MARKET PRICE

BEHAVIOR
LEARNING GOALS
Discuss the purpose of technical analysis and explain why the
performance of the market is important to stock valuation.

Describe some of the approaches to technical analysis, including,

among others, the Dow theory, moving averages, charting, and various
indicators of the technical condition of market.

Compute and use technical trading rules for individual stocks and the
market as a whole.
Explain the idea of random walks and efficient markets, and note the
challenges these theories hold for the stock valuation process

Describe the weak, semi-strong, and strong versions of the efficient

market hypothesis, and explain what market anomalies are.

Demonstrate a basic appreciation for how psychological factors can

affect investor’ decisions, and how behavioral finance presents a
challenge to the concept of market efficiency.
PRINCIPLES OF MARKET ANALYSIS
Analyzing the various forces at work in the stock market is
known as technical analysis.
Other definitions of technical analysis:
 It’s another piece of information to use when deciding
whether to buy, hold or sell a stock.
It’s the only input they use in their investment decisions.
Like fundamental analysis, is regarded as a big waste of
time.
 Analyzing market behavior dates back to the 1800s, when
there was no such thing as industry or company analysis.
There were no industry figures, balance sheets, or income
statements to study, no sales forecasts to make, and no EPS
data or P/E multiples. About the only thing investors could
study was the market itself.
If the behavior of stock prices were completely
independent of market movements, market studies and
technical analysis would be useless. But we have ample
evidence that stock prices do, in fact, tend to move with the
market.
 For example, studies of stock betas have shown that
as a rule, anywhere from 20% to 50% of the price behavior
of a stock can be traced to market forces. When the market
is bullish, stock prices in general can be expected to behave
accordingly. When the market turns bearish, you can safely
expect most issues to be affected by the “downdraft”.
Investors have a wide range of choices with respect to
technical analysis. They can use the charts and complex
ratios of the technical analysts. Most investors rely on
published sources. Such information provides the investor
with a convenient and low-cost way of staying abreast of
the market.
 Certainly, trying to determine the right (or best) time to
get into the market is a principal objective of technical
analysis- and one of the major pastimes of many investors.

MEASURING THE MARKET

Technical analysis addresses those factors in the

marketplace that can or may have an effect on the price
movements of stocks in general. One way to do is to look at
the over all behavior of the market.
 Several approaches in
looking at the overall
behavior of the market:

The confidence
The Dow theory Trading actions
index
 • The Dow theory is based on the idea that the
market’s performance can be described by the long-
term price trend in the overall market. Named after
Charles H. Dow, one of the founders of Dow Jones,
THE this approach is supposed to signal the end of both
DOW bull and bear markets. This theory is strictly an
THEORY after-the-fact verification of what has already
happened. It concentrates on the long term trend of
the market behavior (known as the primary trend)
and largely ignores day-to-day fluctuations or
secondary movements.
 The Dow Jones industrial and transportation averages are
used to assess the position of the market. Once the primary
trend in the Dow Jones industrial average has been
established, the market tends to move in that direction until
the trend is cancelled out by both the industrial and
transportation averages. Known as confirmation, this crucial
part of the Dow theory occurs when secondary movements in
the industrial average are confirmed by secondary movements
in the transportation average. When confirmation occurs, the
market has changed from bull to bear or vice versa, and a new
primary trend is established.
 • This approach to technical analysis concentrates on
minor trading characteristics in the market. Daily
trading activity over long periods of time is examined
in detail to determine whether certain characteristics
occur with a high degree of frequency.
• Ex. If the year starts out strong (that is, if January is a
Trading good month for the market), the chances are that the
Action whole year will be good; if the party in power wins
the presidential election, it is also going to be good
year for the market; and it is best to by air
conditioning stocks in October and sell the following
March (this buy-and-sell strategy was found to be
significantly more profitable over the long haul than
buy-and-hold.
 • Confidence index deals not with the stock market
but rather with bond returns. Computed and
published weekly in Barron’s, the confidence index
is a ratio that reflects the spread between the average
yield on high grade corporate bonds relative to the
average yield on low-grade corporate bonds. The
Confidenc theory is that the trend of “smart money” is usually
e Index revealed in the bond market before it shows up in
the stock market. Although low-rated bonds provide
higher yields than high-grade issues, the logic is that
the spread in yields between these two types of
obligations will change over time as the amount of
optimism or pessimism in the market outlook
changes.
 • Another way to assess the market is to keep track
Technical of the variables that drive in behavior- things like:
conditions the volume of trading, short-sales, and odd-lot
trading. Clearly, if these kinds of variables do, in
within the fact, influence market prices, then it would be in
Market an investor’s best interest to keep tabs on them, at
least informally.

