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Lecture Presentation Software

to accompany

Investment Analysis and Portfolio Management

Seventh Edition by

Frank K. Reilly & Keith C. Brown

Chapter 16

Chapter 16 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?

Chapter 16 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?

Chapter 16 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?

Chapter 16 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?

Chapter 16 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-andfigure charts? What are some uses of technical analysis in foreign security markets? How is technical analysis used when analyzing bond markets?

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 and these shifts can be detected in the action of the market

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

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 16.2

Typical Stock Market Cycle

Stock Price Declining Trend Channel Peak Flat Trend Channel Sell Point Rising Trend Channel Declining Buy Point Trend Trough Channel Exhibit 16.2

Buy Point Trough

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 Barrons Confidence Index T-Bill - Eurodollar yield spread Short sales by specialists Debit balances in brokerage accounts (margin debt)

Other Market 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 Internet Investments Online

End of Chapter 21
Technical Analysis

Future topics Chapter 17

Equity Portfolio Management Strategies