Chapter 9

Chapter 9

Technical Analysis, Market Efficiency, and Behavioral Finance

2

Market Price Behavior

Learning Goals

1. 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.

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Market Price Behavior

Learning Goals

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

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

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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

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Technical Analysis

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

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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

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Big Picture:Technical Indicators

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

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Big Picture Technical Indicators

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

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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

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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

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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

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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

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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

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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

Used as signal to buy or sell stocks

Bull market when highs outnumber lows

Bear market when lows outnumber highs

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The Trading Index (TRIN) Combines advance-decline line with trading volume Used as signal to buy or sell stocks

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

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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

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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

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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

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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

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A Bar Chart

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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”

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A Point-and-Figure Chart

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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”

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Some Popular Chart Formations

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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

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A 100-Day Moving Average Line

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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

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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

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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 and or 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

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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

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Levels of Efficient Markets

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

allows investors to consistently earn abnormally high returns

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Market Anomalies

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

or time of week Examples: January effect (small stock prices go up

during Jan), weekend effect (Monday’s Open is Lower than Friday Close)

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

even after adjusting for risk

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Market Anomalies

Earnings Announcements Stock price adjustments may continue after earnings

adjustments have been announced (Lots of adjustment prior to announcement)

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

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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

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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

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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

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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

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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

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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

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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

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Using Behavioral Finance to Improve Investment Results

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

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Review

Goals

1. Discussed the purpose of technical analysis and why market performance is important to stock valuation.

2. Described approaches to technical analysis.

3. Computed and used technical trading rules.

4. Explained the idea of random walks and efficient markets.

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Review

Goals

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

6. Showed a basic understanding of how psychological factors could affect investors’ decisions, and how behavioral finance presents a challenge to the concept of market efficiency.

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The End!

Chapter 9

Additional Chapter Art

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Figure 9.2 Some Market Statistics

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Table 9.1 Using Behavioral Finance to Improve Investment Results

Chapter 9

Documents

Transcript of Chapter 9