1. CHAPTER NINE Practical Investment Management Robert A. Strong TECHNICAL ANALYSIS

2. South-Western / Thomson Learning © 2004 9 - 2 Outline  Charting  The Underlying Logic  Types of Charts  Other Chart Annotations  Technical Indicators  Indicators with Economic Justification  Indicators of the Witchcraft Variety

3. South-Western / Thomson Learning © 2004 9 - 3 Outline  Old Puzzles and New Developments  Fibonacci Numbers  Dow Theory  Kondratev Wave Theory  Chaos Theory  Neural Networks  The Future of Technical Analysis

4. South-Western / Thomson Learning © 2004 9 - 4 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.

5. South-Western / Thomson Learning © 2004 9 - 5 Charting: Types of Charts  The technical analyst uses many types of charts:  line charts  bar charts  point and figure charts  candlestick charts

6. South-Western / Thomson Learning © 2004 9 - 6 Linear Scale Line Chart Insert Figure 9-1 here.

7. South-Western / Thomson Learning © 2004 9 - 7 Logarithmic Y-Axis Line Chart Insert Figure 9-2 here.

8. South-Western / Thomson Learning © 2004 9 - 8 Bar Chart Insert Figure 9-3 here.

9. South-Western / Thomson Learning © 2004 9 - 9 Point and Figure Chart Insert Figure 9-4 here.

10. South-Western / Thomson Learning © 2004 9 - 10 Candlestick Chart

11. South-Western / Thomson Learning © 2004 9 - 11 Charting: Other Chart Annotations  support level  resistance level  congestion area  breakout Chartists believe investors remember missed opportunities and look for them to return.

12. South-Western / Thomson Learning © 2004 9 - 12 Charting: Other Chart Annotations Insert Figure 9-6 here.

13. South-Western / Thomson Learning © 2004 9 - 13 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.

14. South-Western / Thomson Learning © 2004 9 - 14 Indicators with Economic Justification  The higher the short interest figure, the larger is the potential demand for the shares.

15. South-Western / Thomson Learning © 2004 9 - 15 Short Interest Insert Table 9-1 here.

16. South-Western / Thomson Learning © 2004 9 - 16 Indicators with Economic Justification  Increased margin buying has historically been associated with rising markets.

17. South-Western / Thomson Learning © 2004 9 - 17 Margin Loans

18. South-Western / Thomson Learning © 2004 9 - 18 Indicators with Economic Justification  Cash held by mutual funds represents potential demand for stock.

19. South-Western / Thomson Learning © 2004 9 - 19 Mutual Fund Cash Position Insert Figure 9-8 (Mutual Fund Cash Position Rule) here.

20. South-Western / Thomson Learning © 2004 9 - 20 Mutual Fund Cash Position

21. South-Western / Thomson Learning © 2004 9 - 21 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.

22. South-Western / Thomson Learning © 2004 9 - 22 Confidence Index Insert Figure 9-10 here.

23. South-Western / Thomson Learning © 2004 9 - 23 Indicators with Economic Justification  An advance-decline line is a graphical representation of the net advances over a period of time.

24. South-Western / Thomson Learning © 2004 9 - 24 Advance-Decline Line Insert Figure 9-11 (Market Breadth) here.

25. South-Western / Thomson Learning © 2004 9 - 25 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.

26. South-Western / Thomson Learning © 2004 9 - 26 Relative Strength Ratio Insert Table 9-3 here.

27. South-Western / Thomson Learning © 2004 9 - 27 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.

28. South-Western / Thomson Learning © 2004 9 - 28 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.

29. South-Western / Thomson Learning © 2004 9 - 29 The Super Bowl Indicator

30. South-Western / Thomson Learning © 2004 9 - 30 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.

31. South-Western / Thomson Learning © 2004 9 - 31 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.” Fibonacci Numbers 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233,...

32. South-Western / Thomson Learning © 2004 9 - 32 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

33. South-Western / Thomson Learning © 2004 9 - 33 Old Puzzles and New Developments Insert Figure 9-12 (The Dow Theory) here.

34. South-Western / Thomson Learning © 2004 9 - 34 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.

35. South-Western / Thomson Learning © 2004 9 - 35 Old Puzzles and New Developments Insert Figure 9-13 (Investment- Style Topography) here.

36. South-Western / Thomson Learning © 2004 9 - 36 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.

37. South-Western / Thomson Learning © 2004 9 - 37 Review  Charting  The Underlying Logic  Types of Charts  Other Chart Annotations  Technical Indicators  Indicators with Economic Justification  Indicators of the Witchcraft Variety

38. South-Western / Thomson Learning © 2004 9 - 38 Review  Old Puzzles and New Developments  Fibonacci Numbers  Dow Theory  Kondratev Wave Theory  Chaos Theory  Neural Networks  The Future of Technical Analysis