Investment Theory and Portfolio Development - Technical Analysis

In contrast to fundamental analysis, technical analysis uses historical price and trading volume in chart format to attempt to predict the direction of securities prices and the demand for them. It does not make use of the tools of either top-down or bottom-up fundamental analysis. The entire premise of technical analysis would appear to fly in the face of the efficient markets. While market technicians and fundamental analysts take issue with the other's opinions on the validity of their respective approaches, planners will often use technical analysis to supplement fundamental analysis in determining points of entry to and exit from specific securities. Below are brief discussions of some of the basic tools.

  • Charting - This is the use of graphs and charts to study the direction of markets based on the view that history repeats itself, so the examination of past trends provides fodder for the prediction of future ones. Two such tools that are the stock in trade of most technicians include the following:
    1. Bar charts - plot price against time.
    2. Point-and-figure charts - price is plotted on the y-axis, movement on the x-axis is plotted if price reversals occur.
  • Sentiment Indicators - such measures look beyond the charts to gauge the degree to which market players are bearish or bullish as embodied in their expectations of markets.
    1. Contrary Opinion Rules - following the herd is wrong. Contrarians do the opposite of what most investors do, as they maintain that the majority is often wrong. For example, contrarians would be inclined to short a stock if the consensus was to buy it.
    2. Odd-Lot Short Sales Theory -
      • Consistent with their contrarian bent, technicians would look upon a great deal of short selling as a telltale sign that the market was approaching bottom and would soon experience an upturn.
      • When a large percentage of odd-lot sales consists of short sales, then the market would appear to most to be bearish, a cue for technicians to purchase stocks. Were the percentage of odd-lot sales small, then technicians would be inclined to be bearish.
    3. Mutual Fund Cash Position - fund managers maintain cash to meet redemptions, receive cash from inflows to be put to work in the market or may choose to stay out of the market if they have a bearish view of it. Technicians look upon large mutual fund balances as yet another sign of a market trough and a signal to purchase stocks. Conversely, low cash balances in the view of technical analysts would constitute a bearish sign.
    4. Brokerage Account Credit Balances - analogous to mutual fund cash positions, the amounts of cash in brokerage account balances is a bullish or bearish indicator. Market technicians would trade in the opposite direction of the prevailing trend. For example, low cash balances in brokerage accounts would seem to indicate a market top, a bearish sign for technicians.
    5. CBOE Put/Call Ratio (PCR)-puts/calls. - For technical analysts, an increase in the ratio is a bullish indicator as the surfeit of puts would point to a market bottom.
      PCR>/=.5 - bearish for markets, bullish for contrarians.
      PCR</=.35 - bullish for markets, bearish for contrarians.
    6. Stock Index Futures - contrarians may track the relative number of bullish v. bearish futures traders.
      >/=75% of speculators are bullish, a bearish signal for contrarians.
      </=25% of speculators are bullish, a bullish signal for contrarians.
    7. The Confidence Index - this indicator indicates how strong or weak the economy would appear to be.
      1. Average yield of high (investment) grade bonds/Average yield of low-grade bonds. In a weak economy, investors experience a flight to quality, seeking safety in low risk credits. The closer the index is to 1.0, the more the economy is strengthening and the more bullish is the market as investors reach for greater yield. Conversely, larger purchases of investment grade bonds would constitute a flight to quality in anticipation of economic decline.
      2. Brokerage Account Debt Balances - investors trading on margin are deemed to be more sophisticated and their activity technicians monitor accordingly. High margin balances would seem to indicate confidence in the strength of the economy and market, whereas lower balances would be a bearish signal.
Technical Analysis – Other Indicators
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