Technical analysis, market efficiency, and behavioral finance

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Technical analysis, market efficiency, and behavioral finance

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Technical analysis, market efficiency, and behavioral finance

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

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