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  • 1. Technical Analysis, Market Efficiency, and Behavioral Finance
  • 2. 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.
  • 3. 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.
  • 4. 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
  • 5. 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
  • 6. 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
  • 7. Figure 9.1 The Dow Theory in Operation
  • 8. 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
  • 9. 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
  • 10. 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
  • 11. 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
  • 12. 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
  • 13. 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
  • 14. 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
  • 15. 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
  • 16. 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
  • 17. 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
  • 18. 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
  • 19. 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
  • 20. Figure 9.3 A Stock Chart
  • 21. 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
  • 22. Figure 9.4 A Bar Chart
  • 23. 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”
  • 24. Figure 9.5 A Point-and-Figure Chart
  • 25. 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”
  • 26. Figure 9.6 Some Popular Chart Formations
  • 27. 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
  • 28. Figure 9.7 A 100-Day Moving Average Line
  • 29. 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
  • 30. 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
  • 31. 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
  • 32. 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
  • 33. Levels of Efficient Markets (cont’d)
    • Strong Form
      • There is no information, public or private, that allows investors to consistently earn abnormally high returns
  • 34. 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
  • 35. 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
  • 36. 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
  • 37. 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
  • 38. 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
  • 39. 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
  • 40. 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
  • 41. 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
  • 42. 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
  • 43. 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
  • 44. Table 9.1 Using Behavioral Finance to Improve Investment Results