Chapter 13Technical Analysis

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Underlying Assumptions

of Technical Analysis1. The market value of any good

or service is determined solely by the interaction of supply and demand.

2. Supply and demand are governed by numerous factors, both rational and irrational.

3

Underlying Assumptions

of Technical Analysis3.The prices for individual

securities and the overall value of the market tend to move in trends.

4.Prevailing trends change in reaction to shifts in supply and demand relationships

5.These shifts can be detected in the action of the market

4

Technical View of Price Adjustment to New Information

Exhibit 13.1

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Advantages of Technical Analysis

Not heavily dependent on financial accounting statements Problems with accounting

statements:1. Lack information needed by security

analysts2. GAAP allows firms to select reporting

procedures, resulting in difficulty comparing statements from two firms

3. Non-quantifiable factors do not show up in financial statements

6

Advantages of Technical Analysis

Fundamental analyst must process new information and quickly determine a new intrinsic value, but technical analyst merely has to recognize a movement to a new equilibrium

Technicians trade when a move to a new equilibrium is underway, but a fundamental analyst finds undervalued securities that may not adjust their prices as quickly

7

Challenges to Technical Analysis

Assumptions of Technical Analysis Empirical tests of Efficient Market

Hypothesis (EMH) show that prices do not move in trends

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Technical trading rules The past may not be repeated Patterns may become self-fulfilling

prophecies ( 預言 ) A successful rule will gain followers

and become less successful Rules require a great deal of

subjective judgement.

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Technical Trading Rules and Indicators

Stock cycles typically go through a peak and trough( 低谷 )

Analyze the following chart of a typical stock price cycle and we will show a rising trend channel, a flat trend channel, a declining trend channel, and indications of when a technical analyst would want to trade

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Typical Stock Market Cycle

Stock Price

Exhibit 13.2

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Typical Stock Market Cycle

Stock Price

Exhibit 13.2

Declining Trend

Channel

Trough

Buy Point

Rising Trend Channel

Flat Trend Channel

Sell Point

Peak

Declining Trend

Channel TroughBuy Point

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Contrary-Opinion

Many analysts rely on rules developed from the hypothesis that the majority of investors are wrong as the market approaches peaks and troughs

Technicians try to determine whether investors are strongly bullish or bearish and then trade in the opposite direction

These positions have various indicators

13

Contrary-Opinion Rules

Mutual fund cash positions Credit balances in brokerage

accounts Investment advisory opinions OTC versus NYSE volume Chicago Board Options

Exchange (CBOE) put/call ratio Futures traders bullish on stock

index futures

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Time-Series Plot of Dow Jones Industrial Average and the Bullish and Bearish Advisory Services (1)

Exhibit 13.3

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Time-Series Plot of Dow Jones Industrial Average and the Bullish and Bearish Advisory Services (2)

Exhibit 13.3

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Time-Series Plot of Dow Jones Industrial Average and the Bullish and Bearish Advisory Services (3)

Exhibit 13.3

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Follow the Smart Money

Indicators showing behavior of sophisticated investors

The Barron’s Confidence Index T-Bill - Eurodollar yield spread Short sales by specialists Debit balances in brokerage

accounts (margin debt)

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Other Market Indicators

Breadth of marketAdvance-declineDiffusion index

Short interest Stocks above their 200-day

moving average Block uptick-downtick ratio

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Stock Price and Volume Techniques

The Dow theory – oldest technical trading rule 1. Major trends are like tides in the

ocean 2. Intermediate trends resemble waves 3. Short-run movements are like ripples

Importance of volume Ratio of upside-downside volume

Support and resistance levels Moving average lines

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Stock Price and Volume Techniques

Relative-strength (RS) ratiosFor individual stocks and

industry groups Bar charting Multiple indicator charts Point-and-figure charts Overall feel from a consensus

of numerous technical indicators

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Sample Bullish Price Pattern

Exhibit 13.8

22

Daily Stock Prices for Stryker Corp. with Indications of Support and Resistance Levels

Exhibit 13.9

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Daily Stock Prices for Concord EFS with 50-Day and 200-Day Moving Average Lines and a 14-Day Relative Strength Index Compared to the S&P 500 Index

Exhibit 13.10

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How to Read Industry Group Charts Exhibit 13.11

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A Typical Bar Chart

Exhibit 13.12

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Sample Point-and-Figure Chart

Exhibit 13.13