© 2000 John Petroff
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© 2000 John Petroff |
J- Charting and technical analysis
This approach is used by traders (i.e. investors who seek to take advantage of daily stock price variations by actively buying and selling shares, as introduced in Chapter 4 Section J-1). The approach has been discredited by modern portfolio theory efficient market hypothesis which suggests that prices reflect all available information, and by random walk tests of stock behavior that establish that stock price changes are random and cannot be predicted using past information. Yet, the number of web sites (see Chapter 1 Section D-4) devoted to charting suggests that the approach is alive and well.
Those engaged in this approach are sometimes called chartists because they study charts (i.e. graphs) of stock prices and/or indexes over time. Their view is that fundamental analysis is a waste of time because it is not possible to measure the value of a stock: it changes all the time in response to economic and market forces. What is more important than any "true" value is the direction and size of price changes: that is what is called price momentum. Their answer to modern portfolio theorists is that they do not only use past price changes but also many other techniques. It is from this use of techniques that the name of technical analysis originated.
See review questions Q-5J.1 through Q-5J.3.
1)- Charts
The premise of trading is that one should buy before price increases and sell before price decreases. Small changes are not important. What must be found is what was previously identified as price momentum. Traders keep a watch on a large number of stocks and indices, and start trading as soon as a significant price movement is observed. There are several methods of recognizing price momentum
The Dow Theory is essentially a time series analysis of a major index such as the Dow Jones Industrial Average (DJIA). The idea is to catch the beginning of either a bullish or a bearish market attitude that will push all stock prices higher or lower. DJIA daily changes plotted in a chart are separated into trend, secondary movement and daily fluctuations. When the stock market is rising it may be interrupted by a resistance area (i.e. a plateau in the secondary movement). If the market breaks through two consecutive resistance areas, this is a signal of the start of a bull market. If a declining market breaks through two support areas (i.e. a plateau in the secondary movement caused by investors who waited for the stock to decline and buy then), that indicates that the peak has been reached and a bear market has started.
A trend cannot however be determined on the basis of a single index. If, for instance, the Dow Jones Industrial Average has peaked, but this peak is quickly followed by a new peak in the index of transportation companies, this means that the bullish trend is intact. In addition, any movement in an index is significant only if it is confirmed by a large trading volume.
Bar charts plot daily stock price variations showing in each bar the high, low and closing price of a day's trading. The movements are analyzed in similar terms of support and resistance areas (sometime referred to as head and shoulders analysis) as above. Chartists talk about target price, which is not any actual stock value or quote, but the price level that signals that a high or low has been reached when daily prices fall below or above it.
This is an old technique, rarely used in today's computer age. The method is revealing of chartist thinking. Significant price changes (i.e. say 5% or more) of each followed stock are recorded as "o" for down and "x" for up in a unidimensional chart (i.e. without regard as to time). A buy or sell signal is detected when two or more consecutive o's or x's indicate a break out from the congestion area (i.e. the congestion area is where there are no price changes of interest to a trader).
d)- Other uses of charts
When a daily fluctuations line intersects a 200 days moving average line, it is a signal that a trend is taking place and that a stock should therefore be bought or sold. Relative strength compares the behavior of individual stocks during bullish and bearish markets. Traders switch into stocks with high relative strength at the outset of a bullish market because these stocks have outperformed bullish markets in the past. Conversely, the same stock are dropped when a bearish market is expected.
See review questions Q-5J1.1 through Q-5J1.8.
See research assignment R-5.15.
2)- List of techniques
The following indicators are used to confirm a trend.
- Secondary offerings are shares of existing companies offered
to investors and are indicative that the company has a growth
vision of itself (see Chapter
12 Section B-2).
- Baron's confidence index calculated as a ratio of yield on 10
top grade corporate bonds divided by yield of 40 bonds, is revealing
of market attitude and trend because the high yield bonds become
especially risky in pessimistic downturns, which causes their
yield (in the denominator of the index as part of the 40 bonds)
to increase, and the index to decrease.
- Debit balances at brokerage firms represent purchases of stock
on margin by those who are knowledgeable enough to buy on margin.
- Put to call ratio which is simply
the volume of put options divided by the volume of call options,
shows whether more investors have purchased options to buy than
to sell, which is indicative whether investors who use options
are bullish or not.
- Insider trading reported to the SEC
and often published in the press is certainly an important influence
on prices of the stock involved.
b)- Contrary opinion indicators
The following indicators are used to determine if the trend is likely to move in an opposite direction to that shown by the indicator.
-Mutual funds cash to value position shows that, when mutual
funds have large cash balances, they will have to start buying,
which will push prices higher; so it is time to buy before they
do.
- Short interest ratio calculated as
volume of short sales divided by total volume of trade, tells
traders that, when the volume of short sales is large, those who
entered in short sale contracts, will have to start buying to
close their open positions; this means that it is time to buy
now before they do.
- Investment advisory opinion, an index
maintained by Investors Intelligence, becomes evermore overwhelmingly
bearish at the approach of a market trough, and it is, therefore,
time to start buying.
- An indicator much used in the past
was the volume of odd-lot trading which showed the activity of
small investors who are excessively emotional, and who are attracted
to buy stock in the euphoria of a bull market peak; thus, when
small investors are buying it is time to sell. The indicator is
no longer relevant in today's age of accounts on-line, and trading
of any size (i.e. higher commissions are no longer charged for
trading lots smaller than 100 shares, as it used to be).
c)- Other indicators
- Breadth of market is the ratio
of advances divided by declines, already mentioned in Chapter
1 Section D-4b.
- Price to earnings, and price to earnings
plus inflation are two indicators that show that when prices are
historically too high, the market will have to come down. Believers
of these indicators have been put to the test by the ever bullish
market of the beginning of this century.
See review questions Q-5J2.1 through Q-5J2.3.
See research assignment R-5.16.
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