Chapter 18    Technical Analysis

OPEN QUESTIONS

1. Using the S&P 500 index, calculate the monthly relative strength ratios for the steel
industry (index provided) and for the ABC Steel Company (prices provided).
Month S&P 500 Steel Industry ABC Steel
January 1,300 563 129
February 1,290 540 127
March 1,305 545 127
April 1,310 570 135

Answer:
Month Steel Ind/S&P 500 ABC Steel/S&P
January 563/1,300 = 0.433 * 129/1,300 = 0.099
February 540/1,290 = 0.419 127/1,290 = 0.098
March 545/1,305 = 0.418 127/1,305 = 0.094
April 570/1,310 = 0.435 135/1,310 = 0.103
* Rounded to 3 decimals

2. The daily prices for Delphi Company are given below. Complete the point-and-figure
chart that identifies $1 price changes for Delphi Company.
Day Price Day Price
1 $52 11 $53
2 53 12 52
3 53 13 51
4 54 14 49
5 57 15 52
6 54 16 53
7 53 17 54
8 50 18 55
9 52 19 55
10 52 20 56

Answer:
The point-and-figure chart for Delphi Company follows.

58
57 X
56 X O X
55 X O X
54 X O X
53 X O X X
52 O X O X
51 O X O X
50 O O X
49 O
48
47
Chapter 18    Technical Analysis

3. Given the following data, construct the advance-decline line. The advance-decline
line of day zero is 2,222.

Advancing Declining Issues

Day Issues
1 1,389 1,884
2 2,082 764
3 995 2,100
4 1,800 1,045
5 2,225 437
6 2,117 840
7 1,654 1,114

Answer:
The advance-decline line for day t is ADLt = At – Dt + ADLt-1.

Advancing Declining
Day Issues Issues ADLt
1 1,389 1,884 1,727
2 2,082 764 3,045
3 995 2,100 1,940
4 1,800 1,045 2,695
5 2,225 437 4,483
6 2,117 840 5,760
7 1,654 1,114 6,300

4. Consider the following data.

Day New 52-Week New 52-Week Lows Market

Highs I
n
d
e
x
1 170 30 108
2 102 52 118
3 133 40 122
4 100 48 124
5 93 198 130

As a technical analyst, would you recommend that your clients increase or decrease
their proportions of wealth invested in the stock market?
Chapter 18    Technical Analysis

Answer:
The ratio of issues hitting new 52-week highs to issues hitting new 52-week
lows is taken as an indication of the overall market’s strength. For example, if
the overall market performs well, but the ratio of new highs to new lows is
small, technical analysts believe that the market will not sustain its good
performance because the good results are driven by a few stocks instead of the
market as a whole. Let’s calculate the ratio of new highs to new lows for each
day.

Ratio of New Highs to

Day New Lows Market Index
1 5.67 108
2 1.96 118
3 3.33 122
4 2.08 124
5 0.47 130

Since the ratio is declining while the market rises, technical analysis suggests
that the market cannot continue to post gains for very long. You should advise
your clients to avoid stocks.

5. The following stock price data are for General Electric.

Day Open High Low Close

1 $88.94 $89.88 $87.88 $87.88
2 88.50 89.93 87.81 89.38
3 86.25 87.50 85.69 87.31
4 88.06 89.19 87.50 87.81
5 89.94 90.31 87.75 88.13
6 86.75 89.19 86.69 88.81
7 85.94 88.44 85.50 86.75
8 90.69 90.69 85.44 85.44
9 88.69 91.06 88.63 89.50
10 91.31 92.69 88.06 89.31
11 90.25 91.94 90.06 91.31
12 91.50 91.75 89.25 89.50
13 91.69 92.25 89.63 90.81
14 90.81 92.75 90.38 92.00
Construct a bar chart for GE. Using the first six data points, add a trend line. Is the
trend up or down?

Answer:
The bar graph is given below. The first six data points reveal an up trend.
Chapter 18    Technical Analysis

Bar Chart for General Electric

$94
$92
$90
$88
Price

$86
$84
$82
$80
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Day

6. Use the GE data from the preceding problem to construct a candlestick chart.

Answer:
The candlestick chart for GE appears below.

