Chapter 9 - PPT

11

Chapter Nine

A Basic View of Technical Analysis and Market Efficiency

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

22

A Basic View of Technical Analysis A Basic View of Technical Analysis and Market Efficiencyand Market Efficiency

Technical Analysis: The Use of ChartingTechnical Analysis: The Use of Charting Key Indicator SeriesKey Indicator Series Efficient Market HypothesisEfficient Market Hypothesis Weak Form of the Efficient Market HypothesisWeak Form of the Efficient Market Hypothesis Semistrong Form of the Efficient Market Semistrong Form of the Efficient Market

HypothesisHypothesis Strong Form of the Efficient Market HypothesisStrong Form of the Efficient Market Hypothesis

33

The Technical Approach to The Technical Approach to Investment TimingInvestment Timing

A gap exists between the practices of A gap exists between the practices of brokerage houses and Wall Street brokerage houses and Wall Street ((charting and other technical analysescharting and other technical analyses) ) and the beliefs held in the academic and the beliefs held in the academic community (community (such as in the efficient such as in the efficient market hypothesismarket hypothesis) )

Since a consensus does not exist, it may Since a consensus does not exist, it may pay to consider many schools of thought pay to consider many schools of thought in valuing a securityin valuing a security

44

Technical AnalysisTechnical Analysis

Examines prior price and volume data Examines prior price and volume data and other market-related indicators to and other market-related indicators to determine past trends hoping this will determine past trends hoping this will help forecast future trendshelp forecast future trends

Emphasis on charts and graphs of Emphasis on charts and graphs of internal market datainternal market data

Less emphasis on fundamental factorsLess emphasis on fundamental factors

55


Belief that the discovery of fundamental Belief that the discovery of fundamental information may not lead to profitable information may not lead to profitable trading because of timing trading because of timing considerations and market considerations and market imperfectionsimperfections

Market ImperfectionsMarket Imperfections: ability of the : ability of the market to adjust rapidly to the supply of market to adjust rapidly to the supply of new information in valuing a securitynew information in valuing a security

66


Efficient Market HypothesisEfficient Market Hypothesis::

““All securities are correctly priced at any All securities are correctly priced at any point in time”point in time”• Implies neither fundamental analysisImplies neither fundamental analysis

nor technical analysis work to profitablynor technical analysis work to profitably

predict security valuationpredict security valuation

77

Technical AnalysisTechnical Analysisassumes:assumes:

1. Market value is determined solely by 1. Market value is determined solely by the interaction of demand and supplythe interaction of demand and supply

2. Although there are minor fluctuations in 2. Although there are minor fluctuations in the market, stock prices tend to move in the market, stock prices tend to move in trends that persist for long periodstrends that persist for long periods

ContinuedContinued

88

Technical AnalysisTechnical Analysisassumes:assumes:

3. Reversals in trends are caused by 3. Reversals in trends are caused by shifts in demand and supply shifts in demand and supply

4. Shifts in demand and supply can be 4. Shifts in demand and supply can be detected sooner or later in chartsdetected sooner or later in charts

5. Many chart patterns tend to repeat 5. Many chart patterns tend to repeat themselvesthemselves

99

Technical AnalysisTechnical AnalysisMost Significant Assumptions:Most Significant Assumptions:

Stock prices move in trends that persist for Stock prices move in trends that persist for long periodslong periods

These trends can be detected in chartsThese trends can be detected in charts

Thus past trends in market movements can Thus past trends in market movements can be used to forecast or understand the future. be used to forecast or understand the future.

The lag between the time a technical analyst The lag between the time a technical analyst perceives a change in the value of a security perceives a change in the value of a security and when the investing public ultimately and when the investing public ultimately assesses this change provides a profit assesses this change provides a profit opportunity to the chartistopportunity to the chartist

1010

Technical AnalysisTechnical AnalysisTools to project future market Tools to project future market

movementsmovements

ChartingCharting

Key indicator seriesKey indicator series

1111

Technical AnalysisTechnical AnalysisUse of ChartingUse of Charting

Often linked to development of theOften linked to development of the Dow TheoryDow Theory in the late 1890s by in the late 1890s by Charles DowCharles Dow

Generally believed successful in Generally believed successful in signaling the market crash of 1929signaling the market crash of 1929

1212

Essential Elements of the Dow TheoryEssential Elements of the Dow Theory

There are 3 major movements in the market:There are 3 major movements in the market:

1. Daily fluctuations1. Daily fluctuations

2. Secondary movements 2. Secondary movements (two weeks to a month)(two weeks to a month)

3. Primary trends (long term)3. Primary trends (long term) May be bullish or bearish in natureMay be bullish or bearish in nature Daily fluctuations and secondary Daily fluctuations and secondary

movements only important to extent they movements only important to extent they reflect on the persistence of the long term reflect on the persistence of the long term primary trendprimary trend

1313

1414

Presentation of the Dow Theory:Presentation of the Dow Theory:Example of use to analyze a trendExample of use to analyze a trend

Chart shows positive Chart shows positive primary trend despite primary trend despite two secondary two secondary downward trendsdownward trends

Bullish primary trend is Bullish primary trend is confirmed by the confirmed by the increases in the levels of increases in the levels of secondary lows and highssecondary lows and highs

Pattern assumed to Pattern assumed to persist long term persist long term but ultimately to endbut ultimately to end

1515

1616

Presentation of the Dow Theory:Presentation of the Dow Theory:Market reversal and confirmationMarket reversal and confirmation

Ultimate end of a bullish trend Ultimate end of a bullish trend detected by a new pattern:detected by a new pattern:

Recovery fails to exceed Recovery fails to exceed previous high (Abortive previous high (Abortive recovery) +recovery) +

New low penetrates a New low penetrates a previous low +previous low +

New pattern confirmed by New pattern confirmed by subsequent movement in subsequent movement in Dow Jones Transportation Dow Jones Transportation AverageAverage

1717

Support and Resistance LevelsSupport and Resistance Levels

Chartists attempt to define trading levels Chartists attempt to define trading levels where price movements might face a where price movements might face a challenge or barrierchallenge or barrier

This assumes the existence of This assumes the existence of Support levelsSupport levels (lower ends of trading (lower ends of trading

ranges) andranges) and Resistance levelsResistance levels (upper ends of (upper ends of

trading ranges)trading ranges)

1818


A A breakoutbreakout above a resistance level or above a resistance level or below a support level is assumed to be below a support level is assumed to be significant in suggesting that a stock is significant in suggesting that a stock is now trading in a new range now trading in a new range andand

A A breakoutbreakout suggests higher or lower suggests higher or lower trading values outside the previous trading values outside the previous range may now be expectedrange may now be expected

1919

2020

Support and Resistance LevelsSupport 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

2121

Support and Resistance LevelsSupport and Resistance Levels•SupportSupport –– at a sufficiently at a sufficiently low price, the quantity low price, the quantity demanded of a security demanded of a security increases keeping the price increases keeping the price from falling furtherfrom falling further

•ResistanceResistance –– at a at a sufficiently high price, the sufficiently high price, the quantity supplied of a quantity supplied of a security increases keeping security increases keeping the price from rising furtherthe 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

2222


•BreakoutBreakout – the security – the security price moves out of the price moves out of the previous trading range previous trading range (breaching the resistance or (breaching the resistance or support level) suggesting a support level) suggesting a new consensus and new new consensus and new trading levelstrading levels

2323

VolumeVolume

The volume of trading supporting a given market The volume of trading supporting a given market movement is considered significantmovement is considered significant

A stock price (or the general market) making A stock price (or the general market) making a new high on a new high on heavyheavy trading volume is trading volume is viewed as bullishviewed as bullish

A stock price (or the general market) making A stock price (or the general market) making a new low on a new low on heavyheavy trading volume is viewed trading volume is viewed as very bearishas very bearish

Continued Continued

2424

VolumeVolume

The volume of trading supporting a given market The volume of trading supporting a given market movement is considered significant movement is considered significant cont.cont.

A stock price (or the general market) making a A stock price (or the general market) making a new high or low on new high or low on lightlight trading volume may trading volume may indicate a temporary move likely to be reversedindicate a temporary move likely to be reversed

2525

Types of ChartsTypes of Charts

Line charts (like the previous ones shown Line charts (like the previous ones shown here to visualize market patterns)here to visualize market patterns)

Bar chartsBar charts Point and figure chartsPoint and figure charts

2626

Types of Charts: Bar ChartsTypes of Charts: Bar Charts

Bar chart showing the high and low Bar chart showing the high and low prices of a stock during trading days in prices of a stock during trading days in November with a horizontal dash along November with a horizontal dash along the line to indicate the closing pricethe line to indicate the closing price

On November 12th, this stock traded between a high of $41 and a low of $38 and closed at $40 a share

2727

2828

Chart EvaluationsChart EvaluationsMarket technicians carefully evaluate charts –– looking for what they perceive to be significant patterns of movement

2929

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

Chart EvaluationsChart Evaluations

Chart Representation of a Market Bottom

3030

Chart Representations

3131

Chart Representations

3232

Types of Charts:Types of Charts: Point and Figure Chart (PFC)Point and Figure Chart (PFC)

•Emphasizes significant Emphasizes significant price changes and the price changes and the reversal of significant reversal of significant price changesprice changes

•Has no time dimensionHas no time dimension

•Chartists carefully read Chartists carefully read PFCs to observe market PFCs to observe market patterns: support, patterns: support, resistance, breakouts, resistance, breakouts, congestion, and so on.congestion, and so on.

3333

Types of Charts:Types of Charts: Point and Figure ChartPoint and Figure Chart

In Figure 9-7, assume In Figure 9-7, assume stock price starts at $30.stock price starts at $30.

Only moves of $2 or more Only moves of $2 or more are plottedare plotted

Advances Advances x x

Declines Declines o o

Reversals from advance Reversals from advance to a decline & vice versa to a decline & vice versa calls for a shift in columnscalls for a shift in columns

3434

Types of Charts:Types of Charts: Point and Figure ChartPoint and Figure Chart

Thus:Thus:

The stock price initially The stock price initially goes from $30 to $42 goes from $30 to $42 and then shifts columns and then shifts columns in its subsequent decline in its subsequent decline to $36 before moving up to $36 before moving up again in column 3.again in column 3.

A similar pattern persists A similar pattern persists throughout the chart.throughout the chart.

3535

ChartsCharts

TrendlineTrendline, published through a division of , published through a division of Standard & Poor’sStandard & Poor’s

Provides excellent charting information on Provides excellent charting information on a variety of securities traded on the major a variety of securities traded on the major exchangesexchanges

Is available at many libraries and Is available at many libraries and brokerage housesbrokerage houses

3636

ChartsCharts

The problem in reading charts has The problem in reading charts has always been to analyze patterns in such always been to analyze patterns in such a fashion that they truly predict stock a fashion that they truly predict stock market movements before they unfold.market movements before they unfold.

To justify this effort, one must assume To justify this effort, one must assume there are discernible trends over the long there are discernible trends over the long term.term.

