CFA Level 1 (2009) - 1

Scudy Session 3

Cross-Reference to CFA Institute Assigned Reading # 12 - Technical Analysis

Efficien t market followers say all this looking is a hopeless and profi dess exercise, since prices will change very rapidly in response to new information.

The difference in the three views is illustrated in Figure 1, where the following interpretations can be made:

Fundamentalists look for reasons why the valuation band will shift upward. The shift will happen when they find it. Price changes will occur over a period of days or weeks as analysts determine the situation. The fundamentalists' price-adjustment process is described by the path from Point 1 to Point 2.

•Technicians look for signs that the valuation band has moved. Technicians base their strategies on the premise that price changes will occur over a long period, as indicated by the path from Point 1 to Point 3.

EMH advocates hold that when the value band shift happens, the price will shift rapidly. This adjustment process is described by the path from Point 1 to Point 4.

Figure I: Technical, Fundamental, and EMH Price Adjustment Process

·.U~·= ILl,: Discuss the advantages of and challenges to technical analysis.

Technical analysis offers the following advantages:

•It is quick and easy.

It docs not involve accounting data and analytical adjustments for differences in accounting methods.

It incorporates psychological as well as economic reasons behind price changes. It tells when to buy (not why investors are buying).

The major challenge to technical analysis is the efficient market hypothesis. Efficient market analysts feel all available information is impounded in the current security price. They argue that technical relationships may nor be repeated. Technical analysis is also challenged by the argument that technical rules require toO much subjective interpretation and that technical decision variables change over time.

Study Session 3

Cross-Reference to CFA Institute Assigned Reading #12 - Technical Analysis

Technical analysis often involves some sort of trading rule. Some of the challenges to technical trading rules are as follows:

•Almost without exception, EMH studies using autocorrelation and runs tests have found no evidence that prices move in trends (i.e., past price patterns may not be repeated in the future). EMH followers say that the market appears to react quickly and completely to the release of new information.

•If technical trading rules worked, the price movements would become a self-fulfilling

prophecy. That is, if enough people believe the price is going to rise $5 per share once a specific breakout price is reached, the buying pressure at the breakout price will cause the $5 price increase, although it will likely be temporary.

•If technical trading proved to be successful, others would copy it. As more traders implemented the strategy, its value would be neutralized.

•Interpreting the rules is too subjective, and the decision variables change over time.

LOS I2.e: Lis! and describe examples of each major category of technic<ll trading rules and indic.ltors.

Professor:( Note: Thr l/Jordi nK o.f'this LOS does not ask yOll to ealmLatc these measures, on~J' to ident~6' thelll. FocllS your attention 011 ll'hat high and LoU' vaLues o.(the indiCtltors SIIggest to an alla~yst, not on the ({etlllI! numeric value." that arc ideiltified ,15 buLLish or bearish vaLues.

Technical trading rules and indicators fall into four classes:

•The contrarian vie\-\'. Contrary-opinion technicians (contrarians) argue that the majority is generally wrong, so they recommend doing the opposite of what the majority of investors are doing.

•FoLLow the smart money view. Smart-money technicians feel that smart investors know what they are doing, so they suggest "jumping on the bandwagon" while there is still time.

•Momentum indicators arc used to make decisions based on the direction of market pnces.

•Technical analysts employ a variety of priceand voLume-based indicators.

Contrary Opinion Rules

Contrary-opinion technicians use the following six technical indicators:

1.Cash position of mutual funds. The mutual fund cash position is a function of investor expectations and the institution's view of market expectations. Contraryopinion technicians feel that mutual fund cash positions are a good indicator of institutional investors' expectations and that they are usually wrong at picking the peaks and troughs of the market cycle.

mutual fund cash Mutual fund ratio = -------

total fund assets

Study Session 3

Cr9ss-Reference to CFA Institute Assigned Reading #12 - Technical Analysis

•If the mutual fund ratio (MFR) is greater than II %, it implies funds are holding cash and are therefore bearish on the market. In this case, contrary-opinion technicians are bullish.