Candlestick Chart for GE

$94

$92

$90

$88
Price

$86

$84

$82

$80
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Day
Chapter 18    Technical Analysis

7. For the GE data in Question 5, calculate the 5-day moving average closing price.

Answer:
The moving average is calculated as in Exhibit 18-11.

Day Close Five-day Total Five-day Moving

(A) Average (A/5)
1 $87.88
2 89.38
3 87.31
4 87.81
5 88.13 $440.51 $88.10
6 88.81 441.44 88.29
7 86.75 438.81 87.76
8 85.44 436.94 87.39
9 89.50 438.63 87.73
10 89.31 439.81 87.96
11 91.31 442.31 88.46
12 89.50 445.06 89.01
13 90.81 450.43 90.09
14 92.00 452.93 90.59

8. Using data from the preceding problem, graph the moving average and daily closing
prices on the same chart. Use a bar chart to represent closing prices and a line to
represent the moving average.

Answer:
The moving average chart appears below.

Moving Average Chart for GE

$94
$92
$90
Closing Price
Price

$88
5-day Moving Average
$86
$84
$82
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Day

9. Describe moving averages.

Chapter 18    Technical Analysis

Answer:
A simple moving average is built by taking the arithmetic average of a stock
price over the past predetermined number of days and graphing these results
over a period of time. If a security or index is above its moving average, then
the security should rise, and if it is below its moving average, then the security
should fall. Many technical analysts use moving averages in an attempt to
identify the primary, intermediate, and short-term trends.

10. How do technical analysts use charts to make inferences about future prices?

Answer:
Technical analysts plot market data on charts, such as bar charts, point-and-
figure charts, and candlestick charts. The charts display historical information
that enables technical analysts to extrapolate trends into the future.

11. Describe the candlestick chart.

Answer:
The candlestick chart was developed in Japan and only became popular in the
United States recently. Each observation on a candlestick chart is based on a
day’s opening, high, low, and closing prices. For each day, the chart contains a
candlestick line, which has two parts. The real body is the broad part
consisting of the difference between the opening and closing prices, and the
shadows are the vertical thin line above and below the real body. If the opening
price is above the closing price, then the real body is shaded dark. If the
opening price is below the closing price, then the real body is not shaded.
Technical analysts use candlestick charts to determine trends and to observe
when these trends will reverse themselves.

12. Compare and contrast technical analysis and fundamental analysis.

Answer:
Fundamental analysis is based on economic factors like the firm's earnings,
the firm's growth rate of dividends, the cash available, the P/E ratio, the
strength of the firm's balance sheet, and so forth. Technical analysis, on the
other hand, is based on historical technical figures of the firm or the whole
economy; for example, the amount of short selling, the volume of trading, past
price behavior, and so forth.
Technical analysis could be beneficial only if the market is not weak-form
efficient, whereas fundamental analysis could be beneficial only if the market
is not semi-strong form efficient. Thus, if the market is weak-form efficient and
not semi-strong form, then technical analysis would not be worthwhile when
fundamental analysis would be beneficial.

13. What is the assumption on which technical analysis is typically built?

Chapter 18    Technical Analysis

Answer:
The underlying premise of technical analysis is that financial prices are
determined by investors' attitudes. Investors' attitudes are influenced by a
wide variety of factors, some of which are rational and some of which are
irrational. Hence, formal rational models of financial prices will never fully
reflect or explain the behavior of financial prices. However, technical analysts
assume that human nature is fairly static. That is, when investors face similar
situations as have been faced by investors in the past, the modern investors will
behave in a similar fashion. Therefore, the study of historical price patterns and
relationships with other variables will give clues as to how market participants
will behave in the future. Implicitly, technical theories assume that the market
is inefficient in the weak-form sense.

