CHAPTER NINE

Practical Investment Management

Robert A. Strong

TECHNICAL ANALYSIS

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Outline

Charting The Underlying Logic Types of Charts Other Chart Annotations

Technical Indicators Indicators with Economic Justification Indicators of the Witchcraft Variety

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Outline

Old Puzzles and New Developments Fibonacci Numbers Dow Theory Kondratev Wave Theory Chaos Theory Neural Networks

The Future of Technical Analysis

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Charting: The Underlying Logic

The technical analyst believesthat charts can be used to predict changes in supply and demand and investor behavior.

Market participants seldom waitfor things to completely unfold. They try to anticipate events rather than merely react to them.

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Charting: Types of Charts

The technical analyst uses many types of charts: line charts bar charts point and figure charts candlestick charts

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Linear Scale Line Chart

Insert Figure 9-1 here.

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Logarithmic Y-Axis Line Chart

Insert Figure 9-2 here.

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Bar Chart

Insert Figure 9-3 here.

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Point and Figure Chart

Insert Figure 9-4 here.

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Candlestick Chart

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Charting: Other Chart Annotations

support level

resistance level

congestion area

breakout

Chartists believe investors remember missed opportunities and look for them to return.

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Charting: Other Chart Annotations

Insert Figure 9-6 here.

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Technical Indicators

These statistics, either calculated or directly observed, are alleged to have a relationship with the future direction of the overall stock market or with an individual security.

Indicators with economic justification are based on economic activities that are measurable and observable.

Indicators of the witchcraft variety have no logical connections between the measurements and what the measurements purport to show.

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Indicators with Economic Justification

The higher the short interest figure, the larger is the potential demand for the shares.

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Short Interest

Insert Table 9-1 here.

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Indicators with Economic Justification

Increased margin buying has historically been associated with rising markets.

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Margin Loans

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Indicators with Economic Justification

Cash held by mutual funds represents potential demand for stock.

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Mutual Fund Cash Position

Insert Figure 9-8 (Mutual Fund Cash Position Rule) here.

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Mutual Fund Cash Position

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Indicators with Economic Justification

When the confidence index gets closer to 1.0, investors are more likely to be bullish about the economy, and therefore about corporate earnings.

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Confidence Index

Insert Figure 9-10 here.

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Indicators with Economic Justification

An advance-decline line is a graphical representation of the net advances over a period of time.

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Advance-Decline Line

Insert Figure 9-11 (Market Breadth) here.

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Indicators with Economic Justification

A high relative strength ratio, such as a high relative PE, means that investors are willing to pay more for the past earnings of a company than average.

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Relative Strength Ratio

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Indicators with Economic Justification

Advocates of moving averages in stock selection believe that changes in the slope of the line are important.

Market indicators can help present data in a more intuitive way and may suggest areas for further investigation. However, they cannot always predict the future movements of a stock or of the overall market.

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Indicators of the Witchcraft Variety

The super bowl indicator states that the stock market will advance the following year if the super bowl football game is won by a team from the original National Football League.

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The Super Bowl Indicator

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Indicators of the Witchcraft Variety

Increased sunspot activity every eleven years leads to better weather for an improved harvest, leading in turn to a stronger economy, and finally to higher stock prices.

Hemline indicator : As shorter dresses for women become the fashion, the market advances, and vice versa.

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Old Puzzles and New Developments

Fibonacci numbers occur frequently and inexplicably in nature.

1.618, the golden mean of the numbers,is used to calculate the Fibonacci ratios.

Many Fibonacci advocates in the investment business use the first two ratios, 0.382 and 0.618, to “compute the retracement levels of a previous move.”

Fibonacci Numbers

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, ...

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Dow Theory

The Dow theory holds that there are three components in the movement of stock prices:The primary trend is the long-term direction of

the market and is the most important.The secondary trend refers to a temporary

reversal in the primary trend.Daily fluctuations in the stock price are

meaningless and contain no useful information.

Old Puzzles and New Developments

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Old Puzzles and New Developments

Insert Figure 9-12 (The Dow Theory) here.

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Old Puzzles and New Developments

The Kondratev wave theory states there is a 50-60 year business cycle.

The Chaos theory sees systematic behavior amidst apparent randomness.

A neural network is a trading system in which a forecasting model is trained to find a desired output from past trading data.

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Old Puzzles and New Developments

Insert Figure 9-13 (Investment-Style Topography) here.

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The Future of Technical Analysis

Technical analysis has persisted for more than 100 years, and it is not likely to disappear from the investment scene anytime soon.

Improved quantitative methods coupled with improved behavioral research will continue to generate ideas for analysts to test.

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Review

Charting The Underlying Logic Types of Charts Other Chart Annotations

Technical Indicators Indicators with Economic Justification Indicators of the Witchcraft Variety

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Review

Old Puzzles and New Developments Fibonacci Numbers Dow Theory Kondratev Wave Theory Chaos Theory Neural Networks

The Future of Technical Analysis