Investments

Lecture 10

Technical Analysis

Technical vs. Fundamental Analysis

Fundamentalist looks forward Technician looks backward Fundamentalist concerned with future earnings and

dividends Technician is concerned little if at all with these Fundamentalist concerned with where the price is moving

in the future Technician makes recommendations on the timing of

purchases and sales Fundamental analysis designed to answer “What” Technical analysis designed to answer “When”

Technical Analysis Definition –

Technical analysis is the study of internal stock exchange information. The word technical implies a study of the market itself and not of those external factors which are reflected in the market…all the relevant factors, whatever they may be, can be reduced to the volume of the stock exchange transactions and the level of share prices… (Rosenfeld)

At odds with market efficiency – The methodology of technical analysis…rests upon the assumption

that history tends to repeat itself in the stock exchange. If a certain pattern of activity has in the past produced certain results nine times out of ten, one can assume a strong likelihood of the same outcome whenever the pattern appears in the future. It should be emphasized, however, that a large part of the methodology of technical analysis lacks a strictly logical explanation.

Uses for Technical Analysis

Analyzing the various forces in the market is used in different ways by different investors

As only input necessary in their decision-making As another piece of information in making buy/sell decisions As a waste of time

Study of price and volume data in an attempt to gain insight on where future prices (especially in the short-term) will be moving

“Information is pretty thin stuff unless mixed with experience.” (Day, 1920)

History of Technical Analysis

Early development Developed in the late 1800s by Charles Dow (editor of

the WSJ) Developed theory to describe past price movements –

this was a completely new way of analyzing markets Developed more by William Hamilton who used to

predict movements in the market

History of Technical Analysis Analyzing market behavior goes back to 1800s

No such thing as industry or firm analysis Some used charts to see what was going on in market overall –

charts focused on price movements• Movements made “formations”• “formations indicated buy/sell decisions

If stock price behavior is independent of market movements, then technical analysis is worthless.

Studies of betas of stocks prices react to demand for securities and supply of funds As balance between supply and demand shifts, future prices will

change Technical analysis is aimed at detecting this shift

Technical Analysis

On what should stock prices be based? Fundamental characteristics of the firm? Investors expectations?

The price of a stock at any one time represents a consensus view of the market of that stock’s current intrinsic value

Rationality of investors – if investors are rational, then the use of fundamental analysis should at all times be directly related to the intrinsic value of firms

Are investors perfectly rational with respect to investing? “I believe that the future is only the past again, entered

through another gate.” (Sir Arthur Wing Pinero, 1893)

Underlying Assumptions

Market value is determined solely by the interaction of supply and demand

Supply and demand are governed by numerous factors both rational and irrational.

Disregarding minor fluctuations in the market, stock prices tend to move in trends which persist for an appreciable length of time.

Changes in trend are caused by shifts in demand and supply. These shifts no matter why they occur, can be detected sooner or later in the action of the market itself.

Framework for Technical Analysis

Able to be applied to the aggregate market or individual stocks

Uses graphs or charts and technical trading rules and indicators

Price and volume are primary tools Believe that forces of supply and demand lead to

certain patterns of price behavior Volume data used to gauge the general condition in the

market and to help assess the trend• Most evidence suggests that rising (falling) prices

are usually associated with rising (falling) volume

Technical Analysis

“It is futile to assign an intrinsic value to a stock certificate. One share of US Steel, for example, was worth $261 in the early fall of 1929, but you could buy it for only $22 in June 1932. By March 1937 it was selling for $126 and one year later for $38…This sort of thing, this wide divergence between presumed value and intrinsic value, is not the exception, it is the rule… (Damodaran)

Transaction price is the settlement point that reflects both fundamental characteristics of firm and all other qualitative factors that affect investors dealings in the market

Technical Analysis

Are investors rational? In studies of investments/portfolio management, we

generally assume investors are rational. Behavioral finance is one area of research that

addresses the legitimacy of this assumption Speculative bubbles Overreaction

Implications of irrationality for technical analysis

Technical Analysis

Computerized trading If we agree that prices are affected by factors that can

not be quantified and are not always rational, we must accept that our decision-making on buying/selling is driven by these same factors.

Trading rules and computerized trading can take away some of our irrationality.

However remember that even if you establish specific rules that prevent you from being irrational, the computer is still “making decisions” in a market that is not always rational.

Technical Analysis

Problems with accounting statements that make technical analysis feasible

Lack a lot of information that security analysts need Firms can choose different ways to present certain

numbers in accounting statements that make it difficult for analysts to compare across firms

Large number of nonquantifiable variables not included in financial statements

Tools for Technical Analysis

“A picture is worth a thousand words.”Bar chartsLine chartsVolume bar chartsCandlestickPoint and figure charts

Contrarian Indicators

Observed behavior is that individuals tend to overreact to surprising news events

Evidence that this behavior also occurs in the market (overweight new information and underweight older information)

If markets overreact, then big changes in prices will be followed by price movements in the other direction.

Questions about whether overreaction occurs

Sentiment Indicators

Investment advisory opinionsMutual fund cash positionsPut/call ratioPublic short interest ratio

Support and Resistance Market price is consensus view of market on security’s

intrinsic value Buyers are bullish on stock Sellers are bearish on stock Price movements indicate one side winning

Support levels arise when consensus is price is at its bottom and will not fall further

Buyers outnumber sellers

Resistance levels when consensus is price is at its highest Sellers outnumber buyers

Support and Resistance

Penetration of support/resistance occurs when supply/demand changes

Volume / trader’s remorseRationale for importance of support/resistance

Institutional trading programs Self-fulfilling prophecy

Moving Averages

Oldest tool of technical analysisSmooths out fluctuations in prices so that

technical analyst can search for trendsSimple moving average

Average of price expectations over period of time during which moving average is calculated

Comparison of security price to moving average Current price > ma current expectations exceed

average expectations over period ma calculated (bullish or buy signal)

Momentum Indicators

Absolute breadth Looks at volatility and price changes Direction of prices is unimportant =absolute value (advancing issues – declining issues)

Advance/decline line Most popular measure of market breadth Line moves up when more stocks are advancing than declining “trouble looms when the generals lead and the troops refuse to

follow” (Achelis)

Numeric value of line is unimportant – slope and pattern are impt.

Relative Strength

Ratios determined for firm or industry group Computed as price of stock relative to value of a

market series (ie, S&P 500) Increasing ratio says stock outperforming market In a bear market, if the stock price falls by less than the

decline in the market series, then techs believe that this stock will do well in the next bull market

RSI first presented as a 14 day index Now 9 day and 25 day are popular