•If the MFR is less than 4%, it implies funds are investing cash and are therefore bullish on the market. Contrary-opinion technicians are therefore bearish.

Another way to look at this is that when the mutual fund cash ratio is high, contrarians are bullish because these cash holdings indicate potential future buying power in the market.

2.Investor credit balances in brokerage accounts. Credit balances are uninvested cash. Falling credit balances mean "normal" investors are bullish, so contrarians will be bearish and sell. Rising credit balances mean "normal" investors are bearish, so contrarians will be bullish and buy. A technical view of a build-up in credit balances would be that there is an increase in potential future buying power in the market, which is considered to be bullish.

3.Opinions of investment advisory services. The bearish sentimcllts index is lL~cd ro indiclIt lhe level of bearish selltimellt among investmenc advisors. II'more than 60(~iJ

of invcscmellt advisory services arc bearish, colltrarians are bullish. If less than 10% of ad .. isors are bearish, advisors are relatively bullish, so colltrarians are bearish and sell.

4.Over-the-counter vs. NYSE volume. Over-the-counter (OTC) issues are more speculative than NYSE issues, and speculative trading increases at market peaks. The kvel of speculative trading is measured using the ratio of OTC volume to NYSE volume. If the volume ratio is increasing, speculation is increasing, therefore contrarians are bearish. If the ratio is decreasing, investors are bearish, and therefore contrarians are bullish.

5.CBOE put/call ratio. Contrarians use the put/call ratio as an indicator of investors'

bearishness. As such, contrary-opinion technicians become bullish as the ratio increases. If the put-call ratio is equal to or greater than 0.6, the market is bearish, so contrarians are bullish. If the racio is less than or equal to 0.4, che market is bullish, so can trarians are bearish.

6.Stock index futures. Some contrarians track the relative number of futures traders who are bullish. When 70% or more of index futures speculators are bullish, contrarians become bearish. When 30% or less of speculators arc bullish, contrarians become bullish.

Professor:" Note: DOIl't won~J' about the "trigger points" such as 10% bullish or

~20% bearish. These are specific to the individual technical analyst. Do worry

~about how a high or low measure ofthese indicators would be viewed by a contrarian.

Study Session 3

Cross-Reference to CPA Institute Assigned Reading #12 - Technical Analysis

Smart Money Rules

Smarr money technicians use the following three indicators to help them determine what the smarr investors are doing.

J.Confidence index. The Confidence Index published by Barron's measures the ratio of average yields on high-qualiry corporate bonds to the average yields on a broader set of bonds.

In periods of confidence, investors sell high-quality bonds and buy lower-quality bonds to increase yields. Quality bond prices will fall and their yields rise. Lowergr;lde hond prices rise and their !'ields ~~lli. Thus. the confidence index (Cl) r~ltio will increase during periods of confldencc ie.g.. from 0.0 7 I 0.10 = 0.7 to 0.08 I COl) " 0.89). Note that the CI move~ in the opposite direction of yield spreads. In r-:rioch of confidence, yield spreads narrow and the CI gets bigger. In periods of pessimism. spreads widen and the CI falls.

T-bill-eurodollar yield spread. SOIllC technicians believe thar spreads will orecn widen during times of international crisis as money flows to a safe haven in l.S. Treasury bills. An increasing "TED" spread is a bearish indicator.

3.Debit balances in brokerage accounts (margin debt). Debit balances in brokerage accounts represent the level of margin trading, which is usually only done by knowledgeable investors and traders.

•An increase in debit balances would indicate an increase in purchasing by astute buyers. This is a bullish sign for smarr money technicians.

•A decline in debit balances would indicate astute traders are selling stocks. This is a bearish sign for smarr money technicians.

Momentum Indicators

Breadth of market. The technician's story in this case is that:

•The indices represent a few large companies, not the whole marker.

