1. Chapter 16
TECHNICAL ANALYSIS

2. Chapter 16 Questions
How does technical analysis differ from fundamental analysis?
What are the underlying assumptions of technical analysis?
What major assumption causes a difference between technical analysis and the efficient market hypothesis?
What are the major advantages of technical analysis compared to fundamental analysis?

3. Chapter 16 Questions
What are the major challenges to technical analysis and its rules?
What is the logic for the major contrary-opinion rules used by technicians?
What are some of the significant rules used by technicians who want to follow the smart money, and what is the logic of those rules?
What are the breadth of market measures and what are they intended to indicate?

4. Chapter 16 Questions
What are the types of price movements postulated in the Dow Theory, and how are they used by a technician?
Why is the volume of trading important and how do technicians it in their analysis?
What are support and resistance levels, when do they occur, and how are they used by technicians?

5. Chapter 16 Questions
What is the purpose of moving average lines and how do technicians use them to detect major changes in trends?
What is the rationale behind the relative-strength line for an industry or a stock?
How are bar charts different from point-and-figure charts?
What are some uses of technical analysis in foreign security markets?
How is technical analysis used when analyzing bond markets?

6. Technical Analysis vs. Fundamental Analysis
Technical analysis involves the development of trading rules based on past price and volume data for individual stocks and the overall stock market.
Fundamental analysis involves economic, industry, and company analysis that lead to valuation estimates for companies, which can then be compared to market prices to aid in investment decisions.

7. Technical Analysis
To “non-believers,” technical analysis can sound like a lot of focus-pocus!

8. Underlying Assumptions of Technical Analysis
Trading via technical analysis involve a number of assumptions about markets
The market value of any good or service is determined solely by the interaction of supply and demand
Supply and demand are governed by numerous factors, both rational and irrational

9. Underlying Assumptions of Technical Analysis
Technical analysis assumptions:
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
Prevailing trends change in reaction to shifts in supply and demand relationships and these shifts can be detected in the action of the market

10. Advantages of Technical Analysis
Unlike fundamental analysis, technical analysis is not heavily dependent on financial accounting statements
Problems with accounting statements:
Lack information needed by security analysts
GAAP allows firms to select reporting procedures, resulting in difficulty comparing statements between firms
Many psychological and other non-quantifiable factors do not show up in financial statements

11. 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 equilibrium
Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds undervalued securities that may not adjust to “correct” prices as quickly

12. Challenges to Technical Analysis
Challenges to basic assumptions
Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends
Challenges to technical trading rules
Rules that worked in 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 judgement

13. Technical Trading Rules and Indicators
Stock cycles typically go through a peak and trough
For instance, consider the following stock price graph over time, and then consider how a technical analyst would interpret the chart

14. Typical Stock Market Cycle
Stock Price

15. Typical Stock Market Cycle
Stock Price
Declining Trend Channel
Peak
Flat Trend Channel
Sell Point
Rising Trend Channel
Declining Trend Channel
Buy Point
Buy Point
Trough
Trough

16. Contrary-Opinion Rules
Many 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 direction
These positions have various indicators

17. Contrary-Opinion Rules
Mutual fund cash positions
Buy when the mutual fund cash position is high, sell when low
Assumes that mutual fund managers are poor judges of market turning points
Credit balances in brokerage accounts
Buy when credit balances increase, sell when credit balances fall
Investment advisory opinions
Buy when advisory firms become more bearish

18. Contrary-Opinion Rules
OTC versus NYSE volume
If OTC volume increases relative to NYSE volume, sell since speculation increases at peaks
Chicago Board Options Exchange (CBOE) put/call ratio
Buy when option purchasers are bearish (when the put/call ratio increases)
Futures traders bullish on stock index futures
Sell when speculators are bullish

19. Follow the Smart Money
While contrary-opinion rules assume that most investors are not smart, these indicators seek to follow the path of sophisticated, and assumed smart, investors
The Barron’s Confidence Index
Measures the yield spread between high-grade bonds and a large cross section of bonds
Declining (increasing) yield spreads increase (decrease) this index, and are a bullish (bearish) indicator

20. Follow the Smart Money T-Bill - Eurodollar yield spread
Decreases in this spread indicates greater confidence, and is a bullish indicator
Debit balances in brokerage accounts
Such balances represent buying on margin, which is assumed to be done by largely sophisticated investors
Increases are a bullish signal

21. Other Market Indicators
These indicators are meant to gauge overall market sentiment
Breadth of market
Advance-decline (number of advancing minus the number of declining issues)
Short interest
Cumulative number of shares sold short in uncovered positions
Actually a bullish indicator, as it indicates potential demand

22. Other Market Indicators
Stocks above their 200-day moving average
Technicians use moving averages to compute general trends, and evaluate current stock prices relative to those trends
Block uptick-downtick ratio
Gauges institutional investor sentiment by looking at the proportion of block trades that resulted in an uptick (buy) or a downtick (sell)

23. Stock Price and Volume Techniques
The Dow theory
Major trends are like tides in the ocean
Intermediate trends resemble waves
Short-run movements are like ripples
Key is to identify the nature of a current price movement
Importance of volume
Ratio of upside-downside volume
Price movements are not very important unless they are “confirmed” by volume

24. Stock Price and Volume Techniques
Support and resistance levels
Support level: the level that a price is unlikely to decline below; when price reaches the support level, demand surges for the stock
Resistance level: the level that a price is unlikely to rise above; when price reaches the resistance level, we observe selling or “profit taking”
Movements below (bearish) and above (bullish) this range provide indicators

25. Stock Price and Volume Techniques
Moving average lines
Moving average prices are calculated and track for several different time periods
When the shorter-term moving average line is consistently above the longer-term line, it is considered a bullish signal

26. Stock Price and Volume Techniques
Relative-strength (RS) ratios
For individual stocks and industry groups
Measure relative price changes across different stocks or industries
Other Indicators
Bar charting
Multiple indicator charts
Point-and-figure charts
Idea is to get an overall feel from numerous technical indicators

27. Technical Analysis of Foreign Markets
Some foreign market data is more limited than U.S. market data
Greater reliance on stock and volume data
Merrill Lynch publishes various indicators for several countries
Technical analysis of foreign exchange rates
Traders look for trends in exchange rates that could give rise to profit opportunities

28. Technical Analysis of Bond Markets
Many of the same indicators and trading rules can be applied to bond markets
Generally not possible to get bond market volume data