technical analysis, market efficiency, and behavioral finance

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Technical Analysis, Market Efficiency, and Behavioral Finance

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 9-2

Market Price Behavior

• Learning Goals1. Discuss the purpose of technical analysis and why

market performance is important to stock valuation.

2. Describe approaches to technical analysis, such as the Dow Theory, moving averages, charting and indicators of the technical condition of the market.

3. Compute and use technical trading rules.

4. Explain the idea of random walks and efficient markets and note the challenges these theories hold for the stock valuation process.


Market Price Behavior

• Learning Goals (cont’d)

5. Describe the weak, semi-strong, and strong versions of the efficient market hypothesis and explain what market anomalies are.

6. Demonstrate a basic appreciation of how psychological factors can affect investors’ decisions, and how behavioral finance presents a challenge to the concept of market efficiency.


Technical Analysis

• Before financial data/financial statements were required to be disclosed, investors could only watch the stock market itself to determine buy-or-sell decisions

• Investors began keeping “charts” of stock market movements to look for patterns, or “formations” that indicated whether to buy or sell

• Studies have shown that anywhere from 20% to 50% of the price behavior of a stock can be traced to overall market forces


Technical Analysis (cont’d)

• Technical Analysis is the study of the various forces at work in the marketplace and their affect on stock prices.– Focus is on trends in a business’ stock price and the

overall stock market

– Stock prices are a function of supply and demand for shares of stock

– Used to get a general sense of where the stock market is going in the next few months

– Several technical indicators may be used together


Big Picture Technical Indicators

• The Dow Theory– Market’s performance is based upon long-term

price trend (primary trend) in overall market

– Used to signal end of both bull and bear markets

– An after-the-fact measure with no predictive power


Figure 9.1 The Dow Theory in Operation


Big Picture:Technical Indicators (cont’d)

• Trading Action

– Looks at minor trading characteristics in market over long periods of time

– Assumes the market moves in cycles and these cycles repeat themselves

– Trading rules are formed from patterns:• January indicator• Presidential election indicator• Super Bowl indicator


Big Picture Technical Indicators (cont’d)

• Confidence Index

– Looks at ratio between yields on high-grade corporate bonds compared to low-grade corporate bonds

– Optimism and pessimism about the future outlook is reflected in the bond yield spread

– Trend of “smart money” is revealed in bond market before it shows up in stock market


Market Technical Indicators

• Market Volume– Pure supply and demand analysis for

common stocks

– Strong market when volume goes up

– Weak market when volume goes down


Market Technical Indicators (cont’d)

• Breadth of the Market– Looks at number of stock prices that go up

(advances) versus number of stock prices that go down (declines)

– Strong market when advances outnumber declines

– Weak market when declines outnumber advances



• Short Interest– Looks at number of stocks that have been sold

short at any given time

– Can give two different interpretations:• Measure of Future Demand for Stock

– Strong market when short sales are high since guarantees future stock sales to cover the short positions

• Measure of Present Market Optimism or Pessimism – Weak market when short sales are high since professional

short sellers think stocks will decline



• Contrary Opinion and Odd-Lot Trading– Measures the volume of small traders

– Assumes that small traders will do just the opposite of what should be done

• Panic and sell when market is low• Speculate and buy when market is high

– Bull market when odd-lot sales significantly outnumber odd-lot purchases

– Bear market when odd-lot purchases significantly outnumber odd-lot sales


Trading Rules and Measures

• Advance-Decline Line

– Measures the difference between stocks closing higher and stocks closing lower than previous day

– Difference is plotted on graph to view trends

– Used as signal to buy or sell stocks

– Bull market when advances outnumber declines

– Bear market when declines outnumber advances


Trading Rules and Measures (cont’d)

• New Highs–New Lows

– Measures the difference between stocks reaching a 52-week high and stocks reaching a 52-week low

– 10-day moving average is plotted on graph to view trends


– Bull market when highs outnumber lows

– Bear market when lows outnumber highs



• The Trading Index (TRIN)– Combines advance-decline line with trading volume


– Bull market when TRIN values are lower

– Bear market when TRIN values are higher

TRIN Number of up stocks

Number of down stocks

Volume in up stocks

Volume in down stocks



• Mutual Fund Cash Ratio (MFCR)– Tracks cash position of mutual funds

– High cash positions in mutual funds provides liquidity for future stocks purchases or protection from future mutual fund withdrawals

– Bull market when MFCR values are higher

– Bear market when MFCR values are lower

MFCR Mutual fund cash position Total assets under management



• On Balance Volume– Tracks the volume to price change relationship as a

running total– Up-volume occurs when stock closes higher and is added

to running total; down-volume occurs when stock closes lower and is subtracted from running total

– Direction of indicator is more important than actual value

– Used to confirm price trends– Bull market when OBV values are higher– Bear market when OBV values are lower


Using Technical Analysis

• Charting– Shows visual summary of stock activity

over time

– Easy to use and to understand

– Use to spot developing trends

– Major types• Bar Charts• Point-and-Figure Charts• Chart Formations


Figure 9.3 A Stock Chart


Using Technical Analysis (cont’d)

