William Raymond Forecasting summer 2 for Robert Vinaja Research paper 1 July 22, 2010

Forecasting on Technical Analysis

ABSTRACT This paper talks about

INTRODUCTION Can trends from the past help investor predict prices for the future? That is a question fund managers and investors have toyed with for many years. One of the most fascination and very controversial topics that I have across and learned from my past finance courses has been the term technical analysis. Technical analysis in my undergraduate studies was somewhat controversial subject that was explained to me briefly and later on toward my senior year was more encouraged to use when I took financial analysis. Could predicating the price of the stock and pinpointing cycles really exist in this world of uncertainly? When I first heard of technical analysis, that is using information in or related to stock prices in the past to make future decisions to buy and sell, I was eager to learn more about it. Technical analysts believed that they can accurately predict the future price of a stock by looking at its historical prices and other trading variables. Bloomberg definition of Technical analysis is the study charts of trading patterns to forecast price changes. Technical analysis is also known as efficient-market hypothesis. HISTORY AND THE FORMS The efficient-market hypothesis was developed by Professor Eugene Fama. He studied at the University Of Chicago School Of Business as an academic concept of study through his published Ph.D. Fama proposed three types of efficiencies. The weak-form efficiency, that state that future prices cannot be predicted by analyzing price from the past. The Semi strong- test of fundamental analysis and technical analysis combined. Can the open use of public information lead to buying and selling decisions that beat the market? The Strong-form efficiency all

William Raymond Forecasting summer 2 for Robert Vinaja Research paper 1 July 22, 2010

relevant information, includes privately held, is reflected in the share price. How does this one fare to the other three. Its a mystery still. PATTERNS Technical analysis is interested in patterns driven by the market over and under reactions to emotions according to my previous finance professor Mr. Sweet. Moving averages are one of the most popular and easy to use tools available to the technical analyst. The most commonly used time frames for moving averages are 10, 20, 50, and 200 day periods on a daily chart. According to wiki invest they say, Technical traders will look to the convergence or divergence of moving averages, known as MACD, with different periods (or values of "N") to indicate patterns of resistance or support which technical traders believe indicate where a stock price is likely to move in the future. Timing is one of the main elements of technical analysis. Technical analysis is not going to find out how expensive a stock can be. Its help one determines when to get into the market and when to leave. I was told by stocks take a long time to make money. Therefore, one will have to leave his/her money in the market for a very long time to see results. However, with the correct use of trend analysis and stock charts one doesnt have to wait for decades to make money. THE QUESTIONING OF TECHNICAL ANALYSIS Whats the controversy behind technical analysis? In 1978 Michael Jensen, an American economist declared the efficient-market hypothesis is one of the most solid foundations models that one can use. If the efficient-market hypothesis held true to its claim then markets would price financial assets broadly correctly. However what happened in 2007? Yes, a crash happened. What else happened? The dot-com bubble, quickly followed by the housing bubble also appeared. I read on the Wall Street Journal a small section about the credit rating agencies such as Standard & Poor's and Fitch Ratings that they were unreliable. They noted these agencies were putting top-notch grades on what turned out to be dodgy mortgage-related securities. I believe that these agencies created some of the housing bubble, not technical analysis. The New York Times also noted that mass psychology, herd behavior and the like can have an enormous effect on stock prices: meaning perhaps the market isnt quite so efficient after all. How did it all of this happened if the market is rational? We had technical analysis on our side. Academic took a hit as well. According to the Economist they interviewed Myron Scholes and he believed much of the blame for the recent disaster should not be pinned on economists' theories and models but on those on Wall Street who pushed hard for the models and not considering the exceptions. A quote from Myron explains more in detailed that Financial firms plugged in data that reflected a "view of the world that was far more benign than it was reasonable to take, emphasizing recent inputs over more historic numbers," says Mr. Scholes. According to Smart money they interviewed Ted Weisberg, a septuagenarian trader with Seaport Securities on the floor of the New York Stock Exchange and he, said hed never heard of
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William Raymond Forecasting summer 2 for Robert Vinaja Research paper 1 July 22, 2010

