Technical Analysis Lec3-Investment Managment And Portfolio-Lecture Notes, Study notes of Investment Management and Portfolio Theory

Download Technical Analysis Lec3-Investment Managment And Portfolio-Lecture Notes and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 10 TECHNICAL ANALYSIS Contd… Dow Theory: Charles Dow was one of the founders of Dow Jones & Co. (DJ, NYSE), publisher of The Wall Street Journal. He is sometimes credited with being the inventor of the point and figure chart. The Dow Theory holds that there are three components in the movement of stock prices. The primary trend is the long-term direction of the market and is the most important. The terms bull and bear originated with the direction of Dow Theory primary trend. The secondary trend refers to a temporary reversal in the primary trend, one that does not persist long enough to become the primary trend. Finally, daily fluctuations in the stock price are meaningless and contain no useful information. The Dow Theory is often illustrated by an ocean analogy. The tide is either is coming in or going out – the primary trend. Even when the tide is going out, waves still wash ashore – the secondary. And as everyone who has ever spread a blanket on the beach knows, sometimes for no apparent reason ripples from the waves reach far up the sand and soak your belongings. The Dow Theory is based on the price movement of the Dow Jones Industrial Average (DJIA). Changes in the primary trend of the DJIA are confirmed by the Dow Jones Transportation Average. The logic is that industrial firms make products, and transportation companies ship them. When both averages are advancing, the economy is in good shape. An explanation of the technical points of this famous market technique is available in the most public libraries. Surprising, Charles Dow had little to do with the development of this theory. The Wall Street Journal, in fact, suggests that the entire field of technical analysis may have originated from “the distortion and selective editing of Mr. Dow’s ideas.” While Dow were believed highly correlated with the business cycle. In Charles H. Dow and the Dow Theory, George W. Bishop, a financial historian, states, “there is no evidence that Dow looked upon the averages as containing anything more than an indication of statistical nature of the trend.” There is also no evidence Dow ever suggested prices would be predicted by interpreting charts. The term “Dow Theory” appears to have first been used in a 1902 book by Samuel Armstrong Nelson entitled the ABC of stock speculation. docsity.com y g ( ) OLD PUZZLES & NEW DEVELOPMENT: Fibonacci Numbers: Fibonacci Numbers have intrigued mathematics and scientist for hundreds of years. Leonard Fibonacci (1170-1240) was a medieval mathematician who discovered the series of numbers while studying the reproductive behavior of rabbits. The beginning of the Fibonacci series is shown below. 1,1,2,3,5,8,5,13,21,34,55,89,144,233,…… After the initial pairs of ones, each succeeding number is simply the sum of the previous two. The remarkable thing about these numbers is the frequency with which they appear in the environment. Sunflowers have seeds spirals around the center of the plant. Some spirals contain seeds leaning counterclockwise, with other spirals going the other way. On most sunflowers, the number of clockwise spirals and the number of counter clockwise spirals are adjacent Fibonacci numbers. A blossom might have 34 counterclockwise spirals and 55 clockwise spirals. The structure of pine cones, the number of chambers in a nautilus seashell, the topology of spiraling galaxies, and the ancestry of bees all reveal Fibonacci numbers. Even a professional journal, the Fibonacci quarterly, is devoted to the study of this series. Technical Analyst who follows Fibonacci numbers usually makes use of the number 1.618. This number is called the golden mean and appears in ancient writings and architecture. (The golden mean features prominently in the dimensions of the Parthenon). After the first 10 or so numbers in the series, each Fibonacci number divided by its immediate predecessor equals 1.618. For example, 89/55=1.618; 134/89= 1.618 and so on. This magic number is used to calculate Fibonacci ratios. Many Fibonacci advocates in the investment business use the first two ratios, 0.382 and 0.618, to “compute retrenchment levels of a previous move.” For instance, a stock that falls from $50 to $35(a 30 percent drop) will encounter resistance to further advances after it recoups 38.2 percent of its loss (that is, after it rises to $40.73). Some technical analysts keep close tabs on resistance and support levels as predicted by the Fibonacci ratios. Even people who do not subscribe to this business know that many other people do, and that when stock prices approach important Fibonacci levels, unusual things can occur. Fibonacci numbers occur frequently and inexplicably in nature. Kondratev Wave Theory: Nikolay Kondratev was a Russian economist and statistician born in 1892. He helped develop the first soviet five-year plan. From 1920 to1928 he was Director of the study of business activity at the Timiriazev