules suggests a buy signalIndicates increasing pessimism by option traders and contrary rules suggests a buy signal

9-47 Contrary Opinion Rules: Put-Call Ratio Cont. When the ratio goes down to 0.40 When the ratio goes down to 0.40 decreasing pessimism (increasing optimism) may indicate that it is time to sell decreasing pessimism (increasing optimism) may indicate that it is time to sell The put-call ratio has a better than average record for calling market turns. The put-call ratio has a better than average record for calling market turns. Put-call ratio data is found in the “Market Week – Options” section of Barron’s Put-call ratio data is found in the “Market Week – Options” section of Barron’sBarron’s

9-48 Smart Money Rules Some investors attempt to track the pattern of sophisticated traders Some investors attempt to track the pattern of sophisticated traders They might provide unusual insight into the future They might provide unusual insight into the future

9-49 Smart Money Rules: Barron’s Confidence Index  Used to observe trading pattern of investors in the bond market  Bond traders may be more sophisticated than stock traders  They may pick up trends more quickly  The theory suggests that a person who can figure out what bond traders are doing today may be able to determine what stock market investors will be doing in the near future

9-50 Smart Money Rules: Barron’s Confidence Index Cont. Computed by taking yield on 10 top-grade corporate bonds, dividing by yield on 40 intermediate-grade bonds and multiplying by 100: Computed by taking yield on 10 top-grade corporate bonds, dividing by yield on 40 intermediate-grade bonds and multiplying by 100: Barron’s Confidence Index Published weekly in the “Market Laboratory – Bonds” section of Barron’s

9-51 Smart Money Rules: Barron’s Confidence Index Cont.  As top-grade bonds pay smaller yields than intermediate-grade bonds, the Confidence Index is always below 100%  Normal trading range is between 80 and 96 Continued

9-52 Smart Money Rules: Barron’s Confidence Index Cont. If bond investors are bullish about future economic prosperity, they are indifferent between holding top-grade and intermediate-grade bonds If bond investors are bullish about future economic prosperity, they are indifferent between holding top-grade and intermediate-grade bonds the yield differences between the two categories will be relatively small the yield differences between the two categories will be relatively small  Confidence Index near 96  Confidence Index near 96

9-53 Smart Money Rules: Barron’s Confidence Index Cont. 10 Top Grade Bonds yielding 8.4%, while 40 Intermediate Grade Bonds yield 9.1%: Assume:10 Top Grade Bonds yielding 8.4%, while 40 Intermediate Grade Bonds yield 9.1%: Barron’s Confidence Index = x 100 = 92% If Investors become concerned about the economy’s future health they will invest in lower-quality bond issues only at a sufficiently high yield differential to justify the risk – the gap widens: Barron’s Confidence Index = x 100 = 83% 8.4% 9.1% 8.9% 10.7%

9-54 Smart Money Rules: Barron’s Confidence Index Cont.  Few months lead time between what happens to Confidence Index and what happens to the economy and stock market  The Confidence Index has a mixed record of predicting future events  Mixed record may partly be due to the fact that the supply of new bond issues can influence yields as much as investor attitudes (demand)

9-55 Smart Money Rules: Short Sales By Specialists Ratio of specialists’ short sales to total amount of short sales on exchange Ratio of specialists’ short sales to total amount of short sales on exchange Market technicians ascribe unusual importance to Specialists’ decisions Market technicians ascribe unusual importance to Specialists’ decisions

9-56 Smart Money Rules: Short Sales By Specialists Cont. The normal ratio of specialists’ short sales to the total amount of short sales on an exchange is about 45% The normal ratio of specialists’ short sales to the total amount of short sales on an exchange is about 45% If the ratio goes above 50%, technicians interpret this as a bearish signal If the ratio goes above 50%, technicians interpret this as a bearish signal If the ratio falls below 40%, technicians consider this bullish If the ratio falls below 40%, technicians consider this bullish

9-57 Overall Market Rules Breadth of the Market Breadth of the Market Cash Position of Mutual Funds Cash Position of Mutual Funds

9-58 Overall Market Rules Breadth of the Market Attempts to measure what broad range of securities are doing compared to a market average Attempts to measure what broad range of securities are doing compared to a market average Compare advance-declines: Compare advance-declines: The number of stock prices which are rising compared to those decliningThe number of stock prices which are rising compared to those declining relative to movements in a stock market average relative to movements in a stock market average potential signal of a turning point in the market potential signal of a turning point in the market

9-59 E.g., if the Dow-Jones Industrial Average (DJIA) is rising while the number of daily declines consistently exceeds the number of daily advances, this might signal the end of a bull market. E.g., if the Dow-Jones Industrial Average (DJIA) is rising while the number of daily declines consistently exceeds the number of daily advances, this might signal the end of a bull market. Why? Why? Although conservative investors are investing in blue-chip stocks, there is a lack of a broad-based confidence in the market. Although conservative investors are investing in blue-chip stocks, there is a lack of a broad-based confidence in the market. Overall Market Rules Breadth of the Market cont’d

9-60 Overall Market Rules Breadth of the Market Cont. Breadth of the Market Cont. In Table 9-1, future weakness in the market is signaled by a strength in the DJIA that is not reflected in the advance-decline data

9-61 When the DJIA is going down but advanced consistently lead declines, the market may be posed for recovery When the DJIA is going down but advanced consistently lead declines, the market may be posed for recovery Weighted averages calculated of daily advances/declines are also used Weighted averages calculated of daily advances/declines are also used Daily data on the DJIA and advancing & declining issues may be found in the “Stock Market Data Bank” section of the Wall Street Journal Daily data on the DJIA and advancing & declining issues may be found in the “Stock Market Data Bank” section of the Wall Street JournalWall Street JournalWall Street Journal Overall Market Rules Breadth of the Market cont’d

9-62 Overall Market Rules Cash Position of Mutual Funds Indicates buying potential of mutual funds Indicates buying potential of mutual funds Representative of the purchasing potential of other large institutional investorsRepresentative of the purchasing potential of other large institutional investors Varies between % as a percent of total assetsVaries between % as a percent of total assets

9-63 At the lower end of this range, mutual funds appear to be fully invested and can provide little in the way of additional purchasing power At the lower end of this range, mutual funds appear to be fully invested and can provide little in the way of additional purchasing power As cash position goes to 15% or higher, might represent significant purchasing power that might help trigger a market upturn As cash position goes to 15% or higher, might represent significant purchasing power that might help trigger a market upturn Problems arise in identifying significant cash positions for mutual funds Problems arise in identifying significant cash positions for mutual funds Overall Market Rules Cash Position of Mutual Funds cont’d

9-64 WEBSITECOMMENT Provides data, charts and technical indicators, free cbs.marketwatch.com Market news and data Contains some technical analytical data and charts Has technical charts

9-65 WEBSITECOMMENT Provides free technical charts and education on technical analysis Provides a searchable database