3737

Key Indicator SeriesKey Indicator Series

A number of technical indicator series A number of technical indicator series may be watched for bearish ( )and may be watched for bearish ( )and bullish ( ) trendsbullish ( ) trends

• Contrary opinion rulesContrary opinion rules

• Smart money rulesSmart money rules

• Overall market indicatorsOverall market indicators

3838

Contrary Opinion RulesContrary Opinion Rules

Suggest observing unsuccessful market Suggest observing unsuccessful market behavior and choosing a contrary position:behavior and choosing a contrary position:

Odd-lot TheoryOdd-lot Theory

Short Sales PositionShort Sales Position

Investment Advisory RecommendationsInvestment Advisory Recommendations

Put-Call RatioPut-Call Ratio

3939

Contrary Opinion Rules:Contrary Opinion Rules:Odd-Lot TheoryOdd-Lot Theory

An odd-lot trade is one of less than 100 An odd-lot trade is one of less than 100 shares — only small investors tend to engage shares — only small investors tend to engage in odd-lot transactionsin odd-lot transactions

This theory suggests This theory suggests watching what the small watching what the small investor is doing and then do the oppositeinvestor is doing and then do the opposite

The weekly The weekly Barron’sBarron’s reports odd-lot trading on reports odd-lot trading on a daily basis in its “Market Laboratory – a daily basis in its “Market Laboratory – Stocks” section Stocks” section

It is easy to construct a ratio of odd-lot It is easy to construct a ratio of odd-lot purchases to odd-lot salespurchases to odd-lot sales

4040

Contrary Opinion Rules:Contrary Opinion Rules:Odd-Lot Theory Odd-Lot Theory Cont.Cont.

As shown in Figure 9-8, As shown in Figure 9-8, the odd-lot trader is on the odd-lot trader is on the correct path as the the correct path as the market is going up (net market is going up (net selling position) but selling position) but becomes a net buyer becomes a net buyer preceding a fall in the preceding a fall in the marketmarket

4141


The odd-lot trader is also presumed to be a The odd-lot trader is also presumed to be a strong seller right before the bottom of a strong seller right before the bottom of a bear marketbear market

A corollary to the odd-lot theory says that A corollary to the odd-lot theory says that Monday odd-lot trades are particularly Monday odd-lot trades are particularly suspectsuspect

4242


The theory actually suggests the small trader The theory actually suggests the small trader does all right most of the time but badly misses does all right most of the time but badly misses on key market turnson key market turns

While the odd-lot theory appeared to have some While the odd-lot theory appeared to have some validity in the 1950s and 1960s, it was not validity in the 1950s and 1960s, it was not particularly valuable in more recent decades.particularly valuable in more recent decades.

However, odd-lot traders outguessed many However, odd-lot traders outguessed many professional traders in the mid-1970s and late professional traders in the mid-1970s and late 1980s as well as in October 1997 and in the fall 1980s as well as in October 1997 and in the fall of 2003of 2003

4343

Contrary Opinion Rules:Contrary Opinion Rules:Short Sales PositionShort Sales Position

A rule based on the volume of short sales in A rule based on the volume of short sales in the marketthe market

[A short sale represents the selling of a security [A short sale represents the selling of a security you do not own with the anticipation of you do not own with the anticipation of purchasing the security in the future to cover purchasing the security in the future to cover your short position]your short position]

The contrary opinion stems from two sources:The contrary opinion stems from two sources: Short seller are sometimes emotional and may Short seller are sometimes emotional and may

overreact to the market, and more importantlyoverreact to the market, and more importantly There is now a built-in demand for stocks that There is now a built-in demand for stocks that

have been sold short by investors who will have been sold short by investors who will have to repurchase shares to cover their short have to repurchase shares to cover their short positionspositions

4444

Contrary Opinion Rules:Contrary Opinion Rules:Short Sales Position Short Sales Position Cont.Cont.

When the number of short sellers is When the number of short sellers is large (i.e., they are bearish), this is large (i.e., they are bearish), this is thought to be a bullish signalthought to be a bullish signal

Daily short sale totals for the NYSE are Daily short sale totals for the NYSE are reported in the reported in the Wall Street JournalWall Street Journal as as well as midmonth figures for the two well as midmonth figures for the two major exchanges and securities traded major exchanges and securities traded on those exchangeson those exchanges

4545


Technical analysts compute a ratio ofTechnical analysts compute a ratio of total short sales positions on an total short sales positions on an

exchange to average daily exchange exchange to average daily exchange volume for the monthvolume for the month• Normal ratio is between 2.0 and 3.0Normal ratio is between 2.0 and 3.0

• A ratio of 2.5 indicates current short A ratio of 2.5 indicates current short sales are equal to 2 ½ times the day’s sales are equal to 2 ½ times the day’s average trading volumeaverage trading volume

4646


As the ratio (called the short As the ratio (called the short interest ratio) approaches the interest ratio) approaches the higher end of the normal range, this higher end of the normal range, this would be considered bullishwould be considered bullish

Use of the ratio has produced Use of the ratio has produced mixed resultsmixed results

4747

Contrary Opinion Rules:Contrary Opinion Rules:Investment Advisory RecommendationsInvestment Advisory Recommendations

A further contrary opinion rule:A further contrary opinion rule:

Watch the predictionsWatch the predictions

of investment advisory servicesof investment advisory services

and do the oppositeand do the opposite Investors IntelligenceInvestors Intelligence has formalized this into an Index of has formalized this into an Index of

Bearish Sentiment:Bearish Sentiment:

When 60% or more of advisory services are When 60% or more of advisory services are bearish, expect a market upturnbearish, expect a market upturnWhen only 15% or fewer are bearish, When only 15% or fewer are bearish,

expect a decline in the marketexpect a decline in the market

4848

Contrary Opinion Rules:Contrary Opinion Rules:Investment Advisory Recommendations Investment Advisory Recommendations Cont.Cont.

