CH 12

Fin2802:
Fin2802: Investments
Investments
Spring,
Spring, 2010
2010
Dragon
Dragon Tang
Tang
Lectures 11&12
Behavioral Finance and Technical Analysis
February 23&25, 2010
Readings: Chapter 12
Practice Problem Sets: 1,2,4,10, 11
Fin 2802, Spring 10 - Tang
Chapter 12: Behavioral Finance and Technical Analysis
Where
Where Are
Are We?
We?
How?
Securities
Markets
Institutions
Trading
Delegated investment
Why?
Market efficiency
Historical performance
What?
Stock
Bond
Evaluation
International
Where
Where Are
Are We?
We?
How?
Securities
Markets
Institutions
Trading
Delegated investment
Why?
Market efficiency
Historical performance
What?
Stock
Bond
Evaluation
International
So What?
Behavioral
Behavioral Finance
Finance and
and Technical
Technical Analysis
Analysis
Objectives:
1. Understand the principles of behavioral finance.
2. Identify reasons why technical analysis may be profitable.
3. Use the Dow theory to identify situations that technicians
would characterize as buy or sell opportunities.
4. Use indicators such as volume, breadth, short interest, or
confidence indexes to measure the "technical condition" of
the market.
5. Explain why most of technical analysis is at odds with an
efficiently functioning stock market.
Behavioral
Behavioral Finance
Finance
Traditional theories (e.g., CAPM) assume rational investors
Systematic behavioral biases (anomalies) have been
observed
Behavioral finance tries to incorporate some aspect of
investors behavior and explain those anomalies using
psychological principles
It is a developing and important area
Companies exploiting behavioral biases:
Lakonishok, Shleifer and Vishny (LSV)
Dimensional Fund Advisors (DFA)
Fuller and Thaler Asset Management
Case-Shiller-Weiss
Individual
Individual Behavior
Behavior
Cooperation and Altruism
Bidding and the Winners Curse
Endowment Effect, Status Quo Bias and Loss
Aversion
Mental Accounts
Figure
Figure12-1
12-1 Loss
LossAversion
Aversion Preference
Preference Function
Function
Asset
Asset Returns
Returns and
and Behavioral
Behavioral
Explanations
Explanations
Calendar Effects
Cash Dividends
Overreaction and Mean Reversion
Controversial explanations from behavioral finance
Closed-end fund discount puzzle
Excess volatility in stock prices
Loss aversion
Limits
Limits to
to Arbitrage
Arbitrage
Fundamental Risk
Implementation Costs
Model Risk
Siamese Twin Companies
Equity Carve-outs
Closed-End Funds
Figure
Figure12.2
12.2Pricing
Pricingof
ofRoyal
RoyalDutch
DutchRelative
Relativeto
toShell
Shell(Deviation
(Deviationfrom
fromParity)
Parity)
10
Technical
Technical Analysis
Analysis
Attempts to exploit stock price patterns for

profit.
Assumes prices adjust slowly to their true
equilibrium values
11
Technical
Technical Analysis
Analysis and
and EMH
EMH
Technical analysis clashes with the EMH
hypothesis.
EMH predicts rapid adjustment of prices
with the onset of new information.
Evidence for the success of technical
analysis is poor.
12
Technical
Technical Analysis
Analysis Tool-kit
Tool-kit
Charting: The analysis of charts of stock price
and volume with the hope of finding patterns to
exploit in the markets.
The Dow Theory
Point and Figure Chart
Elliott Wave Theory
Technical Indicators
Sentiment Indicators: Market Volume (Trin Statistic); Oddlot Trading; Confidence Index; Put/Call Ratio; Mutual Fund
Cash Position
Flow of Funds: Short Interest; Credit balances in brokerage
accounts
Market Structure: Moving Averages; Breadth; Relative
Strength;
13
Charting:
Charting: The
The Dow
Dow Theory
Theory
The Dow Theory:
Uses price and volume trends to predict
stock prices.
Identifies primary, secondary, and tertiary
trends.
Predicts support and resistance price levels.
14
Figure
Figure 19-2
19-2 Dow
Dow Theory
Theory Trends
Trends
15
Figure
Figure19-3
19-3 Dow
DowJones
Jones Industrial
IndustrialAverages
Averages in
in 1988
1988
16
Charting:
Charting: Elliott
Elliott Wave
Wave Theory
Theory
Elliott Wave Theory:
Stock prices can be described by a set of
wave patterns
Long-term and short-term wave cycles are
superimposed on each other
By interpreting the cycles, one can predict
broad movements
17
Figure
Figure19-4
19-4 Point
Point and
and Figure
FigureChart
Chart for
forTable
Table19-2
19-2
18
Table
Table 19-2
19-2 Stock
Stock Price
Price History
History
19
Figure
Figure19-5
19-5 Point
Point and
and Figure
FigureChart
Chart for
forAtlantic
AtlanticRichfield
Richfield
20
Figure
Figure 19-6
19-6 Candlestick
Candlestick Chart
Chart
21
Charting:
Charting: A
AWarning
Warning
A Warning:
Seeing patterns that dont exists
After the fact, one can always find patterns
and trading rules that would have generated
enormous profits
What has worked in the past may not work
in the future.
22
Figure
Figure19-7
19-7Actual
Actual and
and Simulated
Simulated Stock
StockPrices
Prices for
for52
52Weeks
Weeks
23
Figure
Figure 19-8
19-8 Actual
Actual and
and Simulated
Simulated Changes
Changes
in
in Weekly
Weekly Stock
Stock Prices
Prices for
for 52
52 Weeks
Weeks
24
Technical
Technical Indicators:
Indicators: Sentiment
Sentiment Indicators
Indicators
Market Volume: Higher volume gives strong confirmation
to price trend.
Volume declining/Number declining

Trin
Volume advancing/Number advancing
Trin>1: Bear Market; Trin<1: Bull Market
Odd-lot Trading (less than 100 shares): Small investors

tend to miss key market turning points.
- Odd-lot buying heavy investors should be bearish.

