Chapter 16

Charles P. Jones and Gerald R. Jensen,

Investments: Analysis and Management,
13th Edition, John Wiley & Sons

16-1
 Use of published market data to analyze both
aggregate and individual firm stock prices
◦ Not based on firm fundamentals
◦ Market data includes price and volume data
 May produce insight into the psychological
dimensions of the market
 Technical analysts often believe that it’s
extremely difficult to estimate intrinsic value

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Technical Analysis Framework
 Technicians believe that supply and demand
produce price patterns
 Charting
◦ Using charts to analyze price and volume data
◦ Trading signals are identified from price
patterns
◦ Volume data used to gauge market conviction
behind price moves
 Technical analysis has evolved to include
other techniques

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 Oldest and best-known theory of technical
analysis
 Based on three types of price movements
◦ Primary move: broad market move, lasts several years
◦ Secondary moves: occur within primary move
◦ Day-to-day moves: occur randomly around primary
and secondary moves
 Bull (bear) market refers to upward (downward)
primary move

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 Bull market exists when successive rallies
penetrate previous highs
◦ Declines remain above previous lows
 Bear market exists when successive rallies fail
to penetrate previous highs
◦ Declines penetrate previous lows
 Secondary moves called technical corrections
 Day-to-day “ripples” are of minor importance

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 Intended to forecast the start of a primary
movement
◦ Does not tell how long movement will last
 Subject to a number of criticisms
◦ Studies have not confirmed its success
 Several versions available
◦ Can predict different, even conflicting
movements

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 Secondary reactions
P
r
i
c
es
Abortive
recovery Penetration of
Primary trend previous low

Time

16-7
 Price changes can be recognized and
categorized
 Trendline: identifies a trend or direction
 Support level: price level at which a significant
increase in demand for stock is expected
 Resistance level: price level or range at which
significant increase in supply is expected
 Momentum: indicates speed of price changes

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 Bar Chart
◦ Price on vertical axis, time on horizontal
◦ Vertical bar’s top (bottom) represents the high
(low) price of the day
 Candlestick adds open and close price
 Point-and-Figure Chart
◦ Compresses price changes into small space
◦ X (O) used to indicate significant upward
(downward) movement

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 Used for analyzing both the overall market
and individual stocks
 Used specifically to detect both the
direction and rate of change
◦ New value for moving average calculated by
dropping earliest and adding latest observation
◦ Comparison to current market prices produces
buy or sell signal
 Show what prices have done, not what they
will do

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 Ratio of price to index value or price to past
average price
◦ Ratios plotted to form graph of relative price
across time
◦ Rising (falling) ratio indicates relative
strength (weakness)
◦ Can also be used to analyze industries
◦ What if overall market is weak?
◦ What if stock declining less than the market?

16-11
 Advance-Decline Line
◦ Measures the net difference between number
of stocks advancing and declining
◦ Plot of running total across time is compared
to a stock average to analyze any divergence
 Divergence implies trend changing

 Number hitting new highs (lows)

 High trading volume regarded as bullish

16-12
 Short interest is number of stocks that have
been sold short but not yet bought back
 Short interest ratio:
◦ Total short interest/Ave. daily volume
◦ Indicates number of days needed to “work
off” the short interest
 Short interest figures may be distorted

16-13
 Contrary investing
◦ Acting in opposite way of most investors
◦ Many technicians take a high short interest
ratio as a bullish sign
 The more shares sold short, the more shares
that must eventually be re-purchased
◦ Mutual fund liquidity
 If funds fully invested (low on cash), contrarians
sell
 If funds mostly liquid, contrarians buy

16-14
 Bearish sentiment index
◦ Ratio of advisory services bearish to total
number with an opinion
◦ When at 55 to 60% (20%), bearish (bullish)
attitude indicated
◦ Advisory services assumed wrong at extremes
 Services may follow trends rather than forecast
them

16-15
 Speculators buy calls (puts) when stock
prices expected to rise (fall)
 Relatively high (low) ratio indicates investor
pessimism (optimism)
◦ Contrarians buy (sell) when investors are
pessimistic (optimistic)
◦ Extreme readings (below .45 or above .8)
convey trading information
 Exact trigger levels subject to debate

16-16
Trading Rule Bullish Bearish
Cash holdings High Low
VIX High Low
IPO/SEO activity Low High
Opinion polls Pessimistic Optimistic
Put/Call ratio High Low
Short interest High Low
Margin debt Low High
 What constitutes a fair test of a technical
trading rule?
◦ Risk considerations
◦ Include transaction and other costs
◦ Consistency in performance
◦ Out-of-sample validation
 Filter rule tests
◦ Trades based on price changes greater than
predetermined filter

16-18
Efficiency and Evidence
 Efficient market hypothesis (EMH) poses
major challenge to technical analysis
◦ Many tests suggest technical analysis does not
produce superior returns when risk and costs
accounted for
 Academic studies generally do not indicate
technical analysis works
 Some research supports merits of technical
analysis

16-19
 Thorough tests of technical analysis
typically have failed to confirm its value
 Efficient markets argue against likelihood of
profits
 Several interpretations of technical tools
and chart patterns are common
 Successful rules self-destruct as they gain
popularity

16-20
 Strong evidence exists suggesting that
stock market is weak-form efficient
 Impossible to test all techniques of
technical analysis
 Technical analysis remains popular with
many investors
◦ Should be combined with fundamental
analysis, if used

16-21
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