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Technical analysis, market efficiency, and behavioral finance
 

Technical analysis, market efficiency, and behavioral finance

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Technical analysis, market efficiency, and behavioral finance

Technical analysis, market efficiency, and behavioral finance

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    Technical analysis, market efficiency, and behavioral finance Technical analysis, market efficiency, and behavioral finance Presentation Transcript

    • Technical Analysis, Market Efficiency, and Behavioral Finance
    • Market Price Behavior
      • Learning Goals
        • Discuss the purpose of technical analysis and why market performance is important to stock valuation.
        • Describe approaches to technical analysis, such as the Dow Theory, moving averages, charting and indicators of the technical condition of the market.
        • Compute and use technical trading rules.
        • Explain the idea of random walks and efficient markets and note the challenges these theories hold for the stock valuation process.
    • Market Price Behavior
      • Learning Goals (cont’d)
        • Describe the weak, semi-strong, and strong versions of the efficient market hypothesis and explain what market anomalies are.
        • Demonstrate a basic appreciation of how psychological factors can affect investors’ decisions, and how behavioral finance presents a challenge to the concept of market efficiency.
    • Technical Analysis
      • Before financial data/financial statements were required to be disclosed, investors could only watch the stock market itself to determine buy-or-sell decisions
      • Investors began keeping “charts” of stock market movements to look for patterns, or “formations” that indicated whether to buy or sell
      • Studies have shown that anywhere from 20% to 50% of the price behavior of a stock can be traced to overall market forces
    • Technical Analysis (cont’d)
      • Technical Analysis is the study of the various forces at work in the marketplace and their affect on stock prices.
        • Focus is on trends in a business’ stock price and the overall stock market
        • Stock prices are a function of supply and demand for shares of stock
        • Used to get a general sense of where the stock market is going in the next few months
        • Several technical indicators may be used together
    • Big Picture Technical Indicators
      • The Dow Theory
        • Market’s performance is based upon long-term price trend (primary trend) in overall market
        • Used to signal end of both bull and bear markets
        • An after-the-fact measure with no predictive power
    • Figure 9.1 The Dow Theory in Operation
    • Big Picture: Technical Indicators (cont’d)
      • Trading Action
        • Looks at minor trading characteristics in market over long periods of time
        • Assumes the market moves in cycles and these cycles repeat themselves
        • Trading rules are formed from patterns:
          • January indicator
          • Presidential election indicator
          • Super Bowl indicator
    • Big Picture Technical Indicators (cont’d)
      • Confidence Index
        • Looks at ratio between yields on high-grade corporate bonds compared to low-grade corporate bonds
        • Optimism and pessimism about the future outlook is reflected in the bond yield spread
        • Trend of “smart money” is revealed in bond market before it shows up in stock market
    • Market Technical Indicators
      • Market Volume
        • Pure supply and demand analysis for common stocks
        • Strong market when volume goes up
        • Weak market when volume goes down
    • Market Technical Indicators (cont’d)
      • Breadth of the Market
        • Looks at number of stock prices that go up (advances) versus number of stock prices that go down (declines)
        • Strong market when advances outnumber declines
        • Weak market when declines outnumber advances
    • Market Technical Indicators (cont’d)
      • Short Interest
        • Looks at number of stocks that have been sold short at any given time
        • Can give two different interpretations:
          • Measure of Future Demand for Stock
            • Strong market when short sales are high since guarantees future stock sales to cover the short positions
          • Measure of Present Market Optimism or Pessimism
            • Weak market when short sales are high since professional short sellers think stocks will decline
    • Market Technical Indicators (cont’d)
      • Contrary Opinion and Odd-Lot Trading
        • Measures the volume of small traders
        • Assumes that small traders will do just the opposite of what should be done
          • Panic and sell when market is low
          • Speculate and buy when market is high
        • Bull market when odd-lot sales significantly outnumber odd-lot purchases
        • Bear market when odd-lot purchases significantly outnumber odd-lot sales
    • Trading Rules and Measures
      • Advance-Decline Line
        • Measures the difference between stocks closing higher and stocks closing lower than previous day
        • Difference is plotted on graph to view trends
        • Used as signal to buy or sell stocks
        • Bull market when advances outnumber declines
        • Bear market when declines outnumber advances
    • Trading Rules and Measures (cont’d)
      • New Highs–New Lows
        • Measures the difference between stocks reaching a 52-week high and stocks reaching a 52-week low
        • 10-day moving average is plotted on graph to view trends
        • Used as signal to buy or sell stocks
        • Bull market when highs outnumber lows
        • Bear market when lows outnumber highs
    • Trading Rules and Measures (cont’d)
      • The Trading Index (TRIN)
        • Combines advance-decline line with trading volume
        • Used as signal to buy or sell stocks
        • Bull market when TRIN values are lower
        • Bear market when TRIN values are higher
    • Trading Rules and Measures (cont’d)
      • Mutual Fund Cash Ratio (MFCR)
        • Tracks cash position of mutual funds
        • High cash positions in mutual funds provides liquidity for future stocks purchases or protection from future mutual fund withdrawals
        • Bull market when MFCR values are higher
        • Bear market when MFCR values are lower
    • Trading Rules and Measures (cont’d)
      • On Balance Volume
        • Tracks the volume to price change relationship as a running total
        • Up-volume occurs when stock closes higher and is added to running total; down-volume occurs when stock closes lower and is subtracted from running total
        • Direction of indicator is more important than actual value
        • Used to confirm price trends