Agriculture Academy. While there he devoted his attention to the study of Western capitalist economies. In the economies of Great Bertain and United states, he identified long term business cycles with a period of 50 to 60 years. He became well known after the U.S. crash of 1870. His hypothesis of a long-term business cycle is the called Kondratev wave theory. docsity.com y g ( ) follows that the harvest and the price of grain will depend more or less the solar period, and will go through periodic fluctuations in periods of time equal to those of the sun spots. The essence of his history is that increased sunspot activity leads to warmer temperatures and more rain, leading to an improved harvest and a stronger economy, and finally to higher stock prices. He tested this theory on English grain prices between 1259 and 1400. Jevons observed a ten-to eleven-year cycle in the money market and believed this might be, at least in part, because of the solar influence on crops and the economy. Hemline Indicator: Like the super bowl indicator, the hemline indicator is market folklore that few people take seriously, but many like to talk about it. The essence of the hemline indicator is this: As shorter dresses for women become the fashion, the market advances, and vice versa. Simultaneously plotting skirt lengths and market levels reveals a remarkable correlation. In the 1920s the market rose and so did hemlines. During the Great Depression, dresses touched the ground. There was gradual rise in the market and in hemlines through World War II; the rest of the forties and the fifties peaked in the go-go days of 1960s with miniskirts. The 1970s saw peasant dresses and mixiskirts and an economic recession. During the prosperity of the 1980s things moved back up. During one stretch in the early 1990s the market was nearly flat for over a year. What was the dress fashion? Slits on the side of skirts presumably the marked did not know what to make of them. All these “indicators,” of course, are likely to be purely spurious correlations. What economic cause and effect could possibly be at work? The lack of an economic underpinning is the reason technical indicators of this type are called witchcraft. Breadth Indicators: The Advance-Decline Line (Breadth of the Market): The advance-decline line measures, on a cumulative daily basis, the net difference between the number of stocks advancing in price and those declining in price for group of stocks such as those on the NYSE. Subtracting the number of declines from the number of advances produces the net advance for a given day (which, of course, can be negative). This measure may include thousands of stocks. The advance-decline line, often referred to as the breadth of the market, results from plotting a running of these numbers across time. The line can be based on daily or weekly figures, which are readily available from daily newspaper such as The Wall Street Journal. The advance-decline line is compared to a stock average, in particular in DJIA in order to analyze any divergence that is, to determine whether movements in the market indicator have also occurred in the market as a whole. Technicians believe that divergence can signal that the trend is about to change. The advance-decline line and the market averages normally move together. If both are rising (declining), the overall market is said to be technically strong (weak). If the advance- decline line is rising while the market average is declining, the decline in the market average should reverse itself. Particular attention is paid to a divergence between the two during a bull market. If the market rises while the line weakens or declines to reverse itself and start declining. docsity.com y g ( ) New High and Lows: Part of the information reported for the NYSE and other stocks is the 52-week high and low prices for each stock. Technicians regard the market as bullish when a significant number of stocks each day hit 52-week highs. On the other hand, technicians see rising market indexes and few stocks hitting new highs as a troublesome sign. Volume: Volume is an accepted part of technical analysis. High trading volume, other things being equal, is generally regarded as a bullish sign. Heavy volume combined with rising prices is even more bullish. Sentiment Indicators: Short-Interest Ratio: The short interest for a security is the number of shares that have been sold short but not yet bought back. The short interest ratio can be defined relative to shares outstanding or average daily volume, as in; Short interest ratio = Total shares sold short / Average daily trading volume The NYSE, Amex and NASDAQ report the short interest monthly for each stock. The NYSE and Amex indicate those securities where arbitrage or hedging may be important, but the significant of these activities cannot be determined. For investors interested in th short interest, each month. The Wall Street Journal reports NYSE and Amex issues for which a short interest position of at least 100,000 shares existed or for which a short position change of 50,000 shares occurred from the previous month. A list of stocks with the largest short