• Market volume
Ex. Of market • Breadth of the market
forces: • Short interest
• Odd-lot trading
 • Market volume is an obvious reflection of the
amount of investor interest. Volume is a
function of supply of and demand for stock
and it indicates underlying market strengths
Market and weaknesses.
Volume • As a rule, the market is considered strong
when volume goes up in a rising market or
drops off during market declines. It is
considered weak when volume rises during a
decline or drops during rallies.
 • Each trading day, some stocks go up in price and others go
down. In market terminology, some stocks advance and others
decline.
• Breadth-of-the-market deals with these advances and declines.
The idea is actually quite simple. So long as the number of
Breadth stocks that advance in price on a given day exceeds the number
of the that decline, the market is considered strong. The extend of
Market that strength depends on the spread between the number of
advances and declines.
• The principle behind this indicator is that the number of
advances and declines reflects the underlying sentiment of
investors. When the mood is optimistic, for ex. Look for
advances to outnumber declines.
 • When investors anticipate a market decline, they
sometimes sell a stock short. That is, they sell borrowed
stock. The number of stocks sold short in the market at
any given point in time is known as the short interest.
The more stocks that are sold short, the higher the short
interest. Because all short sales must eventually be
Short “covered” (The borrowed shares must be returned), a
Interest short sale in effect ensures future demand for the stock.
• Thus, the market is viewed optimistically when the level
of short interest becomes relatively high by historical
standards. The logic is that as shares are bought back to
cover outstanding short sales, the additional demand will
push stock prices up.
 The amount of short interest on the NYSE, the AMEX, and
Nasdaq’s National Market is published monthly in the Wall Street
Journal and Barron’s.

Keeping track of the level of short interest can indicate future market
demand, but it can also reveal present market optimism or pessimism.
Short selling is usually done by knowledgeable investor, and a significant
build up or decline in the level of short interest is thought to reveal the
sentiment of sophisticated investors about the current state of the market or
a company. For ex. A significant shift upward in short interest is believed
to indicate pessimism concerning the current state of the market, even
though it may signal optimism with regard to future levels of demand.
 • The investing public usually does not come into the
market in force until a bull market has pretty much run
its course, and does not get until late in a bear market.
Although its validity is debatable, this is the premise
behind a widely followed technical indicator and is the
basis for the theory of contrary opinion.
Odd-lot • Theory of contrary opinion is a technical indicator that
Trading uses the amount and type of odd-lot trading as in
indicator of the current state of the market and pending
changes.
• Because many individual investors deal in transactions
of less than 100 shares, their combined sentiments are
supposedly captured in odd-lot figures.
 The idea is to see what odd-lot investors are doing
“on balance”. So long as there is little or no
difference in the spread between the volume of 0dd-lot
purchases and sales, the theory of contrary opinion
holds that the market will probably continue pretty
much along with its current line (either up of down).
When the balance of odd-lot purchases and sales
begins to change dramatically, it may signal that a
bull or bear market is about to end.
Trading Rules and Measures

Advance-decline lines

New highs and lows

The arms index

The mutual fund cash ratio

On balance volume
The investment newsletter sentiment
index
Advance-Decline Line

• The advance-decline line A/D line is simply the difference

between these two numbers. That is, to calculate it, you take the
number of stocks that have risen in price and subtract the number
that have declined, usually for the previous day.
• For ex, if 1,000 issues advanced on a day when 450 issues
declined, the day’s net number would be 550 (i.e. 1,000-450). If
450 advanced and 1,000 declined, the net number would be -
550( 450-1,000). Each day’s net number is then added to ( or
subtracted from) the running total, and the result is plotted on a
graph.
 If the graph is rising, then the advancing
issues are dominating the declining issue and
the market is considered strong. When
declining issues start to dominate, then the
graph will turn down as the market begins to
soften. Technicians use the A/D line as a
signal for when to buy or sell stocks.
New high-new lows

• This measure is similar to the advance-decline line, but

looks at price movements over a longer period of time. A
stock is defined as reaching a “new high” if its current price
is all the highest level it has been over the past year
(sometimes referred to as the “52 week high”). Conversely,
a stock makes a “new low” if its current price is at the
lowest level it has been over the past year.
The new highs-new lows (NH-NL)
indicator is computed as the number of
stocks reaching new 52 week highs
minus the number reaching new lows.
Thus you end up with a net number,
which can be either positive (when new
highs dominate) or negative (when new
lows exceed new highs), just like with the
advance-decline line.
 To smooth the daily fluctuations, the net number is often
added to ( or subtracted from) a 10 day moving average, and
then plotted on a graph. A graph that’s increasing over time
indicates a strong market, where new highs are dominating,
whereas a declining graph indicates a weak market, where new
lows are more common than new highs.