        • Bull market when OBV values are higher
        • Bear market when OBV values are lower
    • Using Technical Analysis
      • Charting
        • Shows visual summary of stock activity over time
        • Easy to use and to understand
        • Use to spot developing trends
        • Major types
          • Bar Charts
          • Point-and-Figure Charts
          • Chart Formations
    • Figure 9.3 A Stock Chart
    • Using Technical Analysis (cont’d)
      • Bar Charts
        • Shows changes in stock price over period of time
        • Often used to compare current stock price with moving average
        • When current price goes above or below a moving average, indicates significant price change
    • Figure 9.4 A Bar Chart
    • Using Technical Analysis (cont’d)
      • Point-and-Figure Charts
        • Only shows significant changes in stock price patterns
        • Up patterns are shown as an “X” and down patterns are shown as an “O”
    • Figure 9.5 A Point-and-Figure Chart
    • Using Technical Analysis
      • Chart Formations
        • Looking for patterns, or formations, that historically meant that stocks were going up or down
        • Buy when stocks break through a “line of resistance”
        • Sell when stocks break through a “line of support”
    • Figure 9.6 Some Popular Chart Formations
    • Using Technical Analysis (cont’d)
      • Moving Averages
        • Tracks data (usually stock price) as average value over time
        • Used to “smooth out” daily fluctuations and focus on underlying trends
        • Usually calculated over periods ranging from 10 to 200 days
    • Figure 9.7 A 100-Day Moving Average Line
    • Random Walks and Efficient Markets
      • Random Walk : the theory that stock price movements are unpredictable, so there is no way to know where prices are headed
        • Studies of stock price movements indicate that they do not move in neat patterns
        • This could be an indication that markets are highly efficient and respond quickly to changes in the current situation
    • Random Walks and Efficient Markets (cont’d)
      • Efficient Market : a market in which securities reflect all possible information quickly and accurately
      • Efficient Market Hypothesis : markets have a large number of knowledgeable investors who react quickly to new information, causing securities prices to adjust quickly and accurately
    • Random Walks and Efficient Markets (cont’d)
      • To have an efficient market, you must have:
        • Many knowledgeable investors active in analyzing and trading stocks
        • Information is widely available to all investors and is free/easy to obtain
        • Events, such as labor strikes or accidents, tend to happen randomly
        • Investors react quickly and accurately to new information, causing prices to adjust
    • Levels of Efficient Markets
      • Weak Form
        • Past data on stock prices are of no use in predicting future stock price changes
        • Everything is random
        • Should simply use a “buy-and-hold” strategy
      • Semi-strong Form
        • Abnormally large profits cannot be consistently earned using public information
        • Any price anomalies are quickly found out and the stock market adjusts
    • Levels of Efficient Markets (cont’d)
      • Strong Form
        • There is no information, public or private, that allows investors to consistently earn abnormally high returns
    • Market Anomalies
      • Calendar Effects
        • Stocks returns may be closely tied to the time of year or time of week
        • Questionable if really provide opportunity
        • Examples: January effect, weekend effect
      • Small-Firm Effect
        • Size of a firm impacts stock returns
        • Small firms may offer higher returns than larger firms, even after adjusting for risk
    • Market Anomalies (cont’d)
      • Earnings Announcements
        • Stock price adjustments may continue after earnings adjustments have been announced
        • Unusually good quarterly earnings reports may signal buying opportunity
      • P/E Effect
        • Uses P/E ratio to value stocks
        • Low P/E stocks may outperform high P/E stocks, even after adjusting for risk
    • Technical vs. Fundamental: So Who is Right?
      • There is growing consensus that markets may not be perfectly efficient, but they may be at least reasonably efficient
      • Individual investor must determine which approach has merits for their investing decisions
    • Investor Behavior and Security Prices
      • Overconfidence
        • Investors tend to be overconfident in their judgment, leading them to underestimate risks
      • Biased Self-Attribution
        • Investors tend to take credit for successes and blame others for failures
        • Investors will follow information that supports their beliefs and disregard conflicting information
    • Investor Behavior and Security Prices (cont’d)
      • Loss Aversion
        • Investors dislike losses much more than gains
        • Investors will hang on to losing stocks hoping they will bounce back
      • Representativeness
        • Investors tend to draw strong conclusions from small samples
        • Investors tend to underestimate the effects of random chance
    • Investor Behavior and Security Prices (cont’d)
      • Narrow Framing
        • Investors tend to analyze a situation in isolation, while ignoring the larger context
      • Belief Perseverance
        • Investors tend to ignore information that conflicts with their existing beliefs
    • Behavioral Finance at Work in the Markets
      • Stock Return Predictability
        • It maybe profitable to buy underperforming stocks when they are out-of-favor
        • Momentum of stock prices up and down tends to continue over 6- to 12-month time horizons
        • Value stocks may outperform growth stocks
    • Behavioral Finance at Work in the Markets (cont’d)
      • Investor Behavior
        • Investors who believe they have superior information tend to trade more, but earn lower returns
        • Investors tend to sell stocks that have risen in value rather than declined
        • Investors acting on emotions instead of facts may reduce market efficiency
    • Behavioral Finance at Work in the Markets (cont’d)
      • Analyst Behavior
        • Analysts may be biased by “herding” behavior, where they tend to issue similar recommendations for stocks
        • Analysts may be overly optimistic about a favorite stock’s future
    • Using Behavioral Finance to Improve Investment Results (Table 9.1)
      • Don’t hesitate to sell a losing stock
      • Don’t chase performance
      • Be humble and open-minded
      • Review the performance of your investment on a periodic basis
      • Don’t trade too much
    • Table 9.1 Using Behavioral Finance to Improve Investment Results