- Odd-lot selling heavyinvestors should be bullish.
25
Technical
Indicators: Sentiment
Sentiment Indicators
Indicators
Confidence Index:
Average Yield on 10 top - rated Corporate Bonds

Average Yield on 10 intermediate grade Corporate Bonds
Closer to 100% investors should be bullish
Away from 100% investors should be bearish.
Put/Call Ratio: Ratio normally hovers around 65%.

Rising ratio investors should be bearish?
Rising ratio investors should be bullish?
Mutual Fund Cash Positions

More cash bearish?
26
Technical
Indicators: Flows
Flows of
of Funds
Funds
Short Interest: The volume of short selling
High volume investors should be bearish.
or
Low volumeinvestors should be bullish.

High volume investors should be bullish.
Low volumeinvestors should be bearish.
Credit Balances in Brokerage Accounts

High balance bullish
27
Market
Market Structure
Structure Indicators
Indicators
Moving Averages
Average price over some historical period (5 weeks or 200
days)
When current price crosses the average a trading signal
occurs
Bullish signal when the current price rises above the
moving average
Bearish sign when the current price falls below the
moving average
28
Technical
Indicators: Market
Market Structure
Structure
Moving Average: Average over a given interval,
continuously updated.
Price
And
M.A.
Price
Bullish Signal
Bearish Signal
Moving Average
Averaging interval
Time
29
Figure
Figure19-10
19-10 Moving
MovingAverage
Average for
forMicrosoft
Microsoft
30
Figure
Figure 19-11
19-11 Moving
Moving Averages
Averages
31
Technical
Indicators: Market
Market Structure
Structure
Breadth: The spread between the number of advancing
issues and the number of declining issues.
Advances > declines bullish

Advances < declines bearish
Relative Strength:
Price of a Stock
Price Index for the Industry
or
Persistent Rising ratio bullish.

Persistent Falling ratio bearish.
Price Index of an Industry

Market Price Index
Momentum
Strategies
32
Figure
Figure19-12
19-12 Cumulative
Cumulative Difference
Difference in
in Returns
Returns
of
of Previously
Previously Best
Best and
andWorst
Worst Ranking
Ranking Stocks
Stocks
in
in Subsequent
Subsequent Months
Months
33
Value
Value Line
Line System
System
Widely followed with some evidence of superior
performance
Value Line System is predominately a technical
system
Earnings momentum
Relative stock prices
Ratios of moving averages
34
Figure
Figure19-13
19-13 Record
Record of
of Value
Value Line
Line Ranking
Ranking for
forTimeliness
Timeliness
(without
(without adjustment
adjustment for
forchange
change in
in rankings)
rankings) 1965-1990
1965-1990
35
Value
Value Line
Line System
System
Paper vs actual performance indicates that the
system is difficult to implement
Value Line Fund has not shown superior
performance
High turnover costs are associated with the strategy
Evidence shows prices react quickly to reported

ranking changes
36
Technical
Technical Analysis
Analysis and
and Market
Market Efficiency
Efficiency
Reaction time and length of trends

EMH new information is quickly
reflected in prices.
Technical analysis long-lived trends
play out slowly and predictably.
A useful technical rule would be
invalidated once the mass of traders
attempt to exploit it (self-destructing
Patterns)
37
A
ANew
New View
View of
of Technical
Technical Analysis
Analysis
EMH: Public information is available to all;
Price reflect all available information
Study by Brown and Jennings (RFS, 1989):
Many investors have private information
Sequence of past price can be useful in the
inference of information held by other traders
Prices reveal as well as reflect information
38
Summary
Summary
Principles of behavioral finance, individual behavior,
behavioral explanations
Technical analysis is the search for recurring patterns in stock
prices; Technical analysis assumes prices adjust slowly
Charting: The Dow Theory
Point and Figure Charts
Elliott Wave Theory
Technical Indicators: Sentiment Indicators
Flow of Funds
Market Structure
New theories of information dissemination
39

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Fin2802:

Chapter 12: Behavioral Finance and Technical Analysis

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Chapter 12: Behavioral Finance and Technical Analysis

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Attempts to exploit stock price patterns for

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Volume declining/Number declining

Odd-lot Trading (less than 100 shares): Small investors

- Odd-lot buying heavy investors should be bearish.

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Average Yield on 10 top - rated Corporate Bonds

Put/Call Ratio: Ratio normally hovers around 65%.

Mutual Fund Cash Positions

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Low volumeinvestors should be bullish.

Credit Balances in Brokerage Accounts

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis

Fin 2802, Spring 10 - Tang

Chapter 12: Behavioral Finance and Technical Analysis