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Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
VU
Lesson # 8
TECHNICAL ANALYSIS
Technical analysis is entirely different from the fundamental approach to "security analysis".
Consider the following quotations from popular press articles on technical analysis:
"Engage a technical analyst in a conversation about his art, and you soon feel you're in the
shadowy saloon from Star Wars, where freakish aliens lounge about speaking strange languages."
"Spend some time with a technical analyst and you almost need a Technical-to-English
translation guide. Conversations art full of references to support and resistance levels, Fibonacci
retracements, double bottoms and moving averages."
Although the technical approach to common stock selection is the oldest approach (dating back to
the late 1800s), it remains controversial. The techniques discussed in this chapter appear at first
glance to have considerable merit, because they seem intuitive plausible, but they have been
severely challenged in the last three decades by evidence supporting the Efficient Market
Hypothesis. Despite Burton Malkiel's (a well - known proponent of efficient markets) admission
that "the market is not a perfect random walk," the-extensive evidence concerning the efficiency of
the market has challenged the validity of technical analysis and -the likelihood of its success.
Those learning about investments will in all likelihood be exposed to technical analysis,
because numerous investors, investment / advisory firms, and the popular press talk about it and use
it. Furthermore, it may produce some insights into dimension of the market. In fact, technical
analysis is becoming increasingly interrelated with behavioral finance, a popular field of study
today. In effect, technical indicators are being used to measure investor emotions.
Even if this approach is incorrect, many investors act as if it were correct. Therefore, the prudent
course of action is to study this topic, or indeed any other recommended approach to making
investing decisions, and try to make an objective evaluation of its validity and usefulness. At the very
least, an informed investor will be in a Better position to understand what is being said, or claimed,
and better able to judge the validity of the claims.
Although technical analysis can be applied to bonds, currencies and commodities as well as to
common stocks, technical analysis typically involves the aggregate stock market, industry sectors,
or individual common stocks.
What is Technical Analysis?
Technical analysis can be defined as the use of specific market-generated data for the analysis of
both aggregate stock prices (market indices or industry averages) and individual stocks. Martin J.
Pring, in his book Technical Analysis, states:
"The technical approach to investing is essentially a reflection of the idea that prices move in trends
which are determined by the changing attitudes of investors towards a variety of economic,
monetary, political and psychological forces. The art of technical analysis for it is an art is to identify
trend changes at an early stage and to maintain an investment posture until the weight of the evidence
indicates that the trend is reversed."
Technical analysis is sometimes called market or internal analysis, because it utilizes the record of
the market itself to attempt to assess the demand for, and supply of, shares of a stock or the entire
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Investment Analysis & Portfolio Management (FIN630)
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market. Thus, technical analysts believe that the market itself is its own best source of data--as
they say, "let the market tell its own story." The theory of technical analysis is that the price
movement of a security captures all the information about that security.
Economics teaches us that prices are determined by the interaction of demand and. supply.
Technicians do not disagree, but argue that it is extremely difficult to assess all the factors that
influence demand and supply. Since not all investors are in agreement on price, the determining
factor at any point in time is the net demand (or lack thereof) for a stock based on how many
investors are optimistic or pessimistic. Furthermore, once the balance of investors becomes
optimistic (pessimistic), this mood is likely to continue for the near term and can be detected by
various technical indicators. As the chief market technician of one New York firm says, "All I care
about is how people feel about those particular stocks as shown by their putting money in and taking
their money out."
Technical analysis is based on published market data as opposed to fundamental data, such as
earnings, sales, growth rates, or government regulations. Market data primarily include the price of
a stock or a market index and volume data (number of shares traded). Many technical analysts
believe that only such market data, as opposed to fundamental data, are relevant. For example, they
argue that accounting data are subject to all types of limitations and ambiguities, an argument.
Recall that in fundamental analysis, the dividend discount model and the multiplier mode produce
an estimate of a stock's intrinsic value, which is then compared to the market price.
Fundamentalists believe that their data, properly evaluated, can be used to estimate the intrinsic
value of a stock. Technicians, on the other hand, believe that it is extremely difficult to estimate
intrinsic value and virtually impossible to obtain and analyze good information consistently. In
particular, they are dubious about the value to be derived from an analysis of published financial
statements. Instead, they focus on market data as an indication of the forces of supply and demand
for a stock or the market.
