Transcript Class Outline - Villanova University

Investments
Lecture 10
Technical Analysis
Technical vs. Fundamental
Analysis
 Fundamentalist looks forward
 Technician looks backward
 Fundamentalist concerned with future earnings and
dividends
 Technician is concerned little if at all with these
 Fundamentalist concerned with where the price is moving
in the future
 Technician makes recommendations on the timing of
purchases and sales
 Fundamental analysis designed to answer “What”
 Technical analysis designed to answer “When”
Technical Analysis
 Definition –
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Technical analysis is the study of internal stock exchange
information. The word technical implies a study of the market
itself and not of those external factors which are reflected in the
market…all the relevant factors, whatever they may be, can be
reduced to the volume of the stock exchange transactions and the
level of share prices… (Rosenfeld)
 At odds with market efficiency –
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The methodology of technical analysis…rests upon the assumption
that history tends to repeat itself in the stock exchange. If a certain
pattern of activity has in the past produced certain results nine
times out of ten, one can assume a strong likelihood of the same
outcome whenever the pattern appears in the future. It should be
emphasized, however, that a large part of the methodology of
technical analysis lacks a strictly logical explanation.
Uses for Technical Analysis
 Analyzing the various forces in the market is used in
different ways by different investors
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As only input necessary in their decision-making
As another piece of information in making buy/sell decisions
As a waste of time
 Study of price and volume data in an attempt to gain
insight on where future prices (especially in the short-term)
will be moving
 “Information is pretty thin stuff unless mixed with
experience.” (Day, 1920)
History of Technical Analysis
 Early development
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Developed in the late 1800s by Charles Dow (editor of
the WSJ)
Developed theory to describe past price movements –
this was a completely new way of analyzing markets
Developed more by William Hamilton who used to
predict movements in the market
History of Technical Analysis
 Analyzing market behavior goes back to 1800s
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No such thing as industry or firm analysis
Some used charts to see what was going on in market overall –
charts focused on price movements
• Movements made “formations”
• “formations indicated buy/sell decisions
 If stock price behavior is independent of market
movements, then technical analysis is worthless.
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Studies of betas of stocks
prices react to demand for securities and supply of funds
As balance between supply and demand shifts, future prices will
change
Technical analysis is aimed at detecting this shift
Technical Analysis
 On what should stock prices be based?
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Fundamental characteristics of the firm?
Investors expectations?
 The price of a stock at any one time represents a consensus
view of the market of that stock’s current intrinsic value
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Rationality of investors – if investors are rational, then the use of
fundamental analysis should at all times be directly related to the
intrinsic value of firms
Are investors perfectly rational with respect to investing?
 “I believe that the future is only the past again, entered
through another gate.” (Sir Arthur Wing Pinero, 1893)
Underlying Assumptions
 Market value is determined solely by the interaction of
supply and demand
 Supply and demand are governed by numerous factors
both rational and irrational.
 Disregarding minor fluctuations in the market, stock
prices tend to move in trends which persist for an
appreciable length of time.
 Changes in trend are caused by shifts in demand and
supply. These shifts no matter why they occur, can be
detected sooner or later in the action of the market itself.
Framework for Technical
Analysis
 Able to be applied to the aggregate market or individual
stocks
 Uses graphs or charts and technical trading rules and
indicators
 Price and volume are primary tools
 Believe that forces of supply and demand lead to
certain patterns of price behavior
 Volume data used to gauge the general condition in the
market and to help assess the trend
• Most evidence suggests that rising (falling) prices
are usually associated with rising (falling) volume
Technical Analysis
 “It is futile to assign an intrinsic value to a stock
certificate. One share of US Steel, for example, was worth
$261 in the early fall of 1929, but you could buy it for only
$22 in June 1932. By March 1937 it was selling for $126
and one year later for $38…This sort of thing, this wide
divergence between presumed value and intrinsic value, is
not the exception, it is the rule… (Damodaran)
 Transaction price is the settlement point that reflects both
fundamental characteristics of firm and all other qualitative
factors that affect investors dealings in the market
Technical Analysis
 Are investors rational?
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In studies of investments/portfolio management, we
generally assume investors are rational.
Behavioral finance is one area of research that
addresses the legitimacy of this assumption
Speculative bubbles
Overreaction
 Implications of irrationality for technical analysis
Technical Analysis
 Computerized trading
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If we agree that prices are affected by factors that can
not be quantified and are not always rational, we must
accept that our decision-making on buying/selling is
driven by these same factors.
Trading rules and computerized trading can take away
some of our irrationality.
However remember that even if you establish specific
rules that prevent you from being irrational, the
computer is still “making decisions” in a market that is
not always rational.
Technical Analysis
 Problems with accounting statements that make
technical analysis feasible
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Lack a lot of information that security analysts need
Firms can choose different ways to present certain
numbers in accounting statements that make it difficult
for analysts to compare across firms
Large number of nonquantifiable variables not included
in financial statements
Tools for Technical Analysis
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“A picture is worth a thousand words.”
Bar charts
Line charts
Volume bar charts
Candlestick
Point and figure charts
Contrarian Indicators
 Observed behavior is that individuals tend to
overreact to surprising news events
 Evidence that this behavior also occurs in the
market (overweight new information and
underweight older information)
 If markets overreact, then big changes in prices
will be followed by price movements in the other
direction.
 Questions about whether overreaction occurs
Sentiment Indicators
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Investment advisory opinions
Mutual fund cash positions
Put/call ratio
Public short interest ratio
Support and Resistance
 Market price is consensus view of market on security’s
intrinsic value
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Buyers are bullish on stock
Sellers are bearish on stock
Price movements indicate one side winning
 Support levels arise when consensus is price is at its
bottom and will not fall further
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Buyers outnumber sellers
 Resistance levels when consensus is price is at its highest
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Sellers outnumber buyers
Support and Resistance
 Penetration of support/resistance occurs when
supply/demand changes
 Volume / trader’s remorse
 Rationale for importance of support/resistance
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Institutional trading programs
Self-fulfilling prophecy
Moving Averages
 Oldest tool of technical analysis
 Smooths out fluctuations in prices so that
technical analyst can search for trends
 Simple moving average
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Average of price expectations over period of time
during which moving average is calculated
 Comparison of security price to moving average
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Current price > ma  current expectations exceed
average expectations over period ma calculated (bullish
or buy signal)
Momentum Indicators
 Absolute breadth
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Looks at volatility and price changes
Direction of prices is unimportant
=absolute value (advancing issues – declining issues)
 Advance/decline line
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Most popular measure of market breadth
Line moves up when more stocks are advancing than declining
“trouble looms when the generals lead and the troops refuse to
follow” (Achelis)
Numeric value of line is unimportant – slope and pattern are impt.
Relative Strength
 Ratios determined for firm or industry group
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Computed as price of stock relative to value of a market
series (ie, S&P 500)
Increasing ratio says stock outperforming market
In a bear market, if the stock price falls by less than the
decline in the market series, then techs believe that this
stock will do well in the next bull market
 RSI first presented as a 14 day index
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Now 9 day and 25 day are popular