MN0036

Investment Management
TECHNICAL ANALYSIS

ACCOUNTING PROGRAM
 Objective
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?
 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?
 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?
 Technical 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?
 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?
 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
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 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
 Typical Stock Market Cycle
Stock
Price

Declining Peak
Trend
Channel Flat Trend Channel

Sell Point
Rising Trend
Channel
Declining
Buy Point Trend Buy Point
Channel Trough
Trough
 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