14. Classify each of the following activities as either technical analysis or fundamental
analysis.
a. Examining the "quality" of earnings.
b. Computing a percentage balance sheet.
c. Calculating the relative strength of the basic materials sector.
d. Identifying an up trendline on a bar chart.
e. Examining the debt/equity ratio of a firm.
f. Calculating the put/call ratio.

Answer:
The following outlines the classification of each activity:

Activity Classification
a Quality of Earnings Fundamental
b Percentage Balance Sheet Fundamental
c Relative Strength of Basic Technical
Materials Sector
d Up Trendline on a Bar chart Technical
e The Debt Ratio of a Firm Fundamental
f The Put/Call Ratio Technical

15. "All empirical research suggests that technical analysis is totally useless:' Evaluate this
statement.

Answer:
This statement is false. Recently, researchers have discovered patterns in
security prices. For example, Lehmann' found that "the `winners' and `losers'
during one week will experience sizeable return reversals the next week in a
way that reflects apparent arbitrage profits that persist after corrections for
Chapter 18    Technical Analysis

bid-ask spreads and plausible transaction costs. This probably reflects

inefficiency in the market for liquidity around large price changes."

Jegadeesh also found predictable patterns in stock prices for monthly returns
over a long time period (1934-1987). Specifically, Jegadeesh found strong
evidence that the stocks with large losses in one month are likely to experience
a significant reversal in the next month. Also, stocks with large gains in one
month are likely to experience a significant loss in the next month. Brown and
Jennings construct a theoretical framework in which rational investors will
use technical analysis.

16. Can a technical pattern that is statistically significant be economically insignificant?

Explain.

Answer:
Recall a pattern is said to be economically significant if it is profitable after
adjusting for bid-asked spreads and other transaction costs. Thus, it is
possible that a certain technical pattern produces statistically significant
returns, but when put into practice fails to generate additional returns due to
transaction costs.

17. Assuming that the advance-decline line for stocks in the NYSE Composite had a
value of 1.237 on Day 0, calculate the advance-decline line for each of the
following days. (Complete the table, and discuss your results.)

Day Index Advancing Declining

Value Issues Issues
0
1 250.13 1,055 1,199
2 248.37 1,757 580
3 251.87 1,143 1,194
4 252.11 757 1,410
5 253.98 969 1,197
6 254.54 722 1,418
7 255.01 938 1,193
8 254.39 906 1,260
9 257.72 645 1,460
10 260.18 862 1,230

Answer:
The advance-decline line is the number of advancing issues less the number
of declining issues on a particular day plus the cumulative total from the
previous day (so trends can be monitored). The table can be completed as
follows:
Chapter 18    Technical Analysis

Day Index Advancing Declining Advance-

Value Issues Issues Decline
0 Line
1,237
1 250.13 1,05 1,199 1093
2 248.37 1,75 5 580 2270
3 251.87 1,14 7 1,194 2219
4 252.11 757 1,410 1566
5 253.98 969 1,197 1338
6 254.54 722 1,418 642
7 255.01 938 1,193 387
8 254.39 906 1,260 33
9 257.72 645 1,460 -782
10 260.18 862 1,230 -
1150
Thus, we see the pattern of a declining advance-decline line in a rising stock
market. Many technical analysts view this as an indication that the market
will fall.

18. Suppose the beta of a stock is 1.0, and the average rate of return over the past 20 years
of the market portfolio was 12%. A technical analyst claims to have a method
that signals buy and sell decisions. Over 10 years, she has made on average a
return of 15% by trading in this stock.
a. In your view, does the technical analyst have a method with which to buy and
sell successfully?
b. How would you change your answer if the beta of the stock is 2.0 and the risk-
free interest rate is 4%?
Answer:
a. Yes, the chartist has proved an average rate of return that is above normal.
If the beta of the stock is 1, the average rate of return should be similar to
the market portfolio only 12%. That means that the chartist has made an
abnormal performance, or an extra average return of 3%.
b. No, if the beta is 2 and the risk-free interest rate was 4%, the expected rate
of return should be E(R) = r + [E(R,~)-r]R = 4+(12-4)2 = 20%.
Because the chartist's average return is only 15%, his performance is
under average. There is a negative abnormal return.