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

4949

Contrary Opinion Rules:Contrary Opinion Rules: Put-Call Ratio Put-Call Ratio

ILL-CONCEIVED speculation in the options ILL-CONCEIVED speculation in the options market suggests that a “put-call” ratio may tell market suggests that a “put-call” ratio may tell you to do the opposite of what option traders you to do the opposite of what option traders are doingare doing

Puts and calls represent options to buy or Puts and calls represent options to buy or sell stock over a specified period of time at a sell stock over a specified period of time at a given price:given price:• A put is an option to sellA put is an option to sell• A call is an option to buyA call is an option to buy

Put-call ratio data is found in the “Market Put-call ratio data is found in the “Market Week – Options” section of Week – Options” section of Barron’sBarron’s

5050

Contrary Opinion Rules:Contrary Opinion Rules: Put-Call Ratio Put-Call Ratio Cont.Cont.

The ratio of put (sell) to call (buy) options The ratio of put (sell) to call (buy) options is normally about 0.60 – there are is normally about 0.60 – there are generally fewer traders of put options than generally fewer traders of put options than call optionscall options

When the ratio gets up to 0.65 to 0.70 or When the ratio gets up to 0.65 to 0.70 or higher, this indicates increasing higher, this indicates increasing pessimism by option traders and the pessimism by option traders and the contrary rules suggests a buy signalcontrary rules suggests a buy signal

ContinuedContinued

5151

Contrary Opinion Rules:Contrary Opinion Rules: Put-Call Ratio Put-Call Ratio Cont.Cont.

When the ratio goes down to 0.40, When the ratio goes down to 0.40, decreasing pessimism (increasing decreasing pessimism (increasing optimism) may indicate that it is time optimism) may indicate that it is time to sell if you are a contrarianto sell if you are a contrarian

The put-call ratio has a better than The put-call ratio has a better than average record for calling market average record for calling market turns.turns.

5252

Smart Money RulesSmart Money RulesMarket technicians have long attempted Market technicians have long attempted

to track the pattern of sophisticated to track the pattern of sophisticated traders in the hope that they might traders in the hope that they might provide unusual insight into the future:provide unusual insight into the future:

Theories related to bond market traders Theories related to bond market traders (e.g., Barron’s Confidence Index), and(e.g., Barron’s Confidence Index), and

Theories related to stock market Theories related to stock market specialists (e.g., short sales by specialists (e.g., short sales by specialists)specialists)

5353

Smart Money Rules:Smart Money Rules:Barron’s Confidence IndexBarron’s Confidence Index

Barron’sBarron’sConfidence IndexConfidence Index

==

Yield on 10 top-grade corporate bondsYield on 10 top-grade corporate bonds Yield on 40 intermediate-grade bondsYield on 40 intermediate-grade bonds

xx 100100

5454

Smart Money Rules:Smart Money Rules:Barron’s Confidence IndexBarron’s Confidence Index Cont.Cont.

This index is used to observe the trading This index is used to observe the trading pattern of investors in the bond market on pattern of investors in the bond market on the premise that they are more the premise that they are more sophisticated than stock traders and pick sophisticated than stock traders and pick up trends more quicklyup trends more quickly

The theory suggests that a person who The theory suggests that a person who can figure out what bond traders are doing can figure out what bond traders are doing today may be able to determine what stock today may be able to determine what stock market investors will be doing in the near market investors will be doing in the near futurefuture

5555

Smart Money Rules:Smart Money Rules:Barron’s Confidence IndexBarron’s Confidence Index Cont.Cont.

As top-grade bonds pay smaller yields than As top-grade bonds pay smaller yields than intermediate-grade bonds, the Confidence intermediate-grade bonds, the Confidence Index is always below 100%Index is always below 100%

Normal trading range is between 80 and 96Normal trading range is between 80 and 96

ContinuedContinued

5656

Smart Money Rules:Smart Money Rules:Barron’s Confidence Index Barron’s Confidence Index Cont.Cont.

If bond investors are bullish about If bond investors are bullish about future economic prosperity, they are future economic prosperity, they are rather indifferent between holding top-rather indifferent between holding top-grade and intermediate-grade bonds grade and intermediate-grade bonds

the yield differences between the two the yield differences between the two categories will be relatively small categories will be relatively small

Confidence Index near 96Confidence Index near 96

5757

Smart Money Rules:Smart Money Rules:Barron’s Confidence Index Cont’dBarron’s Confidence Index Cont’d 10 Top Grade Bonds yielding 8.4% while 10 Top Grade Bonds yielding 8.4% while 40 Intermediate Grade Bonds yield 9.1%:40 Intermediate Grade Bonds yield 9.1%:

Barron’s Confidence IndexBarron’s Confidence Index = x 100 = 92%= x 100 = 92%

Investors become quite concerned about the Investors become quite concerned about the economy’s future health and will invest in lower-economy’s future health and will invest in lower-quality bond issues only at a sufficiently high yield quality bond issues only at a sufficiently high yield differential to justify the risk – the gap widens:differential to justify the risk – the gap widens:

Barron’s Confidence IndexBarron’s Confidence Index = x 100 = 83%= x 100 = 83%

8.4% 8.4% 9.1%9.1%

8.9% 8.9% 10.7%10.7%

5858

Smart Money Rules:Smart Money Rules:Barron’s Confidence Index Cont’dBarron’s Confidence Index Cont’d Market technicians assume there are a Market technicians assume there are a few months of lead time between what few months of lead time between what happens to the Confidence Index and what happens to the Confidence Index and what happens to the economy and stock markethappens to the economy and stock market

The Confidence Index has a mixed record The Confidence Index has a mixed record of predicting future eventsof predicting future events

This mixed record may partly be due to This mixed record may partly be due to the fact that the the fact that the supplysupply of new bond issues of new bond issues can influence yields as much as investor can influence yields as much as investor attitudes (attitudes (demanddemand))

5959

Smart Money Rules:Smart Money Rules: Short Sales By Specialists Short Sales By Specialists

Because of the uniquely close position Because of the uniquely close position of specialists to the action on Wall of specialists to the action on Wall Street, market technicians ascribe Street, market technicians ascribe unusual importance to their decisionsunusual importance to their decisions

Frequently monitored isFrequently monitored is

the ratio of specialists’ short sales to the the ratio of specialists’ short sales to the total amount of short salestotal amount of short sales

6060

Smart Money Rules:Smart Money Rules: Short Sales By Specialists Short Sales By Specialists

The normal ratio of specialists’ short The normal ratio of specialists’ short sales to the total amount of short sales sales to the total amount of short sales on an exchange is about 45%on an exchange is about 45%

If the ratio goes above 50%, technicians If the ratio goes above 50%, technicians interpret this as a bearish signalinterpret this as a bearish signal

If the ratio falls below 40%, technicians If the ratio falls below 40%, technicians consider this bullish consider this bullish

6161

Overall Market RulesOverall Market Rules

Breadth of the MarketBreadth of the Market• Attempts to measure what a broad range Attempts to measure what a broad range

of securities are doing compared to a of securities are doing compared to a market averagemarket average

• Advance-declines are often compared with Advance-declines are often compared with movement of a popular market averagemovement of a popular market average

Cash Position of Mutual FundsCash Position of Mutual Funds• Indicates their buying potentialIndicates their buying potential• Is generally representative of the Is generally representative of the

purchasing potential of other large purchasing potential of other large institutional investorsinstitutional investors

6262


Breadth of the MarketBreadth of the Market• Compare advance-declines:Compare advance-declines:

The number of stock prices which are The number of stock prices which are rising compared to those declining rising compared to those declining relative to movements in a stock relative to movements in a stock market average as a potential signal market average as a potential signal of a turning point in the marketof a turning point in the market

Continued

6363

Overall Market RulesOverall Market Rules Breadth of the Market Breadth of the Market Cont’dCont’d

• E.g., if the Dow-Jones Industrial E.g., if the Dow-Jones Industrial Average (DJIA) is rising while the Average (DJIA) is rising while the number of daily declines consistently number of daily declines consistently exceeds the number of daily exceeds the number of daily advances, this might signal the end of advances, this might signal the end of a bull market. Why? Although a bull market. Why? Although conservative investors are investing in conservative investors are investing in blue-chip stocks, there is a lack of a blue-chip stocks, there is a lack of a broad-based confidence in the marketbroad-based confidence in the market

6464

Overall Market RulesOverall Market Rules Breadth of the Market Breadth of the Market Cont.Cont.

In Table 9-1, In Table 9-1, future weakness future weakness in the market is in the market is signaled by a signaled by a strength in the strength in the DJIA that is not DJIA that is not reflected in the reflected in the advance-decline advance-decline datadata

6565


When the DJIA is going down but When the DJIA is going down but advanced consistently lead declines, the advanced consistently lead declines, the market may be posed for recoverymarket may be posed for recovery

Weighted averages calculated of daily Weighted averages calculated of daily advances/declines are also usedadvances/declines are also used

Daily data on the DJIA and advancing & Daily data on the DJIA and advancing & declining issues may be found in the declining issues may be found in the “Stock Market Data Bank” section of the “Stock Market Data Bank” section of the Wall Street JournalWall Street Journal

6666


Comparisons may provide insights but Comparisons may provide insights but also false signals – care in also false signals – care in interpretation should include a look at interpretation should include a look at a wide range of variablesa wide range of variables

Decimalization of stock prices in 2001 Decimalization of stock prices in 2001 may have caused the advance-decline may have caused the advance-decline measure to lose some of its usefulness measure to lose some of its usefulness as an advance or decline of only a as an advance or decline of only a penny is all that is now needed to penny is all that is now needed to make the listmake the list

(You could, with effort, make up your (You could, with effort, make up your own measures)own measures)

6767


Cash Position of Mutual FundsCash Position of Mutual Funds Between 5 - 20% as a percent of total assetsBetween 5 - 20% as a percent of total assets At the lower end of this range, mutual funds At the lower end of this range, mutual funds

appear to be fully invested and can provide appear to be fully invested and can provide little in the way of additional purchasing little in the way of additional purchasing powerpower

As their cash position goes to 15% or higher, As their cash position goes to 15% or higher, this might represent significant purchasing this might represent significant purchasing power that might help trigger a market power that might help trigger a market upturnupturn

While the overall premise is valid, problems While the overall premise is valid, problems arise in identifying significant cash positions arise in identifying significant cash positions for mutual funds in a given market cyclefor mutual funds in a given market cycle

6868

The The real worldreal world of investing of investing Behavioral financeBehavioral finance