Technicians believe that the process by which prices adjust to new information is one of a gradual
adjustment toward a new (equilibrium) price. As the stock adjusts from its old equilibrium level to
its new level, the price tends to move in a trend. The central concern is not why the change is
taking place, but rather the very fact that it is taking place at all. Technical analysts believe that
stock prices show identifiable trends that can be exploited by investors. They seek to identify
changes in the direction of a stock and take a position in the stock to take advantage of the trend.
The following points summarize technical analysis:
1. Technical analysis is based on published market data and focuses on internal factors by
analyzing movements in the aggregate market, industry average, or stock. In contrast,
fundamental analysis focuses on economic and political factors, which are external to
the market itself.
2. The focus of technical analysis is on identifying changes in the direction of stock prices which
tend to move in trends as the stock price adjusts to a new equilibrium level. These trends
can be analyzed, and changes in trends detected, by studying the action of price
movements and trading volume across time. The emphasis is on likely price changes.
3. Technicians, attempt to assess the overall situation concerning stocks by analyzing
technical indicators, such as breadth of market data, market sentiment, momentum, and
other indicators.
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Investment Analysis & Portfolio Management (FIN630)
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Perhaps the bottom line can be stated as: Stock prices (either for the market or individual stocks)
tend to move in trends, and these trends take time to unfold. Such trends can be spotted by careful
analysis, and acted upon by buying and selling.
A framework for Technical Analysis:
Technical analysis can be applied to both an aggregate of prices (the market as a whole or industry
averages) and individual stocks. Technical analysis includes the use of graphs (charts) and
technical indicators.
Price and volume are the primary tools of the pure technical analyst, and the chart is the most
important mechanism for displaying this information. Technicians believe that the forces of
supply and demand result in particular patterns of price behavior, the most important of which is
the trend or overall direction in price. Using a chart, the technician hopes to identify trends and
patterns in stock prices that provide trading signals.
Volume data are used to gauge the general in the market and to help assess its trends. The evidence
seems to suggest that rising (falling) stock prices are usually associated with rising (falling)
volume. If stock prices rose but volume activity did not keep pace, technicians would be skeptical
about the upward trend. An upward surge on contracting volume would be particularly suspected.
A downside movement from some pattern or holding point accompanied by heavy volume would
be taken as a bearish sign.
We first consider stock price and volume technique, often referred to as charting. However,
technical analysis has evolved over time, so that today it is much more than the charting of
individual stocks or the market. In particular Technical indicators are used to assess market
conditions (breadth) and investors' sentiments. It also includes "contrary analysis" which is an
intellectual process more than a technique. The idea behind contrary is go against the crowd when
those in the crowd start thinking alike.
Charts of Price Patterns:
To assess individual stock-price movements, technicians generally rely on charts or graphs of
price movements and on relative strength analysis. The charting of price patterns is one of the
classic technical analysis techniques. Technicians believe that stock prices move in trends, with
price changes forming patterns that can be recognized and categorized. By visually assessing the
forces of supply and demand, technicians hope to be able to predict the likely direction of future
movements. The most basic measure of a stock's direction is the trendline, which simply shows
the direction the stock is moving. If demand is increasing more rapidly than supply and the stock
shows successively higher low points, it is in an uptrend. Consistently lower highs indicate that
supply is increasing more rapidly, and the stock is in a downtrend. Obviously, investors seek to buy
in an uptrend and sell on a downtrend.
Technicians seek to identify certain signals in a chart of stock prices, and use certainly terminology
to describe the events. A support level is the level of price (or, more correctly, a price range) at which
a technician expects a significant increase in the demand for a stock. In other words, a lower bound
on price where it is expected that buyers will act, supporting the price and preventing additional price
declines. A resistance level, on the other hand, is the level of price (range) at which a technician expects
a significant increase in the supply of a stock. In other words, an upper bound on price where sellers are
expected to act, providing a resistance to any further rise in price.
