FNCE 625 – Investment Analysis and Management

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 16

Technical Analysis

What is Technical Analysis?

Use of published market data to analyze both aggregate and individual firm stock prices

Not based on firm fundamentals

Market data includes price and volume data

May produce insight into the psychological dimensions of the market

Technical analysts often believe that it’s extremely difficult to estimate intrinsic value

Technical Analysis Framework

Technicians believe that supply and demand produce price patterns

Charting

Using charts to analyze price and volume data

Trading signals are identified from price patterns

Volume data used to gauge market conviction behind price moves

Technical analysis has evolved to include other techniques

The Dow Theory 1

Oldest and best-known theory of technical analysis

Based on three types of price movements

Primary move: broad market move, lasts several years

Secondary moves: occur within primary move

Day-to-day moves: occur randomly around primary and secondary moves

Bull (bear) market refers to upward (downward) primary move

The Dow Theory 2

Bull market exists when successive rallies penetrate previous highs

Declines remain above previous lows

Bear market exists when successive rallies fail to penetrate previous highs

Declines penetrate previous lows

Secondary moves called technical corrections

Day-to-day “ripples” are of minor importance

The Dow Theory 3

Intended to forecast the start of a primary movement

Does not tell how long movement will last

Subject to a number of criticisms

Studies have not confirmed its success

Several versions available

Can predict different, even conflicting movements

The Dow Theory 4

Charting Price Patterns 1

Price changes can be recognized and categorized

Trendline: identifies a trend or direction

Support level: price level at which a significant increase in demand for stock is expected

Resistance level: price level or range at which significant increase in supply is expected

Momentum: indicates speed of price changes

Charting Price Patterns 2

Bar Chart

Price on vertical axis, time on horizontal

Vertical bar’s top (bottom) represents the high (low) price of the day

Candlestick adds open and close price

Point-and-Figure Chart

Compresses price changes into small space

X (O) used to indicate significant upward (downward) movement

Moving Averages

Used for analyzing both the overall market and individual stocks

Used specifically to detect both the direction and rate of change

New value for moving average calculated by dropping earliest and adding latest observation

Comparison to current market prices produces buy or sell signal

Show what prices have done, not what they will do

Relative Strength

Ratio of price to index value or price to past average price

Ratios plotted to form graph of relative price across time

Rising (falling) ratio indicates relative strength (weakness)

Can also be used to analyze industries

What if overall market is weak?

What if stock declining less than the market?

Breadth Indicators

Advance-Decline Line

Measures the net difference between number of stocks advancing and declining

Plot of running total across time is compared to a stock average to analyze any divergence

Divergence implies trend changing

Number hitting new highs (lows)

High trading volume regarded as bullish

Sentiment Indicators 1

Short interest is number of stocks that have been sold short but not yet bought back

Short interest ratio:

Total short interest/Ave. daily volume

Indicates number of days needed to “work off” the short interest

Short interest figures may be distorted

Sentiment Indicators 2

Contrary investing

Acting in opposite way of most investors

Many technicians take a high short interest ratio as a bullish sign

The more shares sold short, the more shares that must eventually be re-purchased

Mutual fund liquidity

If funds fully invested (low on cash), contrarians sell

If funds mostly liquid, contrarians buy

Opinions of Investment Advisory Services

Bearish sentiment index

Ratio of advisory services bearish to total number with an opinion

When at 55 to 60% (20%), bearish (bullish) attitude indicated

Advisory services assumed wrong at extremes

Services may follow trends rather than forecast them

C B O E Put/Call Ratio

Speculators buy calls (puts) when stock prices expected to rise (fall)

Relatively high (low) ratio indicates investor pessimism (optimism)

Contrarians buy (sell) when investors are pessimistic (optimistic)

Extreme readings (below .45 or above .8) convey trading information

Exact trigger levels subject to debate

Classification of Indicators – Contrary Opinion

Trading Rule	Bullish	Bearish
Cash holdings	High	Low
V I X	High	Low
I P O/S E O activity	Low	High
Opinion polls	Pessimistic	Optimistic
Put/Call ratio	High	Low
Short interest	High	Low
Margin debt	Low	High

Testing Technical Strategies

What constitutes a fair test of a technical trading rule?

Risk considerations

Include transaction and other costs

Consistency in performance

Out-of-sample validation

Filter rule tests

Trades based on price changes greater than predetermined filter

Efficiency and Evidence

Efficient market hypothesis (E M H) poses major challenge to technical analysis

Many tests suggest technical analysis does not produce superior returns when risk and costs accounted for

Academic studies generally do not indicate technical analysis works

Some research supports merits of technical analysis

Conclusions About Technical Analysis 1

Thorough tests of technical analysis typically have failed to confirm its value

Efficient markets argue against likelihood of profits

Several interpretations of technical tools and chart patterns are common

Successful rules self-destruct as they gain popularity

Conclusions About Technical Analysis 2

Strong evidence exists suggesting that stock market is weak-form efficient

Impossible to test all techniques of technical analysis

Technical analysis remains popular with many investors

Should be combined with fundamental analysis, if used

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FNCE 625 – Investment Analysis and Management

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