• Based on cognitive psychologyBased on cognitive psychology

• Suggests individuals may view or “frame” Suggests individuals may view or “frame” economically equivalent events differently economically equivalent events differently if presented in different contexts even after if presented in different contexts even after adjusting for risk and other rational adjusting for risk and other rational considerationsconsiderations

• What is viewed by an individual as a What is viewed by an individual as a rational choice in a context may seem rational choice in a context may seem irrational to an outside observerirrational to an outside observer

6969

The The real worldreal world of investing of investing Behavioral finance continuedBehavioral finance continued::

• A poor or a favorable personal experience A poor or a favorable personal experience with a particular investment may color an with a particular investment may color an individual’s attitude toward choices among individual’s attitude toward choices among alternatives including that investment even alternatives including that investment even if they are economically equivalentif they are economically equivalent

• Financial behaviorists suggest people Financial behaviorists suggest people overreact to both good and bad newsoverreact to both good and bad news This “may well portray the high tech This “may well portray the high tech

fervor and debacle of the last decade”fervor and debacle of the last decade”

7070

The The real worldreal world of investing of investing

Behavioral finance suggests:Behavioral finance suggests:• Focus less on computing expected values, Focus less on computing expected values,

standard deviations, and betasstandard deviations, and betas

• Spend more time examining the “irrational” Spend more time examining the “irrational” human being making investment decisionshuman being making investment decisions

7171

Efficient Market Hypothesis (EMH)Efficient Market Hypothesis (EMH)

New information is very rapidly New information is very rapidly processed so that securities are processed so that securities are properly priced at any given timeproperly priced at any given time

The large number of profit-maximizing The large number of profit-maximizing participants concerned with analysis participants concerned with analysis and valuation of securities promotes thisand valuation of securities promotes this

Any relevant news is likely to be Any relevant news is likely to be absorbed and acted upon very rapidly absorbed and acted upon very rapidly by these profit-maximizing individualsby these profit-maximizing individuals

7272

Efficient Market HypothesisEfficient Market Hypothesis

No stock price can be in disequilibrium or No stock price can be in disequilibrium or improperly priced for longimproperly priced for long

Instantaneous adjustment to new informationInstantaneous adjustment to new information Information travels in a random, independent Information travels in a random, independent

fashionfashion Prices are an unbiased reflection of all Prices are an unbiased reflection of all

currently available informationcurrently available information

7373

Efficient Market HypothesisEfficient Market Hypothesis

The Efficient Market Hypothesis (EMH) is The Efficient Market Hypothesis (EMH) is stated and tested in three forms:stated and tested in three forms:

1.1. The weak formThe weak form

2.2. The semi-strong formThe semi-strong form

3.3. The strong formThe strong form

7474

Weak Form of the EMHWeak Form of the EMH

No relationship between past and future No relationship between past and future prices of securities prices of securities

Prices of securities are presumed to be Prices of securities are presumed to be independent over timeindependent over time

Because EMH maintains that current Because EMH maintains that current prices reflect all available information, and prices reflect all available information, and information travels in a random fashion, it information travels in a random fashion, it is assumed that little or nothing is to be is assumed that little or nothing is to be gained from studying past stock pricesgained from studying past stock prices

7575

Weak Form EMHWeak Form EMH

Has been tested in two ways:Has been tested in two ways:• Tests of independenceTests of independence

• Trading rule testsTrading rule tests Both tests seem to uphold the weak Both tests seem to uphold the weak

form of the EMH:form of the EMH:• Security prices do appear to be Security prices do appear to be

independent over time or move in the independent over time or move in the pattern of a random walkpattern of a random walk

7676

Weak Form EMHWeak Form EMH

Tests imply prices move independently over Tests imply prices move independently over timetime

Past trends cannot be used easily to predict Past trends cannot be used easily to predict the futurethe future

Charting/technical analysis may have limited Charting/technical analysis may have limited valuevalue

No exceptional returns can be earned by No exceptional returns can be earned by using investment strategies based on using investment strategies based on historical stock prices or other financial datahistorical stock prices or other financial data

7777

Tests of IndependenceTests of Independence

The serial correlation between stock The serial correlation between stock prices over time has been consistently prices over time has been consistently small and not statistically significant – small and not statistically significant – they follow a “martingale”they follow a “martingale”

““Securities are priced in an unbiased Securities are priced in an unbiased fashion at any given time” – the only fashion at any given time” – the only factor that affects stock prices is the factor that affects stock prices is the introduction of previously unknown news introduction of previously unknown news or informationor information

7878

Tests of IndependenceTests of Independence A further test based on the frequency and A further test based on the frequency and

extent of runs in stock price data – extent of runs in stock price data – sequences of two or more price changes sequences of two or more price changes in the same direction – also tends to in the same direction – also tends to indicate that stock price movements are indicate that stock price movements are independent over timeindependent over time

(+ + + + - + - + - + - - - + - +)(+ + + + - + - + - + - - - + - +) Price changesPrice changesover timeover timerun run

7979

Trading Rule TestsTrading Rule Tests

Try to determine whether a given trading Try to determine whether a given trading rule based on past price data, volume, rule based on past price data, volume, and so forth, can be used to beat a naïve and so forth, can be used to beat a naïve buy-and-hold approachbuy-and-hold approach

Simulates conditions under which a given Simulates conditions under which a given trading rule is used to determine if trading rule is used to determine if superior returns were produced after superior returns were produced after considering transaction costs and the considering transaction costs and the risks involvedrisks involved