interest ratios broken down by exchange can be found at www.trading-ideas.com In effect, the ratio indicates the number of days necessary to “work off” the current short interest. It is considered to be a measure of investor sentiment, and many investors continue to refer to it. Investors sell short when they expect prices to decline; therefore, it would appear the higher the short interest, the more investors are expecting a decline. A large short interest position for an individual stock should indicate strong negative sentiments against a stock. Many technical analysts interpret this ratio in the opposite manner as a contrarian indicator a high short interest ratio is taken as bullish sign, because the large number of shares sold short represents a large number o shares that must be repurchased in order to close out the short sales. In effect, the short seller must repurchase regardless of whether or not his or her expectations were correct. The larger the short interest ratio, the larger the potential demand that is indicated. Therefore, an increase in the ratio indicates more “pent-up” demand for the shares that have been shorted. The short interest ratio for a given method should be interrupted in relation to historical boundaries, which historically were in the range of 1 to 2 for the NYSE. The problem is that the boundaries keep changing. In the 1960s, 1970s and 1980s, a ratio of 2 was bullish. More recently, the ratio has been in the 3 to 6 range regardless of the market. Mutual Fund Liquidity: docsity.com y g ( ) Several indicators are based on the theory of contrary investing. The idea is to trade contrary to most investors, who supposedly almost always lose. This is an old idea on Wall Street, and over the year technicians have developed several measures designed to capitalize on this concept. As mentioned above, the short interest is often used as a contrarian indicator, with high short levels in a stock viewed as being overly pessimistic. Mutual fund liquidity can be used as a contrary opinion technique. Under this scenario, mutual funds are viewed I a manner similar to odd - lotters, that is, they are presumed to act incorrectly before a market turning point. Therefore, when mutual fund liquidity is low because the funds are fully invested, contrarian believes that the market is at, or near a peak. The funds should be building up cash (liquidity); instead, they are extremely bullish and are fully invested. Conversely, when funds hold large liquid reserves it suggests that they are bearish. Contrarians would consider this a good time to buy, because the market may be at, or near, its low point. The Opinions of Investment Advisory Newsletter: Investors’ intelligence an investment advisory service, samples weekly the opinions of about 150 investments advisory services and calculates an index of investments service opinions. It has found that on average, these services are most bearish at the market bottom and last bearish at the market top. This index, published since 1963, is now available weekly and is widely quoted in the investing community. The “bearish sentiment index” is calculated as the ratio of advisory services that are bearish to the total number with an opinion. When this index approaches 55 or 60 percent, this would indicate a bearish indicate a bearish attitude on the part of investment advisory services. As this ratio approaches 20 percent, the opposite occurs. Thus, a contrarian should react in the opposite direction of the sentiment this ratio is exhibiting. As the ratio nears 60 percent, the contrarian becomes bullish, because a majority of the investment advisory services are bearish, and around 20 percent the contrarian becomes bearish, because most of the investment advisory services are not bearish. The reason for this seeming contradiction to logic that investment advisory services are wrong at the extremes is attributed to the fact these services tend to follow trends rather than forecast them. Thus, they are reporting and reacting to what has happened rather than concentrating on anticipating what is likely to happen. The Future of Technical Analysis: Although there is much in finance that we do not completely understand, technical analysis has persisted from more than 100 years, and it is not likely to disappear from the investment scene anytime soon. Improved quantitative methods coupled with improved behaviorist Werner De Bondt, for instance, recently reported substantial evidence that the public expects the continuation of past price trends. That is, they are bullish in bull markets and pessimistic in bear markets. Technical analysis is a controversial topic. While it currently has little standing in the academic literature, a great deal about price movements has yet to be discovered. Technical analysts like to use charts. They believe that supply and demand determines security prices, that changes in supply and demand cause prices to change, and that charts can be used to predict changes in supply and demand and in investor behavior. Popular types of charts are the line chart, bar chart point and figure chart, and the candlestick chart. docsity.com