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Chapter Nine

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  1. Chapter Nine A Basic View of Technical Analysis and Market Efficiency © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

  2. A Basic View of Technical Analysis and Market Efficiency • Technical Analysis: The Use of Charting • Key Indicator Series • Efficient Market Hypothesis • Weak Form of the Efficient Market Hypothesis • Semistrong Form of the Efficient Market Hypothesis • Strong Form of the Efficient Market Hypothesis

  3. The Technical Approach to Investment Timing • A gap exists between the practices of brokerage houses and Wall Street (charting and other technical analyses) and the beliefs held in the academic community (such as in the efficient market hypothesis) • Since a consensus does not exist, it may pay to consider many schools of thought in valuing a security

  4. Technical Analysis • Examines prior price and volume data and other market-related indicators to determine past trends hoping this will help forecast future trends • Emphasis on charts and graphs of internal market data • Less emphasis on fundamental factors

  5. Technical Analysis • Belief that the discovery of fundamental information may not lead to profitable trading because of timing considerations and market imperfections • Market Imperfections: ability of the market to adjust rapidly to the supply of new information in valuing a security

  6. Technical Analysis • Efficient Market Hypothesis: “All securities are correctly priced at any point in time” • Implies neither fundamental analysis nor technical analysis work to profitably predict security valuation

  7. Technical Analysisassumes: 1. Market value is determined solely by the interaction of demand and supply 2. Although there are minor fluctuations in the market, stock prices tend to move in trends that persist for long periods Continued

  8. Technical Analysisassumes: 3. Reversals in trends are caused by shifts in demand and supply 4. Shifts in demand and supply can be detected sooner or later in charts 5. Many chart patterns tend to repeat themselves

  9. Technical AnalysisMost Significant Assumptions: • Stock prices move in trends that persist for long periods • These trends can be detected in charts Thus past trends in market movements can be used to forecast or understand the future. The lag between the time a technical analyst perceives a change in the value of a security and when the investing public ultimately assesses this change provides a profit opportunity to the chartist

  10. Technical AnalysisTools to project future market movements • Charting • Key indicator series

  11. Technical AnalysisUse of Charting • Often linked to development of theDow Theoryin the late 1890s by Charles Dow • Generally believed successful in signaling the market crash of 1929

  12. Essential Elements of the Dow Theory There are 3 major movements in the market: 1. Daily fluctuations 2. Secondary movements (two weeks to a month) 3. Primary trends (long term) • May be bullish or bearish in nature • Daily fluctuations and secondary movements only important to extent they reflect on the persistence of the long term primary trend

  13. Presentation of the Dow Theory:Example of use to analyze a trend • Chart shows positive primary trend despite two secondary downward trends • Bullish primary trend is confirmed by the increases in the levels of secondary lows and highs • Pattern assumed to persist long term but ultimately to end

  14. Presentation of the Dow Theory:Market reversal and confirmation Ultimate end of a bullish trend detected by a new pattern: • Recovery fails to exceed previous high (Abortive recovery) + • New low penetrates a previous low + • New pattern confirmed by subsequent movement in Dow Jones Transportation Average

  15. Support and Resistance Levels Chartists attempt to define trading levels where price movements might face a challenge or barrier This assumes the existence of • Support levels (lower ends of trading ranges) and • Resistance levels (upper ends of trading ranges)

  16. Support and Resistance Levels • A breakout above a resistance level or below a support level is assumed to be significant in suggesting that a stock is now trading in a new range and • A breakout suggests higher or lower trading values outside the previous range may now be expected

  17. Support and Resistance Levels • Support may develop each time a stock price falls to a lower level as investors who previously passed up a buying opportunity now act • Resistance may develop when a stock price rises to the high side of the normal trading range as investors take a profit or try to get even after having bought at a previous high

  18. Support and Resistance Levels • Support– at a sufficiently low price, the quantity demanded of a security increases keeping the price from falling further • Resistance– at a sufficiently high price, the quantity supplied of a security increases keeping the price from rising further Note that the analyst is looking just at the patterns here and is not really concerned with any fundamentals behind them

  19. Support and Resistance Levels • Breakout– the security price moves out of the previous trading range (breaching the resistance or support level) suggesting a new consensus and new trading levels

  20. Volume The volume of trading supporting a given market movement is considered significant • A stock price (or the general market) making a new high on heavytrading volume is viewed as bullish • A stock price (or the general market) making a new low on heavy trading volume is viewed as very bearish Continued

  21. Volume The volume of trading supporting a given market movement is considered significant cont. • A stock price (or the general market) making a new high or low on lighttrading volume may indicate a temporary move likely to be reversed

  22. Types of Charts • Line charts (like the previous ones shown here to visualize market patterns) • Bar charts • Point and figure charts

  23. Types of Charts: Bar Charts On November 12th, this stock traded between a high of $41 and a low of $38 and closed at $40 a share Bar chart showing the high and low prices of a stock during trading days in November with a horizontal dash along the line to indicate the closing price

  24. Chart Evaluations Market technicians carefully evaluate charts – looking for what they perceive to be significant patterns of movement

  25. Chart Evaluations Chart Representation of a Market Bottom Thus in the Figure 9-4 bar chart, the pattern might be interpreted as the “head-and-shoulders” one (note the head in the middle) with a lower penetration of the neckline to the right indicating a sell signal

  26. Chart Representations

  27. Chart Representations

  28. Types of Charts: Point and Figure Chart (PFC) • Emphasizes significant price changes and the reversal of significant price changes • Has no time dimension • Chartists carefully read PFCs to observe market patterns: support, resistance, breakouts, congestion, and so on.

