Investments: Analysis and Behavior

Chapter 13- Technical Analysis

©2008 McGraw-Hill/Irwin

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Learning Objectives

Learn the graphing tools of technical analysis. Identify stock price patterns. Know how trading volume relates to price patterns. Learn technical indicators for measuring market activity. Understand how investor sentiment is measured and

used.

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Chapter 6 argues that markets are efficient. Chapter 7 illustrates EMH anomalies. Chapter 8 argues that if investors are not always

rational, then markets may not be fully efficient.

If markets are nearly efficient, what tools may be useful for investors to make money? These tools are detailed in Technical Analysis.

Inefficient Markets

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Supply and Demand Fundamental Analysis: stocks prices are

related to the value of the business. Technical Analysis: stock prices are the result

of supply and demand forces for the stock. Priced more like a commodity. Technicians try to understand and measure the

changing supply and demand. Market Technicians Association

(www.mta.org)

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Plotting the Market – measuring trends

Price charts:

Resistance lines and Support lines

Channels and Breakouts

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moving averages

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Dow Theory

Developed by William Hamilton from 1902 to 1929

New primary market trends are confirmed between DJTA and DJIA. Secondary trends Tertiary trends

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Charting Price Patterns Head and Shoulders

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Continuation patterns

Reversal patterns

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Market Cycles Economists talk about the

business cycle

Figure 15.9 The S&P 500 Index and Cycles

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Technicians look for market cycle Kondratieff, or K-waves

60-year cycle 40-week cycle 80-week cycle

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Volume and Price

Volume is used to confirm the strength of a trend. Increasing volume

supports increasing price trend.

Divergence

Source: MSN Money

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Selling and buying pressure measures

Money FlowDollar value of trades at an uptick less value of trades at a

downtick

Up/Down RatioDollar value of trades at an uptick divided by the value of

trades at a downtick

Money Flows--Top Gainers

Company ExchLast Price % Chg.

Money Flow

Uptick volume

Downtick volume Ratio

Block Trades

Uptick volume

Downtick volume Ratio

Citigroup NYSE 46.12 0.12 126.27 182.51 56.23 3.25 116.01 136.41 20.4 6.69

SPDR AMEX 126.68 0.26 108.21 645.32 537.1 1.2 117.69 475.88 358.19 1.33

MerLyn NYSE 72.7 0.6 60.7 118.5 57.81 2.05 64.88 81.76 16.88 4.84

HewlettPk NYSE 31.65 0.31 58.46 84.9 26.43 3.21 57.57 64.89 7.32 8.86

AmExpress NYSE 52.37 0.93 55.04 87.34 32.3 2.7 54.9 65.43 10.53 6.21

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TECHNICAL INDICATORSTECHNICAL INDICATORS

Condition of the Market: Breadth—how many firms are participating in the rally.

Advances and declines Advance/decline ratio

Overbought and oversold TRIN ratio

<0.35 overbought0.35 to 0.6 very bullish1.5 to 1.85 very bearish>1.85 oversold

edown volum volumeup

stocks declining of #stocks advancing of #

TRIN

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Market Breadth Measures

Data source: http://finance.yahoo.com/advances (January 24, 2006).

NYSE AMEX NASDAQ OTC BB

Advancing Issues 2,228 583 2,000 761

Declining Issues 1,073 408 1,018 785

Unchanged Issues 135 89 162 432

Total Issues 3,436 1,080 3,180 1,978

New Highs 248 62 189 161

New Lows 36 20 34 155

Up Volume 1,585,999,550 243,224,612 1,188,539,914 505,671,486

Down Volume 875,383,650 106,015,090 805,549,381 554,470,602

Unchanged Volume 41,660,370 31,142,100 72,784,810 794,041,622

Total Volume 2,503,043,570 380,381,802 2,066,874,105 1,854,183,710

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Momentum Indicators

Rate of Change (ROC): shows the amount prices have changed over a given time period.

Moving Average Convergence/Divergence (MACD): Calculated by subtracting the value of a 26-period exponential moving average from a 12-period exponential moving average. Then take a 9-day exponential moving average of the MACD.

The MACD trading rule is to sell when it falls below its 9-day signal line and to buy when the MACD rises above the 9-day signal line. 

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Sentiment Indicators

Sentiment: The mood of investors drive markets. Investor actions

Odd lot trades (contrary indicator) Mutual fund flow Broker account credit and debit balances Short interest Put/call ratio

Surveys

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AAII Investor Sentiment SurveyMeasures the percentage of individual investors who are bullish, bearish, and neutral on the stock market in the short term: weekly.

Consumer Confidence SurveyThe survey of 5,000 households is conducted for the Conference Board by NFO WorldGroup: monthly.

University of Michigan Consumer SentimentThe Index of Consumer Sentiment (ICS) is based upon consumer responses to each of five survey questions on spending plans.

ABC News/Money Magazine Consumer Comfort IndexThe index is based on ratings of the economy, buying climate, and personal finances: rolling 4-week sample of 1,000 adults.

Investor’s Intelligence Newsletter reviews other investment newsletters and reports the percentage that is bullish on a weekly basis. (www.investorsintelligence.com)

Merrill Lynch Sell Side Indicator This indicator is based on a survey of Wall Street Strategist asset allocation recommendations: monthly.

Robert Shiller’s Stock Market Confidence IndicesYale Professor Rober Shiller compiles four different indices based upon surveys of individual and institutional investors: One-Year Confidence Index, Buy-on Dips Confidence Index, Crash Confidence Index, and Valuation Confidence Index. (icf.som.yale.edu/confidence.index)

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Stock Rotations

Sector RotationSometimes investors like, technology, other

times they like energy… Value/Growth Rotation

Capitalization RotationSmall versus large companies

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Sectors in and out of favor

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Figure 13.9 Sometimes Large Capitalization Stocks Outperform...Sometimes Small Caps Do

$0

$5,000

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Investment in Large Caps

Large Cap Stocks Outperformed 1996 to 1999

Small Cap Stocks Outperformed 2000 to 2003

Data source: Yahoo! Finance

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Criticisms of TA

Not much statistical analysis support for technical trading rules.

Subjective judgment is part of the decision making.

The brain sees patterns in random data