Technicians following a momentum-based strategy will buy

stocks when new highs dominate and sell them when there are
more new lows than new highs.
 The Arms Index
This indicator is also know as TRIN, for “trading index”, builds on
the advance-decline line by considering the volume in advancing and
declining stocks in addition to the number of stocks rising or falling in
price.

TRIN = number of up stocks volume in up stocks

number of down stocks volume in down stocks
Ex. Suppose we are analyzing the S & P 500. Assume that on a
given day, 300 of these stocks rose in price and 200 fell in price. Also
assume that the total trading volume in the rising (“up”) stocks was 400
million shares and the
Total trading volume in the falling (“ down”) stocks was 800 million
shares. The value of the TRIN for the day would be:
TRIN = 300/ 200 divided by 400m/800m = 3.0
Alternatively, suppose the volume in up stocks was 700 million shares
and that in down stocks was 300 million. The value of the TRIN would
then be:
TRIN = 300/200 divided by 700m/300m = .64
Higher TRIN values are interpreted as being bad for the market,
because even though more stocks rose than fell, the trading volume in the
falling stock was much greater. The underlying idea is that a strong
market is characterized by more stocks rising in rpice than falling, along
with greater volume in the rising stocks than in the falling ones.
Mutual Fund Cash Ratio
• This indicator looks at the cash position of mutual funds as indicator
of future market performance. The mutual fund cash ratio (MFCR)
measures the percentage of mutual fund assets that are held in cash
and is computed as follows:
MFCR = mutual fund cash position / total assets under
management
• The assumption is that the higher the MFCR, the stronger the market .
Indeed the ratio is considered very bullish when it moves to abnormally
high levels (i.e. when mutual fund cash exceeds 10% to 12% of total
assets) and bearish when the ratio drops to very low levels (i.e. less than
5% of assets.
 The logic goes as follows: When fund managers hold a lot of
cash and the MFCR is high- that’s good news for the market,
because they will eventually have to invest that cash, buying
stocks and causing prices to rise. If fund managers hold very
little cash, investors might be concerned for two reasons:

1. there is less demand for stocks if most of the cash is already

invested.

2. If market takes a downturn, investors might want to withdraw

their money.
 • OBV is a momentum indicator that relates volume
to price change. It uses trading volume in addition
to price and tracks trading volume as a running
total. In this way, OBV indicates whether volume
On balance is flowing into or out of a security. When the
security closes higher than its previous close, all
volume the day’s volume is considered up-volume, all of
(OBV) which is added to the running total. In contrast,
when a stock closes lower than all the day’s
volume is considered down-volume, which is then
subtracted from the running total.
• The OBV indicator is used to confirm price trends.
 When analyzing OBV, it is the direction or trend that is important,
not the actual value. To begin the computation of OBV, you can start
with an arbitrary number, such as 50,000. Suppose you are calculating
the OBV for a stock that closed yesterday at a price of 50 per share, and
you start with an OBV value of 50,000. Assume that the stock trades
80,000 shares today and closes at 49. Because the stock declined in
price, we would subtract the full 80,000 shares from the previous
balance (our starting point of 50,000), so now the OBV is 50,000-
80,000 = - 30,000. (Note that the OBV is simply the trading volume
running total)
 If the stock trades 120,000 shares on the following
day and closes up at 52 per share, we would then add all
of those 120,000 shares to the previous day’s OBV: -
30,000 + 120,000 = + 90,000. This process would
continue day after day. As long as the graph is moving
up, it’s bullish, when the graph starts moving down, it’s
bearish.
Investment newsletter sentiment index
• This index is published by Investors Intelligence, a firm that
racks popular newsletter across the country. It measures the
percentage of investment newsletter authors who are bullish or
bearish on stocks. The index becomes more bullish as the
newsletter writers become more bullish; it turns bearish when
the letter writers do.
• The logic behind this indicator is that, on average, the
newsletter writers just can’t seem to get it right. Thus the
index tends to become very bullish when the market’s about to
peak and –you guessed it- he index tends to be more bearish
when the market’s pretty much bottomed out.
 Technicians often use the terms overbought and oversold:

Overbought market is usually considered to be overvalued

due to excessive buying (speculation) on the part of
investors.
Oversold market is usually considered a market to be under
valued, due to excessive pessimism and selling by investors.
• It is perhaps the best-known activity of the technical
analyst. It is the activity of charting a price behavior
CHARTING and other market information and then using the
patterns these charts form to make investment
decisions.
 Chartist believe that history repeats itself, so
they study the historical reactions of stocks (or
the market) to various formations, and they
devise trading rules based on these observations.
It makes no difference to chartists whether they
are following he market or an individual stock.
It is the formation that matters, not the issue
being plotted. These chart formations are often
given exotic names such as head and shoulders,
falling wedge, scallop and saucer, ascending
triangle, and island reversal.
PA N E L A I S A N E X O F B UY S I GN AL T HAT OCCURS WHEN PRICES BREAK OUT ABOVE A R E S IS TA NC E L I NE I N A PA RT I C U L A R PAT T E R N .
WHEN PRI CES BREAK OUT BELOW THE SUPPORT LEVEL, AS T H E Y D O AT T H E E N D O F T H E F O R M AT I O N I N PA N E L B , A S E L L S I G N A L IS SAID TO OCCUR.
Moving Averages (MA)
• It is a mathematical procedure that computes and
records the average values of a series of prices, or
other data, over time: results in a stream of average
values that will act to smooth out a series of data. It is
also one of the oldest and most popular technical
indicators and can, even, in fact, be used not only with
share prices, but also with market indexes and even
other technical measures.
• Moving averages are computed over periods ranging
from 10 to 200 days- meaning that from 10 to 200
data points are used in each calculation.
 Using closing share prices as the basis of discussion, the
simple moving average is calculated by adding up the closing prices
over a given time period. (e.g. 10 days), then dividing this total by
the length of the time period. Thus, the simple moving average is
nothing more than the arithmetic mean.
To illustrate, consider the following stream of closing share
prices.
Day: 1 2 3 4 5 6 7 8 9 10 11 12 13……
Price: 4 5 6 6 7 5 3 5 8 9 6 2 4 …..
I F T H E S E C U R I T Y ’ S P R I C E S T A R T S M O V I N G A B O V E T H E M O V I N G AV E R A G E , T H E N T H A T S I T U A T I O N S H O U L D B E R E A D A S A G O O D T I M E T O B U Y B E C . P R I C E S S H O U L D B E D R I F T I N G . I N C O N T R A S T , S I G N A L O C C U R S W H E N S E C U R I T Y ’ S P R I C E M O V E S B E L O W T H E M O V I N G AV E R A G E L I N E .
 Using a 10 day moving average, we’ll add up the closing
prices for days 1 through 10. (4+5+…+8+9= 58) then divide this
total by 10 ( 58/10 = 5.8). Thus the average closing price for this
10-day period was 5.80. The next day, the process is repeated
once again for days 2 through 11; that turns out to be 60/10 = 6.).
These procedure is repeated each day, so that over time we have a
series of these individual averages that, when linked together,
form a moving average line.

If the security‘s price starts moving above the moving average,

then that situation should be read as good time to buy, because
prices should be drifting up. In contrast, a sell signal occurs when
the security’s price moves below the moving average line.
Random Walk Hypothesis
• It is the theory that stock price movements are
unpredictable, so there’s no way to know where
prices are headed.
• The first evidence of random price movements
dates back to the early 1900s. During that
period, statisticians noticed that commodity
prices seemed to follow “a fair game” pattern.
That is prices seemed to move up and down
randomly, giving no advantage to any particular
trading strategy.
Efficient Market
• It is a market in which securities reflect all possible
information quickly and accurately. The concept holds that
investor quickly incorporate all available information into
their decisions about the price at which they are willing to
buy or sell. At any point in time, then, the current price of
a security incorporates all information.
• Because of keen competition among investors, when
new information becomes known, the price of the
security adjusts quickly.
 Why should markets be efficient?

Active markets such as the NYSE, are efficient because they are
made up of many rational, highly competitive investors who react
quickly and objectively to new information. The efficient market
hypothesis (EMH), which is the basic theory describing the
behavior of such market has several tenets:

There are many knowledgeable investors actively

analyzing, valuing and trading any particular security. No
one of these traders alone can affect the price of any
security.
Continuation of tenets of EMH

Information on events, such as labor strikes, industrial

accidents, and changes in product demand, tends to
emerge randomly.