the MACD. You can take all the MACD indexes in the world and they dont mean anything, because the stock markets 75% psychological says Ted Weisberg. ADVATANTAGES AND THE THREE WIDELY HELD PRINCIPLES The advantages of technical analysis over other types of analysis is that with technical analysis, it must be pointed out that trading rules are picking up patterns in the data not accounted for by standard statistical models and that the excess returns thus generated are not simply a risk premium. Fundamental analysis on the other hand copes with the effects of mass psychology. Fundamental analyst can determine with a fair degree of accuracy the future of earnings of a company are likely to be, however, they still have not a exact way of determine how much the market will be prepared to pay for those earnings which, of course, may be a vital determinant of price. Technical analysis on the other hand, incorporates human psychology in the projection of a future share price, such sentiments being discounted by market action. There are three basic principles guide the beliefs of technical analysis. First is that market action (price movements and changes in trading volume) discounts everything. In other words all of the relevant information about a company's earnings and fundamentals are already known and incorporated into the price of its stock and its support and resistance levels. The second principle is that asset prices move in trends which show up on technical charts. Predictable trends are essential to the success of technical analysis, because they enable traders to profit by buying assets when the price is rising, or as the popular saying goes, "the trend is your friend." Borrowing from Newton's Law of motion, technical analysis asserts that trends in motion tend to remain in motion unless acted upon by another force. The third principle of technical analysis is that history repeats itself. Traders and investors will react in same way to the same conditions of the past, because the psychological motivations that drive them never change. This enables the technician to profit from patterns that repeat themselves in the market.

This is an example of technical analysis of Microsoft stock price range in 2008 and 2009 that I did in a finance course. Exhibit1

William Raymond Forecasting summer 2 for Robert Vinaja Research paper 1 July 22, 2010

MSFT historical Close from 2008-2009 prices and the 50, 100, and 200 moving day averages
29 27 25 23 21 19 17 15 12/31/2008

Resistance

Support level
2/28/2009 Close 4/30/2009 200 MA 6/30/2009 100 MA 8/31/2009 50MA 10/31/2009

There are some definitions and layout that I would like to explain. These definitions came from stockcharts.com. Overall Trend: The first step is to identify the overall trend. This can be accomplished with trend lines, moving averages or peak/trough analysis. As long as the price remains above its uptrend line, selected moving averages or previous lows, the trend will be considered bullish. Support: Areas of lows below the current price mark support levels. A break below support would be considered bearish. Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish. Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, then momentum will be considered bullish, or at least improving. Buying/Selling Pressure: For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero. Relative Strength: The price relative is a line formed by dividing the security by a benchmark. For stocks it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell us if the stock is outperforming (rising) or under performing (falling) the major index.

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The final step is to synthesize the above analysis to ascertain the following: Look at the current trend and determine the strength. The next step is to look at the maturity of the current trend. Follow the reward to risk ratio of a new position. The last step is to look for potential new entry levels for long term.

This graph in Exhibit 1 above is to show one the detail of moving averages and prices close. I have labeled the resistance and support levels. There is a breakout price of $24 and $25 at the support level at the date around 8/31/09. Moving averages are one of the most popular and easy to use tools available to the technical analyst. The most commonly used time frames for moving averages are 10, 20, 50, and 200 day periods on a daily chart. However, we will omit the 10 and 20 and add the 100 day moving average. The 200 day moving averages is not as responsive as the 50 day moving averages. If one were to look at the graph above and notice that it would take you around 10/31/09 to get into the market. Where is if you use n=50 moving averages you begin to get into the game at 4/30/09. The MSFT at 2/28/09 price indicates it as $15 at a low support. When it finally reaches past $29 the 200 day moving averages now decides to makes it mind up and shift in a new direction being up. My conclusion to technical analysis price of Microsoft is it works. We begin to move our eyes to the right of the date of 4/30/09. We begin to see the 50 and 100 day moving average beginning to make forward momentum process. This indicates to use that we should start to buy on that date alone. MSFT 50 and 100 day moving average begin to soar from its support level of around $18 and climb up the ladder to $26. Its a fascinating tale of buying and staying in. There might be a question as weather to sell on 8/31/09 and again in the later date; however because of the 50 and 100 day is climbing one might not be inclined to do so.