8080

Trading Rule TestsTrading Rule Tests

Stock price moves up 5% or more, “buy”Stock price moves up 5% or more, “buy”• Assumes this represents a “breakout” and Assumes this represents a “breakout” and

should be considered bullishshould be considered bullish If price drops 5%, “sell” If price drops 5%, “sell” This is a follow-the-market-trend strategy This is a follow-the-market-trend strategy

rather than a buy low-sell high strategyrather than a buy low-sell high strategy

Since stock prices move randomly, Since stock prices move randomly,

such rules such rules

do not consistently achieve exceptional resultsdo not consistently achieve exceptional results

8181

Implications for Implications for Technical AnalysisTechnical Analysis

Any trading rule that relies on historical Any trading rule that relies on historical data and information will be of little data and information will be of little valuevalue

Security prices do appear to be Security prices do appear to be independent over time, or, more independent over time, or, more specifically, move in the pattern of a specifically, move in the pattern of a random walkrandom walk

8282

Semistrong Form EMHSemistrong Form EMH All public information is already All public information is already

impounded into the value of a securityimpounded into the value of a security There is no learning lag in the There is no learning lag in the

dissemination of public informationdissemination of public information• This may depend upon the size of the This may depend upon the size of the

firm which issued the stock and the firm which issued the stock and the attention being paid to it by analysts and attention being paid to it by analysts and others in the marketplaceothers in the marketplace

8383

Semistrong Form of EMHSemistrong Form of EMH

Tests of this form of the EMH attempt Tests of this form of the EMH attempt to see if investors acting on the basis of to see if investors acting on the basis of newly released public information are newly released public information are able to earn superior returns adjusting able to earn superior returns adjusting for risk and transaction costsfor risk and transaction costs

8484


Assume a stock goes up 15% andAssume a stock goes up 15% andthe stock is 20% riskier than the market.the stock is 20% riskier than the market.

Assume the overall market rises by 10%.Assume the overall market rises by 10%.

On a risk-adjusted basis, the stock wouldOn a risk-adjusted basis, the stock would

need to go up in excess of 12% [10% mktneed to go up in excess of 12% [10% mkt

return x 1.2 risk factor] to beat the market.return x 1.2 risk factor] to beat the market.

Since the stock rose by more than 12%, itSince the stock rose by more than 12%, it

is said to have beaten the market on ais said to have beaten the market on a

risk-adjusted basis.risk-adjusted basis.

8585


Tests examining the effects of such Tests examining the effects of such events as stock splits, stock dividends, events as stock splits, stock dividends, and changes in accounting policy indicate and changes in accounting policy indicate that the market is generally efficient in a that the market is generally efficient in a semistrong sense.semistrong sense.

Almost all the market impact of a stock Almost all the market impact of a stock split appears to occur before the public split appears to occur before the public announcement. announcement. Little is gained from Little is gained from acting on the announcementacting on the announcement

8686


Investors are assumed to not only digest Investors are assumed to not only digest information very quickly, but also to be information very quickly, but also to be able to see through mere changes in able to see through mere changes in accounting information that do not have accounting information that do not have economic consequenceseconomic consequences• Changing depreciation schedules for Changing depreciation schedules for

financial reporting (but not tax purposes) financial reporting (but not tax purposes) makes earnings per share look higher but makes earnings per share look higher but provides no economic benefit to the firm provides no economic benefit to the firm and research shows it has no positive and research shows it has no positive impact on valuationimpact on valuation

8787


• Mere accounting changes related to Mere accounting changes related to inventory policy, reserve accounts, inventory policy, reserve accounts, exchange transactions, and other exchange transactions, and other items that appear to have no items that appear to have no economic benefits do not appear to economic benefits do not appear to deceive investorsdeceive investors

• The effect on stocks of such changes The effect on stocks of such changes thus may be neutral or even negativethus may be neutral or even negative

8888

Implications for Implications for Fundamental AnalysisFundamental Analysis

One cannot use fundamental analysis to One cannot use fundamental analysis to determine whether a stock is determine whether a stock is undervalued or overvaluedundervalued or overvalued

The collective wisdom of the The collective wisdom of the marketplace in which everyone is trying marketplace in which everyone is trying desperately to come out ahead will desperately to come out ahead will dominate any individual’s judgment on dominate any individual’s judgment on the value of a stockthe value of a stock

8989

Implications for Implications for Fundamental Analysis Fundamental Analysis Cont.Cont.

Ironically, although many suggest that Ironically, although many suggest that fundamental analysis may not lead to superior fundamental analysis may not lead to superior profits, it is fundamental analysis itself that profits, it is fundamental analysis itself that makes the market efficient:makes the market efficient:

Because everyone is doing fundamentalBecause everyone is doing fundamental

analysis, there is little in the way ofanalysis, there is little in the way of

unabsorbed or undigested information.unabsorbed or undigested information.

One extra person doing fundamental analysis isOne extra person doing fundamental analysis is

unlikely to achieve superior insightunlikely to achieve superior insight

9090

Implications for Implications for Fundamental Analysis, Cont’dFundamental Analysis, Cont’d

AnomaliesAnomalies or deviations from the basic or deviations from the basic proposition that the market is efficient still do proposition that the market is efficient still do occur.occur.• E.g., stocks with low price/earnings ratios E.g., stocks with low price/earnings ratios

consistently provide better returns than stocks consistently provide better returns than stocks with high price/earnings ratios. Perhaps fewer with high price/earnings ratios. Perhaps fewer institutional investors in smaller firms make for a institutional investors in smaller firms make for a less-efficient market and superior potential less-efficient market and superior potential opportunitiesopportunities

9191

Strong Form of EMHStrong Form of EMH

Stock prices fully reflect Stock prices fully reflect allall information, information, whether public or otherwise whether public or otherwise

Requires that no group of investors have Requires that no group of investors have a monopoly on access to any informationa monopoly on access to any information

Perfect markets exist where all Perfect markets exist where all information is available to everyone at information is available to everyone at the same time (full transparency)the same time (full transparency)

No group of investors can be expected to No group of investors can be expected to show superior risk-adjusted returns under show superior risk-adjusted returns under any circumstancesany circumstances

9292


Major test results of this form of the EMH Major test results of this form of the EMH do not support itdo not support it• Specialists on security exchanges have Specialists on security exchanges have

been able to earn superior rates of return been able to earn superior rates of return on invested capital. The “book” they keep on invested capital. The “book” they keep on unfilled limit orders appears to provide on unfilled limit orders appears to provide monopolistic access to information.monopolistic access to information.

