®1999 South-Western College Publishing 1 Chapter 13 Technical Analysis

®1999 South-Western College Publishing 2 Technical Analysis As An Art Prices are Determined by Investors’ AttitudesPrices are Determined by Investors’ Attitudes –Prices move in trends Changing Attitude TowardChanging Attitude Toward –Economic forces –Monetary forces –Political forces –Psychological forces

®1999 South-Western College Publishing 3 Technical Analysis As A Science Study of the Action of the MarketStudy of the Action of the Market Science of Recording in Graphic FormScience of Recording in Graphic Form –Price changes, volume, highs and lows,… –The averages of above Deducing the Probable Future TrendDeducing the Probable Future Trend

®1999 South-Western College Publishing 4 Is Technical Analysis An Art Or Science? ArtArt –Martin J. Pring ScienceScience –Robert D. Edwards and John Magee

®1999 South-Western College Publishing 5 Underlying Assumptions of Technical Analysis 1. The market value of any good or service is determined solely by the interaction of supply and demand 2. Supply and demand are governed by numerous factors, both rational and irrational

®1999 South-Western College Publishing 6 Underlying Assumptions of Technical Analysis 3. 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 4. Prevailing trends change in reaction to shifts in supply and demand relationships and these shifts can be detected in the action of the market

®1999 South-Western College Publishing 7 Advantages of Technical Analysis Not heavily dependent on financial accounting statementsNot heavily dependent on financial accounting statements –Problems with accounting statements: 1. Lack information needed by security analysts 2. GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements from two firms 3. Nonquantifiable factors do not show up in financial statements

®1999 South-Western College Publishing 8 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 equilibriumFundamental 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 quicklyTechnicians 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

®1999 South-Western College Publishing 9 Challenges to Technical Analysis Trading rulesTrading rules –The past may not be repeated –Patterns may become self-fulfilling prophecies –A successful rule will gain followers and become less successful –Rules all require subjective judgment Assumptions - Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trendsAssumptions - Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends

®1999 South-Western College Publishing 10 Is There Any Empirical Evidence To Support Technical Analysis (TA)? Patterns in Security PricesPatterns in Security Prices –Fall one week, bounce back next week –Monthly returns over a long time –Seasonal patterns January effect (Chapter 12)January effect (Chapter 12) Resent Research Merits TAResent Research Merits TA

®1999 South-Western College Publishing 11 Charting Bar ChartsBar Charts –Illustrates each days High, low, and closing priceHigh, low, and closing price –Looks at stock price behavior over time Point-and-Figure ChartsPoint-and-Figure Charts –Identifies stock price reversals –Does not consider time Candlestick ChartsCandlestick Charts –Illustrates each days Opening, high, low, and closing priceOpening, high, low, and closing price

®1999 South-Western College Publishing 12 Bar Charts TrendlineTrendline –Drawn on chart to identify trend ChannelChannel –Pattern formed by 2 trendlines ResistanceResistance –Downward price movement SupportSupport –Upward price movement

®1999 South-Western College Publishing 13 Typical Stock Market Cycle Stock Price Figure 21.2

®1999 South-Western College Publishing 14 Typical Stock Market Cycle Stock Price Figure 21.2 Declining Trend Channel Trough Buy Point Rising Trend Channel Flat Trend Channel Sell Point Peak Declining Trend Channel Trough Buy Point

®1999 South-Western College Publishing 15 Point-And-Figure Charts A Series of Xs and OsA Series of Xs and Os Same as Bar ChartsSame as Bar Charts Popular ToolPopular Tool

®1999 South-Western College Publishing 16 Candlestick Chart Candlestick LineCandlestick Line –Real body Difference between opening and closing priceDifference between opening and closing price –Shadow Vertical line identifying the high and low priceVertical line identifying the high and low price –Can be constructed with Different Time Data IntradayIntraday WeeklyWeekly

®1999 South-Western College Publishing 17 Summary Of Charts

®1999 South-Western College Publishing 18 Contrary-Opinion Many analysts rely on rules developed from the premise that the majority of investors are wrong as the market approaches peaks and troughsMany analysts rely on rules developed from the premise that the majority of investors are wrong as the market approaches peaks and troughs Technicians try to determine whether investors are strongly bullish or bearish and then trade in the opposite directionTechnicians try to determine whether investors are strongly bullish or bearish and then trade in the opposite direction These positions have various indicatorsThese positions have various indicators

®1999 South-Western College Publishing 19 Contrary-Opinion Rules Mutual fund cash positionsMutual fund cash positions Credit balances in brokerage accountsCredit balances in brokerage accounts Investment advisory opinionsInvestment advisory opinions OTC versus NYSE volumeOTC versus NYSE volume Chicago Board Options Exchange (CBOE) put/call ratioChicago Board Options Exchange (CBOE) put/call ratio Futures traders bullish on stock index futuresFutures traders bullish on stock index futures

®1999 South-Western College Publishing 20 Follow the Smart Money Indicators showing behavior of sophisticated investorsIndicators showing behavior of sophisticated investors The Barron’s Confidence IndexThe Barron’s Confidence Index T-Bill - Eurodollar yield spreadT-Bill - Eurodollar yield spread Short sales by specialistsShort sales by specialists Debit balances in brokerage accounts (margin debt)Debit balances in brokerage accounts (margin debt)

®1999 South-Western College Publishing 21 Other Market Indicators Breadth of marketBreadth of market –Advance-decline –Diffusion index Short interestShort interest Stocks above their 200-day moving averageStocks above their 200-day moving average Block uptick-downtick ratioBlock uptick-downtick ratio

®1999 South-Western College Publishing 22 Theoretical Basis Of TA Dow TheoryDow Theory –Trends Moving AveragesMoving Averages –5-day –200-day Relative StrengthRelative Strength –RSI

®1999 South-Western College Publishing 23 Dow Theory Primary Trend - “Tides”Primary Trend - “Tides” –Cycle in years Intermediate Trend - “waves”Intermediate Trend - “waves” –3 Weeks to 6 months Short-Term Trend - “ripples”Short-Term Trend - “ripples” –Volatile and erratic Basic Tenets next slideBasic Tenets next slide

®1999 South-Western College Publishing 24 Basic Tenets Of Dow Theory Requires Data on Stock IndexesRequires Data on Stock Indexes –No additional information Types of Financial Market MovementsTypes of Financial Market Movements –Primary –Intermediate –Short-term Positive Relationship BetweenPositive Relationship Between –Trend –Volume of shares traded

®1999 South-Western College Publishing 25 RSI Range From 0% to 100%Range From 0% to 100% HighHigh –Industry stock prices outperform the market –Indicate a sell signal? Buy signal? Low The trend is your friend!Low The trend is your friend! –Market outperforming the industry stock –Indicates a buy signal? Sell signal?

®1999 South-Western College Publishing 26 Stock Price and Volume Techniques Relative-strength (RS) ratiosRelative-strength (RS) ratios –For individual stocks and industry groups Bar chartingBar charting Multiple indicator chartsMultiple indicator charts Point-and-figure chartsPoint-and-figure charts Overall feel from a consensus of numerous technical indicatorsOverall feel from a consensus of numerous technical indicators

®1999 South-Western College Publishing 27 Technical Indicators Breadth IndicatorsBreadth Indicators –Advance-decline line (ADL) –Volume –New high/new low Sentiment IndicatorsSentiment Indicators –Stock market newsletter –Odd-lot trading –Put/call trading –Specialists short selling

®1999 South-Western College Publishing 28 Advance-Decline Line ADLt = At - Dt + ADLt - 1