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CHAPTER 9

A Basic View of Technical Analysis


and Market Efficiency

FIN 320 Prof. Jim Mallett

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Learning Objectives
Understand the difference between fundamental and
technical analysis.
Understand how technical analysis is related to patterns
of stock price movement.
Explain the types of charting that are used in technical
analysis.
Describe the use of key indicator series in attempting to
track the direction of the market.
Explain the efficient market hypothesis and the various
forms it can take.
Relate the efficient market hypothesis to fundamental
and technical analysis.
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Technical Analysis
Technicians examine prior price and volume data to
determine past trends in the belief that they will help
forecast future ones.
Fundamental Analysis uses expectations of economic
conditions and company information to value an
asset (stock).
Technical analysis relies on charts and graphs of
internal market data.
Technicians believe that even when important
fundamental information is uncovered, it may not
lead to profitable trading because of timing
considerations and market imperfections.
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Assumptions of
Technical Analysis

Market value is determined solely by the interaction


of supply and demand.

It is assumed that there are minor fluctuations in the


market and stock prices tend to move in trends that
persist for long periods of time.

Reversals of trends are caused by shifts in demand


and supply.

Shifts in demand and supply can be detected sooner


or later in charts.

Many chart patterns tend to repeat themselves.

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The Use of Charting


Charles Dow, editor of the Wall Street Journal (WSJ) developed
the charting technique in the late 1890s.
The Dow Theory
There are three major movements in the market:
Daily fluctuations.
Secondary movements - covering two weeks to a month and
are only important to the extent they reflect on the long-term
primary trend in the market.
Primary trends which are either bullish or bearish in nature.
Analysts should not be confused by secondary movement.
New pattern of movement by the DJIA must be confirmed by
DJTA.
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Presentation of
the Dow Theory
(Figure 9-1)
Dow Jones Industrial Average

Primary trend

Secondary
trend
Secondary
trend

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Support and Resistance Levels

Support is a new price level at which new


demand comes into the market.
Resistance is a new price level at which supply
of the stock increases.

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Types of Charts

A bar chart shows the high and low price for a stock
with a horizontal dash to indicate closing price.
A point and figure chart emphasizes significant
price changes and the reversal of significant price
changes.

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Contrary Opinion Rule


Short Sales Position indicates that a large aggregate
number of short sellers is a bullish signal.
It is measured by the ratio of total short sales
positions on an exchange to average daily exchange
volume for the month.
A normal ratio is between 2.0 (bearish) and 5.0
(bullish). The ratio is published daily in the WSJ.
Also known as short interest ratio

Around the 20th of each month, WSJ reports on


total short sale figures.

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Contrary Opinion Rule

Investment Advisory Recommendations.


Investors Intelligence developed the Index of
Bearish Sentiment which suggests that when 60%
or more of the advisory services are bearish, you
should expect an upturn and when only 15% or
less are bearish you should expect a decline.
Published in the Market Laboratory - Economic
Indicators section of Barrons.

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Contrary Opinion Rule


Put/Call Ratio tells you to do the opposite of what option
traders are doing because their speculation is ill
conceived.
The ratio is normally around 0.60.
0.70 or higher

Pessimism by option traders

Buy Signal

0.40 or lower

Optimism by option traders

Sell Signal

Ratio can be found in the Market Week - Options


section of Barrons

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Overall Market Rules

Breadth of the market indicator attempts to measure what a


broad range of securities is doing as opposed to merely
examining a market average.
The technician compares the advance - declines with the
movement of a market average to determine if there is a
divergence between the two.
Advances and declines move in the opposite direction of
market averages at a market peak or bottom.

Breadth Index =

Net Advances or Declines


Number of Issues Traded

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Efficient Market Hypothesis


An efficient market is one in which new information is very rapidly
processed so that securities are properly priced at any given time.
Premise of an Efficient Market Hypothesis A large number of independent profit maximizing participants,
concerned with analysis and valuation of securities.
Information travels in a random independent fashion.
There is almost instantaneous adjustment to new information.
Consequently, no stock price can be in disequilibrium or
improperly priced for very long.
Prices are an unbiased reflection of all currently available
information. No one investor can consistently outperform the
market.
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Weak Form of Efficient


Market Hypothesis
Weak-form of EMH suggests that there is no
relationship between past and future prices and
trading volumes of securities.
Prices are presumed independent over time. There is
nothing to be gained from studying past data.
Tests of independence have examined the degree of
correlation between stock prices over time and found
the correlation to be consistently small (-.10 4 + .10)
and not statistically significant.

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Weak Form of Efficient


Market Hypothesis (continued)
Trading Rule Test
Example: If a stock moves up by $2 (or 10%) or more, the rule
might be to buy it. This supposedly represents a breakout and
should be bullish.
Can a trading rule beat a nave buy-and-hold approach?
Empirical research finds that in a limited number of cases, trading
rules may produce slightly positive returns, but after commissions
and risk are considered, the results are neutral and sometimes
negative.
Implications for Technical Analysis
Prices move independently over time, past trends cannot be used to
predict the future and that charting and technical analysis may have
limited value.
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Semistrong Form of the


Efficient Market Hypothesis
Semi-Strong form of EMH maintains that all public
information is already impounded in the value of a security and
therefore one cannot use fundamental analysis to determine
whether a stock is undervalued or overvalued.
There is no learning lag in the distribution of public
information.
Investors cannot earn superior returns by trading on public
information about stock splits, earning reports, asset sales,
capital restructuring, etc

Tests of semi-strong form of EMH are generally based on risk


adjusted returns.
Research shows that market is generally efficient in semistrong
form.
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Implications of Semi-Strong Form


EMH for Fundamental Analysis
It is very difficult (but not impossible) to earn abnormal
returns.

Although many would suggest that fundamental


analysis may not lead to superior profits in an efficient
market, it is fundamental analysis itself that makes the
market efficient.
Portfolio managers should decide on the desirable level
of risk for their clients and maintain that level of risk
by periodically rebalancing the portfolio, while
minimizing the costs associated with liquidity,
transactions and taxes.
Tests on the performance of mutual funds managers
have consistently indicated that they are not able to
beat the market averages over the long term.
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Market Anomolies

Evidence against semi-strong form EMH


Low P/E stock consistently provide higher returns
than high P/E stocks.
Small firms tend to provide higher returns than large
firms, after adjusting for risk.
Stock market returns are higher in January than rest
of the year.

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Strong Form of the


Efficient Market Hypothesis
Strong form of EMH states that stock prices reflect not
only public information but all information. It goes
beyond the concept of an efficient market to one that is
perfect.
Assumption: No group of investors has monopolistic
access to information.
Results of research do not support strong form of EMH.
Studies report that specialists average return on capital
exceeds 100%.
Insiders consistently achieve higher returns than would
be expected in a perfect capital market.
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