Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Eighth Editionby

Frank K. Reilly & Keith C. Brown

Chapter 15

Chapter 15Technical 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?

Chapter 15Technical 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?

Chapter 15Technical 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?

Chapter 15Technical Analysis

• Why is volume of trading important and how do technicians use it?

• What are support and resistance levels and how are they used?

• How do technicians use moving-average lines to detect changes in trends?

Chapter 15Technical 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?

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. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself.

Advantages of Technical Analysis

• Not heavily dependent on financial accounting statements– Problems with accounting statements:1. Lack information needed by security analysts2. 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 15.2

Typical Stock Market Cycle Stock Price

Exhibit 15.2

Declining Trend

Channel

Trough

Buy Point

Rising Trend Channel

Flat Trend Channel

Sell Point

Peak

Declining Trend

Channel TroughBuy Point

Contrary-Opinion Rules

• 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• 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

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)

Other Market Indicators

• Momentum Indicators• Breadth of market

– Advance-decline– Diffusion index

• Short interest• Stocks above their 200-day moving average• Block uptick-downtick ratio

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

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

Technical Analysis of Foreign Markets

• Foreign stock market series

• Technical analysis of foreign exchange rates

• Technical analysis of bond markets

The InternetInvestments Online

http://www.mta.org

http://www.bigcharts.marketwatch.com

http://www.stockcharts.com

End of Chapter 15–Technical Analysis

Future topicsChapter 16

• Equity Portfolio Management Strategies