TECHNICAL ANALYSIS y y y y y Technical analysts or technicians develop technical trading rules from observations of past (prior) price movements

of the stock market and individual stocks. The philosophy behind technical analysis is in sharp contrast to the efficient market hypothesis. It also differs from fundamental analysis. Technical analysis involves the examination of past market data such as prices and the volume of trading, which leads to an estimate of future price trends and therefore an investment decision. The technical analyst uses data from the market itself because they contend that the market is its own best predictor. Technical analysis is an alternative method of making the investment decision and answering the questions: What securities should an investor buy or sell? When should these investments be made? Technical analysts see no need to study the multitude of economic, industry, and company variables to arrive at an estimate of future value because they believe that past price movements will signal future price movements. Technicians also believe that a change in the price trend may predict a forthcoming change in the fundamental variables such as earning and risk before the change is perceived by most fundamental analysts. Underlying assumptions of technical analysis: 1. The market value of any good or service is determined solely by the interaction of supply and demand. 2. Supply and demand are governed by numerous rational and irrational factors. Included are those economic variables as well as moods, opinions, and guesses. The market weighs all these factors continually and automatically. 3. The prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time. 4. Prevailing trends change reaction to shifts in supply and demand relationships. These shifts no matter why they occur can be detected sooner or later in the action of the market itself. Technical analysts expect stock prices to move trends that persist for long periods because they believe that new information does not come to the market at one point in time but rather enters the market over a period of time. Technicians expect a gradual price adjustment to reflect the gradual dissemination of information. Technicians look for the beginning of a movement from one equilibrium to new equilibrium value but do not attempt to predict the new equilibrium value. According to technical analysts, it is important to recognize that the fundamental analysts can experience superior returns only if they obtain new information before other investors and process it correctly and quickly. Technical analysts do not depend heavily on financial accounting statements the major source of information about the past performance of a firm or industry. Major problems with accounting statements: 1. Lack a great deal of information needed by security analysts

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2. Corporations may choose among several procedures for reporting expenses, assets or liabilities which can produce vastly different values for expenses, income, ROA, and ROE. Investors can have trouble comparing the statements of two firms. 3. Many psychological factors and other non-quantifiable variables do not appear in the financial statements. Examples are employee training and loyalty, customer goodwill, and general investor attitude towards an industry. While fundamentalists need to process new information quickly and correctly to derive a new intrinsic value for the stock before other investors, technicians only need to quickly recognize a movement to a new equilibrium value for whatever reason. Because most technicians do not invest until the move to the new equilibrium is under way, they contend that they are more likely than a fundamentalist to experience ideal timing. Challenges to technical analysis: 1. Challenge some of its basic assumptions 2. Challenge some specific technical trading rules and their long run usefulness The major challenge to technical analysis is based on the empirical tests of the efficient market hypothesis (EMH). Weak form efficient market hypothesis the market would have to be slow to adjust prices to the arrival of new information that is it would have to be inefficient to generate superior riskadjusted returns after taking account of transaction costs. Two sets of tests of the weak-form EMH: (a) statistical analysis of prices to determine if prices moved in trends or were a random walk, (b) the analysis of specific trading rules to determine if their use could beat a buy-and-hold policy after considering transactions costs and risk An obvious challenge to technical analysis is that the past price patterns or relationships between specific market variables and stock prices may not be repeated. Another problem is that the success of a particular trading rule will encourage many investors to adopt it. Specific trading rules all require a great deal of subjective judgment. The standard values that signal investment decisions can change over time. The end of a declining (bear) market finishes in a trough. Confirmation that the declining trend has reversed would be a buy signal. As long as the stock price stayed in the rising trend channel, the technician would hold the stocks. Technicians would sell the stocks at the peak of the cycle until after the trend changes. If the stock begins trading in a flat pattern (flat trend channel), it will necessarily break out of its rising trend channel. If the stock were to break out of the channel on the downside, it is a sell signal. Almost all technical analysts watch many alternative rules and decide on a buy or sell decision based on a consensus of the signals because complete agreement of all rules is rare. Contrary-opinion rules assume that the majority of investors are wrong as the market approaches peaks and troughs. These technicians trade in the opposite direction of the majority. Mutual funds hold some part of their portfolio in cash for several reasons: 1. Need cash to liquidate shares

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2. New investments in the mutual fund may not have been invested 3. Portfolio manager might be bearish on the market and want to increase the funds defensive cash position Mutual funds ratios of cash as a percentage of the total assets in their portfolios, cash ratio, are reported in press. (Range: 4% - 11%) Contrary opinion technicians believe that mutual funds usually are wrong at peaks and troughs. Mutual funds have a high percentage of cash near a market trough the time when they should be fully invested. At the market peak, mutual funds are expected to be almost fully invested with a low percentage of cash. Technicians tend to buy when the cash ratio approaches 11% and sell when the cash ratio approaches 4%. A high cash position is a bullish indicator because of potential buying power. A low cash ratio would mean that the institutions have bought heavily and are left with little potential buying power. Credit balances result when investors sell stocks and leave the proceeds with their brokers, expecting to reinvest them shortly. Technical analysts view them as potential purchasing power. A decline in credit balances is considered bearish because it indicates lower purchasing power as the market approaches peak. A build up in credit balances indicates an increase in buying power and is a bullish signal. Many technicians believe that if a large proportion of investment advisory services are bearish; this signals the approach of a market trough and onset of a bull market. Number of bears is greatest when market bottoms are approaching (bullish indicator). Number of bulls is greatest when market tops are approaching (bearish indicator). Speculative trading typically peaks at market peaks. Contrary opinion technicians use put options which give the holder the right to sell stock at a specified price for a given time period, as signals of a bearish attitude. A higher put-call option indicates a pervasive bearish attitude for investors. In terms of stock index futures, technicians would consider it a bearish sign when more than 70% of the speculators are bullish, and a bullish sign when this ratio declines to 30% or lower. Smart money is a set of indicators and corresponding rules that technicians believe indicate the behaviour of smart, sophisticated investors. Confidence index is the ratio of Barrons average yield on 10 top-grade corporate bonds to the yield on the Dow Jones average of 40 bonds. This ratio is a bullish indicator (during periods of high confidence, investors are willing to invest in lower quality bonds which cause a decrease in yield spread, confidence index increases). A popular measure of investor attitude or confidence on a global basis the spread between T-bill yields and Eurodollar rates measured as the ratio of T-bill/Eurodollar yields. Debit balances in brokerage accounts represent borrowing (margin debt) by knowledgeable investors from their brokers; indicate the attitude of sophisticated investors who engage in margin transactions. Increase in debit balances indicates buying and is considered a bullish sign. Decrease in debit balances indicates selling and is considered a bearish sign.

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Breadth of market measures the number of issues that have increased each day and the number of issues that have declined. Advance-decline index is typically a cumulative index of net advances or net declines. To examine individual stocks, the 200 day moving average of prices has been popular. Overbought negative correction greater percentage above their 200 day moving average Oversold positive correction lesser percentage above their 200 day moving average