Technical Analysis •Technical analysis – technical trading rules based on past price movements •Contrast to EMH –past influence has no impact on future performance •Examination of past market data –Prices and the volume of trade •Which leads to an estimation of future price trends and investment decision –Market is its own best predictor Underlying Assumptions of Technical Analysis •1. 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 Underlying Assumptions of Technical Analysis •3. Disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time •4. Prevailing trends change in reaction to shifts in supply and demand relationships and these shifts can be detected in the action of the market Advantages of Technical Analysis •Not heavily dependent on financial accounting statements –Problems with accounting statements: –1. Lack information needed by security analysts –2. 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 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 Challenges to Technical Analysis •Assumptions of Technical Analysis –Empirical tests of Efficient Market Hypothesis (EMH) show that prices do not move in trends •Technical Trading rules –The past may not be repeated –Patterns may become self-fulfilling prophecies –A successful rule will gain followers and become less successful –Rules require a great deal of subjective judgement Technical Trading Rules and Indicators •Stock cycles typically go through a peak and trough •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 Typical Stock Market Cycle Stock Price Exhibit 16.2 Typical Stock Market Cycle Stock Price Exhibit 16.2 Declining Trend Channel Trough Buy Point Rising Trend Channel Flat Trend Channel Sell Point Peak Declining Trend Channel Trough Buy Point Contrary-Opinion •Many analysts rely on rules developed from the premise 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 Contrary-Opinion Rules •Mutual fund cash positions –4 (TA sell, near peak)– 11 %(TA buy, near trough) •Credit balances in brokerage accounts –Purchasing power •Investment advisory opinions –Trend followers •OTC versus NYSE volume •Chicago Board Options Exchange (CBOE) put/call ratio –0,4 – 0,6 –40:100 - 60:100 •Futures traders bullish on stock index futures –70 % bearish speculators –30 % bullish speculators Follow the Smart Money •Indicators showing behavior of sophisticated investors •The Barron’s Confidence Index •T-Bill - Eurodollar yield spread •Debit balances in brokerage accounts (margin debt) Kinds of charts • •Line chart •Bar charting •Candle stick •Point-and-figure charts –Ch. Dow Line Chart with volume of trade fsspon Bar chart charts-6sunw-ohlc Candel stick charts-6sunw-ohlc Dow theory •Charles Dow •DJTA, DJIA •Grandfather of TA, indexing • 3 trends –Major, intermediate, short-run •Only major trend •Importance of volume – •On the basis of security rates study assumed conclusion that – As market barometry can be used the average closing rate of particular securities. –This can be used as a rate of whole market performance. –First application in 1884 - Railroad Average first index composes of 11 stocks (9 stocks of railroad companies) –In 1896 Dow created new index because Railroad Average was able to describe only part of the economy because of limited number of sector securities. –Dow Jones Industrial Average - average of closing rates of 12 securities •Highly speculative •Industry companies –In 1928 basis of DJIA extent to 30 titles. –Value of DJIA first published in Wall Street Journal in May 1896 its value was 40,96 points (that days 8.000 points) –Former Railroad Average is still used is known as a Dow Jones Transportation Average (DJTA). • Bull Trend bull_trend Bear Trend bear_trend Trend Line • 20060315-chart_a_LG Trend Line 20060418-chart_b_LG Support and resistance level •Support and resistance levels •Overbought v. oversold •Psychological barrier –Price ending by 0 or 5 • • Psychological analysis •Herd behaviour –Bubbles, crissis –Tulip bubble –South sea company bubble –…. Dot com bubble – •A.Kostolany •J.M. Keynes • 800px-Flora's_Malle-wagen_van_Hendrik_Pot_1640 800px-Tulip_price_index1 • Market Year P/E ratio NYSE 1929 21 NYSE 1969 18 NASDAQ 2000 200