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Annotated Bibliography Walter , Updegrave. "Is it time to dump my gold?". CNNmoney. 2/25/2010 <http://money.cnn.com/2010/02/16/pf/sell_gold.moneymag/index.htm>. This article talks about not putting all eggs in one basket. Finding the right time to invest in gold is hard and risky. Even the top analysts cant predict the price of gold in the future. The article goes on to talk about if goes soars to the 2000 ounce dream price then sell a small percentage of it. Bottom line its safer to diversify then to put all your hope into one stock or metal that could go bust. Siegel, Jeremy J. . "Who Dropped the Ball". Kiplinger. 2/25/2010 <http://www.kiplinger.com/magazine/archives/2009/06/siegel.html>. This article talks about statistical models are bad at spotting real crisis. In the beginning it undermines that the formulas such as capital asset-pricing model didnt create the financial crisis. It also Diversification can be bad during a bear market. Toward the end the author talks about some warnings signs that CEO of major firms didnt take notice and paid the ultimate price of losing their companies profits and driving the whole US economy down. Economist, "Efficiency and beyond". Economist. 2/27/2010 <http://www.economist.com/displaystory.cfm?story_id=E1_TQDPDNJG&source=login_payBar rier>. This article talks is about the efficient-markets hypothesis. It shows the valid reason why the model has failed to live up to today expectations. Mr. Scholes also backs behind technical analysis and more or less blames the people on wall-street that put too much faith in the topic and didnt consider the exceptions. Toward the end of the summary they Mr. lo would like a more in depth reason why a crisis even happens in the first place like when a plane crash a full investigation is taken right away. Why not with the stock crisis that crash? He further feels that the blame should go towards the financial economists. Forbes, "Ken Kam On Asset Allocation". Forbes. 2/25/2010 <http://www.forbes.com/2009/12/08/asset-allocation-bernanke-personal-finance-sneak-peek-10investing.html>. This articles talks about how systematic risk is being more of a concern for investor today. As before many people had very little influence on it. Now the Federal Reserve can inject cash in and out and cause bubbles that effect the entire market. Ken also believes that people believe too much in the market and that it will usually go up. Sometimes he says you need not to be 100% in the market.

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Nocera, Joe. "Poking Holes in a Theory on Markets". The New York Times. 2/25/2010 <http://www.nytimes.com/2009/06/06/business/06nocera.html>. This article talks about the efficient market hypothesis that came from the University of Chicago in the 1970s. Though it has taking some hard blows and downs by critics. They interview Jeremy Grantham, a respected market strategist and he claims that the efficient market hypothesis has cause much harm that benefits during its climax period and were still facing its problems today.

BusinessWeek, "Pinning Down the Value of a Stock Option". BusinessWeek. 2/25/2010 <http://www.businessweek.com/magazine/content/02_30/b3793717.htm>. This articles talks about how companies can set a right price for stock options. One method is Black-Scholes. However this methods fails because of the adjusted to account for the added restrictions of employee options. They show how Coke uses an auction typed bid average of four quotes to get the option price to where they deem as fit. There is another method used called the Intrinsic value but however fails for stocks that are extremely volatile. Eddings, Cordell. "U.S. 30-, 10-Year Securities Near Hurdle: Technical Analysis ". Bloomberg. 2/27/2010 http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a5sEDErO37JE This article talks about the treasury rate of the 10 and 30 year bonds that are on the rise if they close below key yield levels theyre approaching according to the Royal Bank of Scotland. It also sites technical analysis as pointing out The yield curve plots the rates of bonds of the same quality, but with different maturities. Yahoo, "Microsoft Corporation". Yahoo. 2/25/2010 <http://finance.yahoo.com/q?s=msft>. This article shows some key stats that are very important to finance. I choose Microsoft as a example. Here they show its current stock price at 26 and the 52 week range from 14.87 - 31.50. Some key stats are the Price to earnings. Peg ratio, and Price to sales. O'Brien, Elizabeth. "The Market Light Is Flashing Green". Smartmoney. 2/25/2010 <http://www.smartmoney.com/investing/stocks/The-Market-Light-is-Flashing-Green/>. This article talks about how some day traders use The Moving Average Convergence Divergence tool to buy stocks. Some investor do and some dont. The main engine behind the moving average is to buy at certain peak times. This is also called technical analysis. A Ted Weisberg, a septuagenarian trader with Seaport Securities on the floor of the New York Stock Exchange says he doesnt use the tool because he thinks the stock market is 75% psychological.
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SHAH , NEIL . "Credit-Rating Firms Amplify Jitters ". wall street journal. 2/25/2010 <http://online.wsj.com/article/SB10001424052748704479404575087112857427430.html?mod= WSJ_Bonds_LEFTTopNews>. This article talks about the leading credit agencies such as S&P and Moodys made some bad ratings on mortgage-related securities. Due to the Greece default spectators are wandering if Greece will get lower ratings from S&P and Moodys. There is a strong agreement that the ratings will go down.