• Bar Charts– Shows changes in stock price over period

of time

– Often used to compare current stock price with moving average

– When current price goes above or below a moving average, indicates significant price change


Figure 9.4 A Bar Chart



• Point-and-Figure Charts

– Only shows significant changes in stock price patterns

– Up patterns are shown as an “X” and down patterns are shown as an “O”


Figure 9.5 A Point-and-Figure Chart


Using Technical Analysis

• Chart Formations– Looking for patterns, or formations, that

historically meant that stocks were going up or down

– Buy when stocks break through a “line of resistance”

– Sell when stocks break through a “line of support”


Figure 9.6 Some Popular Chart Formations



• Moving Averages– Tracks data (usually stock price) as average

value over time

– Used to “smooth out” daily fluctuations and focus on underlying trends

– Usually calculated over periods ranging from 10 to 200 days


Figure 9.7 A 100-Day Moving Average Line


Random Walks and Efficient Markets

• Random Walk: the theory that stock price movements are unpredictable, so there is no way to know where prices are headed

– Studies of stock price movements indicate that they do not move in neat patterns

– This could be an indication that markets are highly efficient and respond quickly to changes in the current situation


Random Walks and Efficient Markets (cont’d)

• Efficient Market: a market in which securities reflect all possible information quickly and accurately

• Efficient Market Hypothesis: markets have a large number of knowledgeable investors who react quickly to new information, causing securities prices to adjust quickly and accurately


Random Walks and Efficient Markets (cont’d)

• To have an efficient market, you must have:– Many knowledgeable investors active in analyzing and

trading stocks

– Information is widely available to all investors and is free/easy to obtain

– Events, such as labor strikes or accidents, tend to happen randomly

– Investors react quickly and accurately to new information, causing prices to adjust


Levels of Efficient Markets

• Weak Form– Past data on stock prices are of no use in predicting

future stock price changes– Everything is random– Should simply use a “buy-and-hold” strategy

• Semi-strong Form– Abnormally large profits cannot be consistently earned

using public information– Any price anomalies are quickly found out and the stock

market adjusts


Levels of Efficient Markets (cont’d)

• Strong Form– There is no information, public or private, that

allows investors to consistently earn abnormally high returns


Market Anomalies

• Calendar Effects– Stocks returns may be closely tied to the time of year or

time of week– Questionable if really provide opportunity– Examples: January effect, weekend effect

• Small-Firm Effect– Size of a firm impacts stock returns– Small firms may offer higher returns than larger firms,

even after adjusting for risk


Market Anomalies (cont’d)

• Earnings Announcements– Stock price adjustments may continue after earnings

adjustments have been announced– Unusually good quarterly earnings reports may signal

buying opportunity

• P/E Effect– Uses P/E ratio to value stocks– Low P/E stocks may outperform high P/E stocks, even

after adjusting for risk


Technical vs. Fundamental:So Who is Right?

• There is growing consensus that markets may not be perfectly efficient, but they may be at least reasonably efficient

• Individual investor must determine which approach has merits for their investing decisions


Investor Behavior and Security Prices

• Overconfidence– Investors tend to be overconfident in their judgment,

leading them to underestimate risks

• Biased Self-Attribution– Investors tend to take credit for successes and blame

others for failures– Investors will follow information that supports their

beliefs and disregard conflicting information


Investor Behavior and Security Prices (cont’d)

• Loss Aversion– Investors dislike losses much more than gains– Investors will hang on to losing stocks hoping they will

bounce back

• Representativeness– Investors tend to draw strong conclusions from

small samples– Investors tend to underestimate the effects of

random chance


Investor Behavior and Security Prices (cont’d)

• Narrow Framing– Investors tend to analyze a situation in isolation,

while ignoring the larger context

• Belief Perseverance– Investors tend to ignore information that

conflicts with their existing beliefs


Behavioral Finance at Work in the Markets

• Stock Return Predictability

– It maybe profitable to buy underperforming stocks when they are out-of-favor

– Momentum of stock prices up and down tends to continue over 6- to 12-month time horizons

– Value stocks may outperform growth stocks


Behavioral Finance at Work in the Markets (cont’d)

• Investor Behavior– Investors who believe they have superior

information tend to trade more, but earn lower returns

– Investors tend to sell stocks that have risen in value rather than declined

– Investors acting on emotions instead of facts may reduce market efficiency


Behavioral Finance at Work in the Markets (cont’d)

• Analyst Behavior

– Analysts may be biased by “herding” behavior, where they tend to issue similar recommendations for stocks

– Analysts may be overly optimistic about a favorite stock’s future


Using Behavioral Finance to Improve Investment Results (Table 9.1)

• Don’t hesitate to sell a losing stock

• Don’t chase performance

• Be humble and open-minded

• Review the performance of your investment on a periodic basis

• Don’t trade too much


Table 9.1 Using Behavioral Finance to Improve Investment Results

technical analysis, market efficiency, and behavioral finance

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