A Basic View Technical Analysis

8/10/2019 A Basic View Technical Analysis

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CHAPTER 9

FI N 320Prof. Jim Mallett

A Basic View of Technical Analysis

and Market Eff iciency


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Learning Objectives

Understand the difference between fundamental andtechnical analysis.

Understand how technical analysis is related to patterns

of stock price movement.

Explain the types of charting that are used in technicalanalysis.

Describe the use of key indicator series in attempting to

track the direction of the market.

Explain the efficient market hypothesis and the variousforms it can take.

Relate the efficient market hypothesis to fundamental

and technical analysis.


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Technical Analysis

Technicians examine prior price and volume data todetermine past trends in the belief that they will help

forecast future ones.

Fundamental Analysis uses expectations of economic

conditions and company information to value anasset (stock).

Technical analysis relies on charts and graphs of

internal market data.

Technicians believe that even when important

fundamental information is uncovered, it may not

lead to profitable trading because of timing

considerations and market imperfections.


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The Use of Charting

Charles Dow, editor of the Wall Street Journal (WSJ) developedthe charting technique in the late 1890s.

The Dow Theory

There are three major movements in the market:

Daily fluctuations.

Secondary movements - covering two weeks to a month and

are only important to the extent they reflect on the long-term

primary trend in the market.

Primary trends which are either bullish or bearish in nature.

Analysts should not be confused by secondary movement.

New pattern of movement by the DJIA must be confirmed by

DJTA.


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Presentation of

the Dow Theory

(Figure 9-1)

Primary trend

Secondary

trend

Secondary

trend

Dow Jones Industrial Average


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Support and Resistance Levels

Support is a new price level at which new

demand comes into the market.

Resistance is a new price level at which supply

of the stock increases.


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Typesof Charts

A bar chart shows the high and low price for a stock

with a horizontal dash to indicate closing price.

A point and figure chart emphasizes significant

price changes and the reversal of significant price

changes.


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Contrary Opinion Rule

Short Sales Position indicates that a large aggregate

number of short sellers is a bull ish signal.

I t is measured by the ratio of total shor t sales

positions on an exchange to average daily exchangevolume for the month.

A normal ratio is between 2.0 (bearish) and 5.0

(bul l ish). The ratio is publi shed daily in the WSJ.

Also known as short interest ratio

Around the 20th of each month, WSJ reports on

total shor t sale f igures.


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Contrary Opinion Rule

Investment Advisory Recommendations.

Investors Intelligence developed the Index of

Bearish Sentiment which suggests that when 60%

or more of the advisory services are bearish, you

should expect an upturn and when only 15% or

less are bearish you should expect a decline.

Published in the Market Laboratory - Economic

Indicators section of Barrons.


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Overal l Market Rules

Breadth of the market indicator attempts to measure what a

broad range of securities is doing as opposed to merely

examining a market average.

The technician compares the advance - declines with the

movement of a market average to determine if there is a

divergence between the two.

Advances and declines move in the opposite direction of

market averages at a market peak or bottom.

Breadth Index =Net Advances or Declines

Number of Issues Traded


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Eff icient Market Hypothesis

An efficient market is one in which new information is very rapidly

processed so that securities are properly priced at any given time.

Premise of an Efficient Market Hypothesis -

A large number of independent profit maximizing participants,concerned with analysis and valuation of securities.

Information travels in a random independent fashion.

There is almost instantaneous adjustment to new information.

Consequently, no stock price can be in disequilibrium or

improperly priced for very long.

Prices are an unbiased reflection of all currently available

information. No one investor can consistently outperform the

market.

W k F f Effi i


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Weak Form of Efficient

Market Hypothesis

Weak-form of EMH suggests that there is no

relationship between past and future prices and

trading volumes of securities.

Prices are presumed independent over time. There is

nothing to be gained from studying past data.

Tests of independence have examined the degree of

correlation between stock prices over time and foundthe correlation to be consistently small (-.10 + .10)

and not statistically significant.


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Weak Form of Eff icient

Market Hypothesis (continued)

Trading Rule Test

Example: If a stock moves up by $2 (or 10%) or more, the rule

might be to buy it. This supposedly represents a breakout and

should be bullish.

Can a trading rule beat a nave buy-and-hold approach?

Empirical research finds that in a limited number of cases, trading

rules may produce slightly positive returns, but after commissions

and risk are considered, the results are neutral and sometimes

negative.

Implications for Technical Analysis

Prices move independently over time, past trends cannot be used to

predict the future and that charting and technical analysis may have

limited value.

S i t F f th


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Semistrong Form of the

Eff icient Market Hypothesis

Semi-Strong form of EMH maintains that all public

information is already impounded in the value of a security and

therefore one cannot use fundamental analysis to determine

whether a stock is undervalued or overvalued.

There is no learning lag in the distribution of public

information.

Investors cannot earn superior returns by trading on public

information about stock splits, earning reports, asset sales,

capital restructuring, etc Tests of semi-strong form of EMH are generally based on risk

adjusted returns.

Research shows that market is generally efficient in semistrong

form.

I l i ti f S i St F


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Implications of Semi-Strong Form

EMH for Fundamental Analysis

It is very difficult (but not impossible) to earn abnormalreturns.

Although many would suggest that fundamentalanalysis may not lead to superior profits in an efficientmarket, it is fundamental analysis itself that makes the

market efficient.

Portfolio managers should decide on the desirable levelof risk for their clients and maintain that level of riskby periodically rebalancing the portfolio, while

minimizing the costs associated with liquidity,transactions and taxes.

Tests on the performance of mutual funds managershave consistently indicated that they are not able tobeat the market averages over the long term.


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Market Anomolies

Evidence against semi-strong form EMH

Low P/E stock consistently provide higher returns

than high P/E stocks. Small firms tend to provide higher returns than large

firms, after adjusting for risk.

Stock market returns are higher in January than rest

of the year.

St F f th


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Strong Form of the

Eff icient Market H ypothesis

Strong form of EMH states that stock prices reflect not

only public information but all information. It goes

beyond the concept of an efficient market to one that is

perfect.

Assumption: No group of investors has monopolistic

access to information.

Results of research do not support strong form of EMH.

Studies report that specialists average return on capital

exceeds 100%.

Insiders consistently achieve higher returns than would

be expected in a perfect capital market.

A Basic View Technical Analysis

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