Investors react quickly and accurately to new

information, causing prices to adjust quickly and on,
average accurately.

Information is widely available to all investors at

approximately the same time, and this information is
practically “ free” or nearly so.
 Levels of Market Efficiency

Three cumulative categories

of EMH:
The efficient market hypothesis
is concerned with information- Past prices only;
not only the type and source of
information , but also the quality
and speed with which it is Past prices plus all other
disseminated among investors. public data;
Past prices and public
data plus private
information
Three forms Weak
of EMH Form

Weak The weak form of the EMH holds that

past data on stock prices are of no use in
predicting future price changes. If prices
Semi follow a random walk, price changes over
strong time are random. Today’s price change is
unrelated to yesterday’s or to that of any
other day.
Strong
 • The semi strong form of the EMH holds that
abnormally large profits cannot be consistently
earned using publicly available information. This
information includes not only past price and
Semi volume data but also data such as corporate
earnings, dividends, inflation, and stock splits. The
strong semi strong information set includes all the
EMH information publicly considered in a weak form, as
well as all other information publicly available.
Tests of the semi-strong form of the EMH are
basically concerned with the speed at which
information is disseminated to investors.
 • The strong form of the EMH holds that there is no
information, public or private, that allows investors to
consistently earn abnormal profits. It states that stock prices
immediately adjust to any information, even it isn’t available
to every investor. This extreme form of the EMH has not
received universal support.
Strong • One type of private information is the kind obtained by
Form corporate insiders, such as officers or directors of a
corporation. Corporate insiders may legally trade shares of
stock in their company, if they report the transactions to the
SEC each month. Other market participants occasionally have
inside-non public-information that they obtained illegally.
With this information, they can gain an unfair advantage that
permits them to earn an excess return.
Market Anomalies
• These are irregularities or deviations from the normal behavior in an
efficient market.

CALENDAR EFFECTS

• One widely cited anomaly is the so-called calendar effect which holds
that stock return may be closely tied to the time of the year or the time
of the week. That is, certain months or days of the week may produce
better investment results than others. For ex., the January effect shows
a seasonality in the stock market, with a tendency for small-stock prices
to go up during the month of January. The weekend effect is the result
of evidence that stock returns on average, are negative from the close of
trading on Fridays until the close of trading on Mondays.
SMALL-FIRM EFFECT

• Small-firm effect or size effect states that the size of the firm has a bearing on
the level of stock returns. Indeed, several studies have shown that small firms
earn higher returns than large firms , even after adjusting for risk and other
considerations.

EARNINGS ANNOUNCEMENT

• Earning announcement contain important information that should, and does,

affect stock prices. However, much of the information has already been
anticipated by the market, and so – if EMH is correct- prices should only react
to the “ surprise” portion of the announcement. Additionally, there is some
documentation that abnormally large profits can consistently be obtained by
buying stocks after unusually good quarterly earnings reports, and selling
stocks after unusually bad quarterly earnings reports.
P/E EFFECT
• According to the P/E effect, the best way to
make money in the market is to stick with stocks
that have relatively low P/E ratios. Studies have
shown that , on average, low P/E stocks
outperform high P/E stocks, even after adjusting
for risk and other factors. Since P/E ratio is a
public information, it should be fully reflected in
the current price, and purchasing low P/E stocks
should not produce larger profits, if the markets
are even reasonably efficient.
Behavioral factors that might influence the actions of
investor

Biased self-
Overconfidence Loss Aversion
attribution
 Behavioral factors

Representativenes Belief Narrow

s perseverance framing
 Behavioral finance at work in the Markets

• If investors systematically underreact or overreact to

some financial news, we may be able to detect
certain patterns in stock returns over time.
STOCK Predictability in stock prices can be measured by
looking at the correlation of stock returns in a given
RETURN period with those in later period.
PREDICT • Additional evidence of predictability in returns can
ABILITY be gleaned from a comparison of growth and value
of stocks. Growth stocks typically have high price-
earnings and price-book ratios, whereas value stocks
tend to have lower ratios.
 • Investor who believe they have superior
information tend to trade more, but earn lower
INVESTOR returns due to the higher transaction costs they
BEHAVIOR incur. In addition, investors tend to exhibit loss
aversion and therefore sell stocks that have recently
risen in price instead of those that have declined.

• Analyst come under fire for being too

ANALYST optimistic-that-is for too frequently issuing
BEHAVIOR buy recommendations and too rarely
suggesting that investors sell stocks.
Thank God bless
you. us all!!!