• Corporate insiders consistently earn Corporate insiders consistently earn higher returns than would be expected in higher returns than would be expected in a perfect capital marketa perfect capital market

9393


• Although there is evidence to not Although there is evidence to not accept the strong form of the EMH, the accept the strong form of the EMH, the range of participants with access to range of participants with access to superior information is not largesuperior information is not large

• Those who act Those who act illegallyillegally with insider with insider information may initially achieve higher information may initially achieve higher returns from their special access to returns from their special access to information, but the price of their information, but the price of their actions (forfeiture of gains, payment of actions (forfeiture of gains, payment of fines, jail time) may be highfines, jail time) may be high

9494

WEBSITEWEBSITE COMMENTCOMMENT

www.bigcharts.comwww.bigcharts.com Provides data, charts and Provides data, charts and technical indicators, freetechnical indicators, free

cbs.marketwatch.comcbs.marketwatch.com Market news and dataMarket news and data

ww.quicken.comww.quicken.com Contains some technical Contains some technical analytical data and chartsanalytical data and charts

www.stockworm.comwww.stockworm.com Has technical chartsHas technical charts

9595

WEBSITEWEBSITE COMMENTCOMMENT

www.stockcharts.comwww.stockcharts.com Provides free technical Provides free technical charts and education on charts and education on technical analysistechnical analysis

www.investopedia.comwww.investopedia.com Provides a searchable Provides a searchable databasedatabase

9696

SummarySummary

While While fundamental analysisfundamental analysis deals with deals with financial analysis and determinants of financial analysis and determinants of valuation, valuation, technical analysistechnical analysis is based on is based on the study of past price and volume data as the study of past price and volume data as well as associated market trends to predict well as associated market trends to predict future price movements.future price movements.

Technical analysis relies heavily on Technical analysis relies heavily on charting charting and the use of key market and the use of key market indicators to make forecasts.indicators to make forecasts.

9797

SummarySummary

Technical AnalysisTechnical Analysis also observes support and also observes support and resistance levels in the market as well as data resistance levels in the market as well as data on volume.on volume.

Line, bar, and point & figure graphs are used to Line, bar, and point & figure graphs are used to spot turns in the marketspot turns in the market

Market technicians also follow a number of key Market technicians also follow a number of key indicator series to predict the stock market – indicator series to predict the stock market – contrary opinion indicators, smart money contrary opinion indicators, smart money indicators, and general market indicators.indicators, and general market indicators.

9898

SummarySummary

Although arguments have traditionally Although arguments have traditionally been made about the relative importance been made about the relative importance of fundamental and technical analysis, of fundamental and technical analysis, current attention is directed to the efficient current attention is directed to the efficient market hypothesis and its implications for market hypothesis and its implications for all types of analysis.all types of analysis.

9999

SummarySummary

The efficient market hypothesis maintains The efficient market hypothesis maintains that the market adjusts very rapidly to the that the market adjusts very rapidly to the supply of new information, and, because supply of new information, and, because of this, securities tend to be correctly of this, securities tend to be correctly priced at any given time (or rapidly priced at any given time (or rapidly approaching this equilibrium value). approaching this equilibrium value).

100100

SummarySummary The efficient market hypothesis has been The efficient market hypothesis has been

stated and tested in three different forms:stated and tested in three different forms:1.1. The The weak formweak form states that there is no states that there is no

relationship between past and future prices relationship between past and future prices (they are independent over time).(they are independent over time).

2.2. The The semistrong formsemistrong form suggests all public suggests all public information is currently impounded in the information is currently impounded in the price of a stock.price of a stock.

3.3. The The strong formstrong form suggests suggests allall information, information, public or otherwise, is included in the value public or otherwise, is included in the value of a security.of a security.

101101

SummarySummary Research tends to support the weak form Research tends to support the weak form

of the efficient market hypothesis which of the efficient market hypothesis which causes many researcher to seriously causes many researcher to seriously question the overall value of technical question the overall value of technical analysis. However, many Wall Streeters analysis. However, many Wall Streeters vigorously debate this positionvigorously debate this position

102102

SummarySummary The semistrong form is also reasonably The semistrong form is also reasonably

supported by research and this fact supported by research and this fact would tend to question the value of would tend to question the value of fundamental analysis by the individual fundamental analysis by the individual investor. (It is the collective wisdom of all investor. (It is the collective wisdom of all fundamental analysis that leads to the fundamental analysis that leads to the efficient market hypothesis in the first efficient market hypothesis in the first place). There are some contradictions to place). There are some contradictions to the semistrong form and much research the semistrong form and much research is aimed at supplying additional such is aimed at supplying additional such data.data.

103103

SummarySummary The strong form of the efficient market The strong form of the efficient market

hypothesis is not generally accepted.hypothesis is not generally accepted.

Business

Chapter 9 - PPT