Support levels tend to develop when profit taking causes a reversal in a stock's price following an
increase; investors who did not purchase earlier are now willing to buy at this price, which becomes a
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Investment Analysis & Portfolio Management (FIN630)
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support level. Resistance levels tend to develop after a stock declines from a higher level. Investors are
waiting to sell the stocks at a certain recovery point. At certain price levels, therefore, a significant
increase in supply occurs, and the price will encounter resistance moving beyond this level.
As noted, a trendline is a line drawn on a chart to identify a trend. If a trend exhibits support and
resistance levels simultaneously that appear to be well defined, the trend lines are referred to as
channel lines, and price is said to move between the upper channel line and the lower channel line.
Momentum is used to indicate the speed with which prices are changing, and a number of measures
of momentum exist, referred to as momentum indicators. When a change in direction occurs in a
short-term trend, technicians say that a reversal has occurred. A correction occurs when the reversal
involves only a partial retracing of the prior movement. Corrections may be followed by periods of
consolidations with the initial trend resuming following the consolidation..
Technical analysts rely primarily on line charts, bar charts, and point-and-figure charts, although
other types of charts are also used, such as candlestick charts.
Bar Charts:
One of the most popular charts in technical analysis bar charts, are plotted with price on the vertical axis
and time on the horizontal axis. Each day's price movements is represented by a vertical bar whose top
(bottom) represents the high (low) price for the day.
(A small, horizontal tick is often used to design the closing price for the day). The bottom of a bar chart
usually shows the trading volume for each day, permitting the simulations observation of noth price and
volume activity. The Wall Street Journal carries a bar chart of the Dow Jones Averages each day on the
page with New York Stock Exchange (NYSE) quotations.
The technician using charts will search for patterns in the chart that can be used to predict future price
moves. The strong uptrend occurring over period of months. This trend ended with a rally on high
volume that forms parts of the left shoulder of a famous chart pattern called a Head and Shoulders
patterns.
The left shoulder shows initially strong demand followed by a reaction on lower volume (2), and then a
second rally, with strong volume; carrying prices still higher (3). Profit taking again causes prices to fall
to the so-called neckline (4), thus completes the left shoulder. A rally occurs, but this time on low
volume, and again prices sink back to the neckline. This is the head (5). The last step is the formation of
the right shoulder, which occurs with light volume (6). Growing weakness can be identified as the price
approaches the neckline. As an be seen, a downside breakout occurs on heavy volume, which
technicians consider to be sell signal.
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Investment Analysis & Portfolio Management (FIN630)
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Technicians have considered a very large number of such patterns. Some of the possible patterns include
flags, pennants, gaps (of more than one type), triangles of various types (e.g., symmetrical, ascending,
descending, and inverted), the inverted saucer or dome, the triple op, the compound fulcrum, the rising
(and falling) wedge, the broadening bottom, the duplex horizontal. Rectangles, and the inverted V.
Obviously, numerous patterns are possible and can usually be found on a chart of stock prices. It is also
obvious that most, if not all, of these patterns are much easier to identify in hindsight than at the time they
are actually occurring.
Point-and-Figure Charts:
Technicians also use point-and-figure charts, types of charts are more complex in that they show
only significant price changes, and volume is not shown at all. The user determines what a
significant price change is and what constitutes a price reversal {$2, $3, $4, and so forth).
Although the horizontal axis still depicts time, specific calendar time is not particularly
important with the passage of time is basically ignored. (Some chartists do show the month in
which changes occur.)
These are the most important price patterns for investors who want to temper their hunches
and the timing of their buy and sell decisions with solid empirical data.
An X is typically used to show upward movements, whereas an O is used for downward
movements. Each X or O on a particular chart may represent Rs. 1 movements, Rs. 2
movements, Rs. 5 movements, and so on, depending on how much movement is considered
significant for that stock. An X or O is recorded only when the price moves by the specified amount.
Moving Average:
A Moving Average is a smoothed presentation of underlying historical data. Each data
point is the arithmetic average of a portion of the previous data. A ten-day moving average
measures the average over the previous ten days. Regardless of the time period used, each
day a new observation is included in the calculation and the oldest is dropped, so a constant
number of points are always being averaged.
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Investment Analysis & Portfolio Management (FIN630)
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Advocates of moving average in the stock selection believe that changes in the slope of the
line are important. A stock whose twenty-day moving average has been trending up might
become a candidate for sale if the line turns downward.
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