  29. Types of Charts: Point and Figure Chart In Figure 9-7, assume stock price starts at $30. Only moves of $2 or more are plotted Advances  x Declines  o Reversals from advance to a decline & vice versa calls for a shift in columns

  30. Types of Charts: Point and Figure Chart Thus: The stock price initially goes from $30 to $42 and then shifts columns in its subsequent decline to $36 before moving up again in column 3. A similar pattern persists throughout the chart.

  31. Charts • Trendline, published through a division of Standard & Poor’s • Provides excellent charting information on a variety of securities traded on the major exchanges • Is available at many libraries and brokerage houses

  32. Charts • The problem in reading charts has always been to analyze patterns in such a fashion that they truly predict stock market movements before they unfold. • To justify this effort, one must assume there are discernible trends over the long term.

  33. Key Indicator Series A number of technical indicator series may be watched for bearish ( )and bullish ( ) trends • Contrary opinion rules • Smart money rules • Overall market indicators

  34. Contrary Opinion Rules Suggest observing unsuccessful market behavior and choosing a contrary position: • Odd-lot Theory • Short Sales Position • Investment Advisory Recommendations • Put-Call Ratio

  35. Contrary Opinion Rules:Odd-Lot Theory • An odd-lot trade is one of less than 100 shares — only small investors tend to engage in odd-lot transactions • This theory suggests watching what the small investor is doing and then do the opposite • The weekly Barron’sreports odd-lot trading on a daily basis in its “Market Laboratory – Stocks” section • It is easy to construct a ratio of odd-lot purchases to odd-lot sales

  36. Contrary Opinion Rules:Odd-Lot Theory Cont. As shown in Figure 9-8, the odd-lot trader is on the correct path as the market is going up (net selling position) but becomes a net buyer preceding a fall in the market

  37. Contrary Opinion Rules:Odd-Lot Theory Cont. • The odd-lot trader is also presumed to be a strong seller right before the bottom of a bear market • A corollary to the odd-lot theory says that Monday odd-lot trades are particularly suspect

  38. Contrary Opinion Rules:Odd-Lot Theory Cont. • The theory actually suggests the small trader does all right most of the time but badly misses on key market turns • While the odd-lot theory appeared to have some validity in the 1950s and 1960s, it was not particularly valuable in more recent decades. However, odd-lot traders outguessed many professional traders in the mid-1970s and late 1980s as well as in October 1997 and in the fall of 2003

  39. Contrary Opinion Rules:Short Sales Position A rule based on the volume of short sales in the market [A short sale represents the selling of a security you do not own with the anticipation of purchasing the security in the future to cover your short position] The contrary opinion stems from two sources: • Short seller are sometimes emotional and may overreact to the market, and more importantly • There is now a built-in demand for stocks that have been sold short by investors who will have to repurchase shares to cover their short positions

  40. Contrary Opinion Rules:Short Sales Position Cont. • When the number of short sellers is large (i.e., they are bearish), this is thought to be a bullish signal • Daily short sale totals for the NYSE are reported in the Wall Street Journalas well as midmonth figures for the two major exchanges and securities traded on those exchanges

  41. Contrary Opinion Rules:Short Sales Position Cont. • Technical analysts compute a ratio of total short sales positions on an exchange to average daily exchange volume for the month • Normal ratio is between 2.0 and 3.0 • A ratio of 2.5 indicates current short sales are equal to 2 ½ times the day’s average trading volume

  42. Contrary Opinion Rules:Short Sales Position Cont. • As the ratio (called the short interest ratio) approaches the higher end of the normal range, this would be considered bullish • Use of the ratio has produced mixed results

  43. Contrary Opinion Rules:Investment Advisory Recommendations A further contrary opinion rule: Watch the predictions of investment advisory services and do the opposite • Investors Intelligence has formalized this into an Index of Bearish Sentiment:

  44. Contrary Opinion Rules:Investment Advisory Recommendations Cont. In Figure 9-9, a summary of bullish and bearish sentiments from the “Market Laboratory—Economic Indicators” section of Barron’s, the AAII Index (American Assoc. of Individual Investors Index) shows the percentage of bears in the 15% range suggesting a possible sell under contrary opinion rules

  45. Contrary Opinion Rules: Put-Call Ratio ILL-CONCEIVED speculation in the options market suggests that a “put-call” ratio may tell you to do the opposite of what option traders are doing • Puts and calls represent options to buy or sell stock over a specified period of time at a given price: • A put is an option to sell • A call is an option to buy • Put-call ratio data is found in the “Market Week – Options” section of Barron’s

  46. Contrary Opinion Rules: Put-Call Ratio Cont. • The ratio of put (sell) to call (buy) options is normally about 0.60 – there are generally fewer traders of put options than call options • When the ratio gets up to 0.65 to 0.70 or higher, this indicates increasing pessimism by option traders and the contrary rules suggests a buy signal Continued