Technical Analysis Chap#15

1. Investment Analysis and
Portfolio Management
by
Frank K. Reilly & Keith C. Brown
Chapter 15

2. Technical Analysis
Questions to be answered:
• How does technical analysis differ from
fundamental analysis?
• What are the underlying assumptions of technical
analysis?
• What major assumption causes a difference
between technical analysis and the efficient
market hypothesis?

3. Technical Analysis
• What are the major advantages of technical
analysis compared to fundamental analysis?
• What are the major challenges to the assumptions
of technical analysis and its rules?
• What is the logic for the major contrary opinion
rules used by technicians?

4. Technical Analysis
• What are some of the significant rules used by
technicians who want to follow the smart money
and what is the logic of those rules?
• What are the breadth of market measures and
what are they intended to indicate?
• What are the types of price movements postulated
in the Dow Theory and how are they used by a
technician?

5. Technical Analysis
• Why do technicians consider the volume of
trading important and how do they use it in their
analysis?
• What are support and resistance levels, how are
they identified, and how are they used by
technicians?
• What is the purpose of moving average lines and
how does the technician use one or several of
them to detect major changes in trends?

6. Technical Analysis
• What is the rationale behind the relative strength
line for an industry or a stock and how is it
interpreted?
• How are bar charts different from point-and-figure
charts?
• What are some uses of technical analysis in
foreign security markets?
• How is technical analysis used when analyzing
bond markets?

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. Typical Stock Market Cycle
Stock
Price
Exhibit 16.2

14. 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

15. 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

16. Contrary-Opinion Rules
• Mutual fund cash positions
• Credit balances in brokerage accounts
• Investment advisory opinions
• OTC versus NYSE volume
• Chicago Board Options Exchange (CBOE)
put/call ratio
• Futures traders bullish on stock index
futures

17. Follow the Smart Money
• Indicators showing behavior of
sophisticated investors
• The Barron’s Confidence Index
• T-Bill - Eurodollar yield spread
• Short sales by specialists
• Debit balances in brokerage accounts
(margin debt)

18. Other Market Indicators
• Breadth of market
– Advance-decline
– Diffusion index
• Short interest
• Stocks above their 200-day moving average
• Block uptick-downtick ratio

19. Stock Price and Volume Techniques
• The Dow theory – oldest technical trading
rule
– 1. Major trends are like tides in the ocean
– 2. Intermediate trends resemble waves
– 3. Short-run movements are like ripples
• Importance of volume
– Ratio of upside-downside volume
• Support and resistance levels
• Moving average lines

20. Stock Price and Volume Techniques
• Relative-strength (RS) ratios
– For individual stocks and industry groups
• Bar charting
• Multiple indicator charts
• Point-and-figure charts
• Overall feel from a consensus of
numerous technical indicators

21. Technical Analysis of Foreign
Markets
• Foreign stock market series
• Technical analysis of foreign
exchange rates
• Technical analysis of bond markets