12.Technical Analysis
12.1.Introduction
This is a broad introduction to
technical analysis, the philosophy or assumptions made by technical analysts,
and the challenges to their work. Technical analysts differ from fundamental
analysts in that they believe prices are driven by both rational and irrational
factors. The Reading also looks at the signals technical analysts use to
indicate that the market or an individual security price is moving into a new
trend.
Technical analysis involves examining
past trading prices and volume data to identify trends that can be used to
predict future market and security price movements.
12.2.Assumptions of technical analysis
The assumptions made by technical
analysts include:
Prices are decided by supply and demand.
Supply and demand are driven by rational and irrational
behaviour.
Prices move in trends that persist for long periods of time.
The shifts in supply and demand can be seen in market price
behaviour.
The main difference between
fundamental analysts, technical analysts and followers of EMH is in the time
that they believe security prices take to react to news. EMH says that prices
react almost immediately to news, fundamentalists believe there is a little
longer to make decisions and technical analysts believe that it takes time for
a new equilibrium price to be established.
Technical analysts also believe that
new information that affects supply and demand comes into the market over a
period of time rather than at one specific point in time.
12.3.Advantages of technical analysis
There is no need to analyze financial statements and adjust
accounting data for different accounting methods.
Technical analysis incorporates psychological and fundamental
reasons for price moves.
Technical analysis signals buys and sells without needing to
justify why other investors are buying and selling.
Technical analysts have more time to decide whether a new
trend for a stock price is being established.
12.4.Challenges to technical analysis
Results of testing correlations between prices and runs and
the use of trading rules, with respect to the weak-form Efficient Market Hypothesis,
have shown that technical analysis based on past market data does not provide
superior performance.
If sufficient technical analysts are operating in a market
then they will drive price moves.
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This will lead to technical analysis working, but only in the
short term, since if a price move is not based on fundamentals the price will
return to its equilibrium.
If a trading rule is found to be successful, several
technical analysts would follow the rule so it is unlikely to continue to
generate profits.
Trading rules are subjective. Different analysts will reach
different conclusions when presented with the same market data.
When referring to technical analysts
it is important to differentiate between:
1. Contrarians who believe that as the
market approaches peaks and troughs, investors will generally become
over-bullish or bearish, and
2. Analysts who follow
the smart money; they wish to follow the positive sentiment of
sophisticated investors.
12.5.Contrary-opinion
technical analysts
This group of analysts uses the
following indicators to assess what the majority of investors are doing, and
then take the opposite view.
1. Mutual fund cash positions. The percentage held in
cash varies between about 5 and 13%. Contrary-opinion analysts believe that
mutual funds generally have a high percentage of cash near the trough of
markets so a high cash position is read as a bullish indicator. On the other
hand a low cash position would be seen as a bearish indicator.
2. Investor credit balances
in brokerage accounts. Investors sell stocks and leave the cash balances in
brokerage accounts if they expect to reinvest the money in the short term. Therefore
if the credit balances increase it is seen as a build up of purchasing power
and is a buy signal. Alternatively a decline in credit balances is a sell
signal.
3. Investor advisory opinions. Based on the view that
most investment advisors are trend followers therefore if the bearish
sentiment index (bearish opinions/total opinions) is more than 60% this would
be seen by technicians as a bullish indicator and if it were lower than 20%
technicians would see it as a bearish indicator.
4. OTC volume versus NYSE
volume.
OTC trading is considered to be speculative compared to NYSE trading and the
percentage of speculative trading is highest at market peaks.
5. Put/Call Ratio. A high ratio is read by
technicians to be a bullish indicator, and a low ratio a bearish indicator.
6. Futures traders bullish or
bearish.
Technical analysts will look at the percentage of speculators in stock index
futures who are bullish or bearish and then take the opposite view.
12.6. Follow
the smart money
Technical analysts who wish to follow
the smart money use the indicators below:
1. Confidence Index. This is published by
Barrons and is the average yield on the 10 top grade corporate bonds divided
by the yield on the Dow Jones average of 40 bonds (with a lower average credit
quality). The ratio will be high, approaching 100, when investors are confident
and relatively happy to invest in lower grade bonds.
2. T. Bill - Eurodollar Yield
Spread.
When the spread is large, typically at times of international crisis, it shows
that investors are keen to invest in Treasury bills as a safe haven investment.
3. Debit balances in
brokerage accounts. These represent margin borrowing. An increase could be read
as a bullish sign, a decrease as a bearish sign.
12.7.Other indicators
These are often used to obtain a view
of overall market sentiment by technical analysts.
1. Breadth of Market. This measures the number
of securities that have risen versus the number that have declined. This can be
measured by following the advance-decline series which is the net advances, or
declines, relative to the market to see if they move in the same direction. If
they move together is shows that the market move is broadly based, if not, it
indicates that the market is near a peak or trough.
2. Short interest ratio. This is equal to the outstanding
short interest/average daily trading volume. A high ratio is considered bullish
since potentially the short sellers will need to buy back stock in the market.
3. Share prices relative to
moving average. If more than 80% of stocks are above the 200- day moving average then
the market is overbought. If less than 20% of stocks are above the 200-day
moving average then the market is oversold.
4. Block uptick - downtick
ratio.
This is an indicator of institutional sentiment. A low ratio indicates an
oversold market and a high ratio indicates an overbought market.
12.8.Price
and volume analysis
Dow Theory. Prices move in major, intermediate and short-term trends.
Followers are hoping to identify the major trends. A major upward trend may be
broken by intermediate downward trends but if each peak was higher than the
last and upward moves are accompanied by high volumes this would be seen as a
bullish signal.
Support and resistance levels are useful in determining price
trends. A support level is the price range at which a substantial
increase in demand for the stock is expected which will reverse a declining
trend. A resistance level is the price range at which a substantial
increase in supply of the stock is expected which will reverse a rising trend.
Moving-average lines. When moving-average lines cross, it
can signal a reversal in trend.
Relative strength. Technicians believe that if a stock
or industry is outperforming the market it will tend to continue to do so.
Charts
Analysts who are looking for repetition
of past trends often use charts; the charts used include bar charts and
point-and-figure charts.
Technical analysis of bond markets
Similar trading rules used for bonds
are used in equity markets. One problem with bonds is that, since trading is
mainly OTC, volume data is not available.