19. Suppose we are given the following data on advancing issues and declining issues:

Day Advancing Declining

Issues Issues

1 1,086 509
2 854 1,237
3 966 902
4 1,234 792
5 950 1,189
Chapter 18    Technical Analysis

Assuming that the advance-decline line had a value of 1,887 on Day 0, calculate the
advance-decline line for Days 1 through 5.

Answer:
The advance-decline line on day 1 is
ADL I = A 1 - D 1 + ADL0 = 1,086 - 509 + 1887 = 2,464
where ADL is the advance-decline line, A is the advancing issues, and D is the
declining issues. The following table provides the remaining calculations.

Day Advancing Declining Advance-

Issues Issues Decline
Line
0 1,887
1 1,086 509 2,464
2 854 1,23 2,081
3 966 7
902 2,145
4 1,234 792 2,587
5 950 1,18 2,348
9

20. Suppose we are given the following information on new highs and new lows in the
market:

Day New High New Low

1 70 20
2 80 10
3 60 30
4 85 15
5 100 8

a. Assess the breadth of the market each day.

b. Suppose the market was rising during these days. Would you buy or sell the
stocks?
Chapter 18    Technical Analysis

Answer:
a. Breadth is typically measured as the ratio of new highs to new lows.
Breadth is computed for these five days as follows:

Day 1 2 3 4 5
New Highs 70 80 60 85 100
New Lows 20 10 30 15 8
Breadth 70/20= 3.5 80/10 = 8 60/30= 2 85/15= 5.67 100/8= 12.5
b. There really is no clear pattern on the direction of the breadth indicator, so
no distinct buy or sell decision can be made.

21. A specialist short position in Xerox stock is as follows:

Day Position
1 1,000
2 1,200
3 1,300
4 1,800
5 2,000

Would you buy or sell the stock based on this information alone? Why?

Answer:
Given the data in the question, we can conclude that the specialist is increasing
his short sales. The specialist typically has superior information regarding a
stock so this is a signal that the stock may decline. Therefore, it indicates a sell
recommendation.

22. Suppose you had the following information on the volume of put and call option
trading:

Day Put Volume Call Volume

1 1.32 0.95
2 1.03 0.99
3 0.98 1.30
4 0.99 1.20
5 0.95 1.35

Compute the put/call ratio. What would you conclude based on this technical index?

Answer:
The put/call ratio is computed as the ratio of put volume to call volume as
illustrated in the following table. Given the data in the question, we can see
Chapter 18    Technical Analysis

that there is a decline in the put/call ratio. This signals that the stock market is
rising.

Day 1 2 3 4 5
Put Volume 1.32 1.03 0.98 0.99 0.95
Call Volume 0.95 0.99 1.30 1.20 1.35
Put/Call Ratio 1.32/0.95= 1.03/0.99= 0.98/1.3= 0.99/1.2= 0.95/1.35=b
1.389 1.04 0.75 0.825 0.7

23. The following table summarizes one measure of market sentiment as of January 19, 1998:
Investors' Intelligence
Last Two Weeks Three Weeks
Week Ago Ago
Bulls 46.3% 45.9% 47.6%
Bears 35.0 36.9 35.2
Correction 18.7 17.2 17.2

Source: Barron's, June 19, 1998, p. MW107.

Explain the bulls-bears sentiment. What can be learned from changes in the
proportions of bulls and bears? Analyze the changes in these proportions as given
in the table.

Answer:
Looking at the percentage of bulls and bears, we may conclude that the
market is slightly bullish, because 46.3% are bulls and only 35.0% are bears.
If we study the changes, we see that the percentage of bulls slightly decreased
from three weeks ago and then slightly increased last week. There is no
substantial change over the last three weeks, however. Therefore, we can
conclude that the market tends to be bullish, though the tendency is not
strong, with no significant change in the last three weeks. However, if we count
the correction class as bullish (although not strongly so), the bull market
tendency is a little stronger.