•The market has many medium and small companies.

•Frequently the index goes one way while smaller issues go the other. Broad market moves include both large and small companies. How do you gauge the strength of market support (i.e., the breadth of the market)? Compare the advance-decline line with the market index.

The advance-decline line is a running total of the daily advances less the declines on the NYSE. If the advance-decline line and the index move together, the movement is broadly based across the marker. A divergence berween the trend in the index and the advance-decline line would signal that the market has hit a peak or trough.

Stocks above their 200-day moving average. The market is believed to be overbought-a bearish indicator-when over 80% of the stocks are selling above their

Study Session 3

Cr<~ss-Reference to CFA Institute Assigned Reading #12 - Technical Analysis

200-day moving averages. Similarly, the market is considered to be oversold-a bullish indicator-if less than 20% of the stocks are selling above their 200-day-moving averages.

Stock Price and Volume Techniques

Dow Theory. The Dow Theory states that stock prices move in trends. There are three types of trends: major trends, intermediate trends, and short-run movements. Technicians look for reversals and recoveries in major market trends.

Importance of volume. Price alone does not tell the story. Technicians attempt to gauge market sentiment, as well as direction, to determine changes in supply and demand. Thus, they look at the volume that accompanies price movements. Price changes on low volume tell us little. Price changes on high volume tell us whether suppliers or demanders are driving the change.

If the upside-downside ratio is t.75 or more, it indicates that the market is overbought. This is a bearish signal. If the ratio is 0.75 or lower. it reflects that the market is oversold. Th is is a bullish signal.

Support and resistance levels. Most srock prices remain relatively stable and fluctuate up and down from their true value. The lower limit [0 these fluctuations is called a support level-the price where a stock appears cheap and attracts buyers. The upper limit is caIleJ a resistance level-the price where a srock appears expensive and initiates selling.

Moving average lines. Technicians believe stock prices move in trends. However, random fluctuations in prices mask these trends. By using moving averages (l0 to 200 days), technicians can eliminate the minor blips from graphs but retain information about any change in longer-term trends in prices.

Relative strength. When prices of an individual srock or industry change, it is difficult to tell if the change is stock-specific or caused by market movements. If the stock price and the market index value are changing at the same rate, the ratio created by dividing one by the other will remain constanr. This ratio is called the relative strength ratio:

If the ratio increases over time, the srock is outperforming the market, a positive trend.

If the ratio declines over time, the stock is underperforming the market, a negative trend.

Study Session 3

Cross-Reference to CFA Institute Assigned Reading #12 - Technical Analysis

Graphs. Some technical analysts are called chartists due to their extensive reliance on charts and graphs to indicate market directions.

•Bar charts. Price is plotted against time.

•Point-and-figure charts. Price is plotted on the y-axis, but movement along the x-axis is only plotted if a preset price reversal occurs.

Technicians read charts looking for patterns. Why? Technicians feci that history repeats itself, so by looking at past trends, they will be able to identify the beginning of new trends.

Study Session 3

Cross-Reference to CFA Institute Assigned Reading #12 - Technical Analysis

KEy CONCEPTS

LOS 12.a

The underlying assumptions of technical analysis are:

• The market price of securities is determined solely by supply and demand.

•Supply and demand are influenced by rational and irrational factors.

• Security prices move in trends that persist for appreciable lengths of time.

•Shifts in supply and demand can be determined by the actions of the market itself.

LOS 12.b

The advantages of technical analysis are:

•It is quick and easy.

•It does not depend heavily on financial statements and is largely unaffected by accounting differences.

•It incorporates psychological as well as economic reasons hchind price changes.

(:hallenges (() lcchnical rrading rules include:

The cfflcienr marker hypothesis says price adjustmenrs happen roo quickj~· to trade

011.

•The behavior of past prices and market variahles may not be repeated in the future.

•Inrerpreting rcchnical dara requires much subjecrive judgment by rhe analyst.

•The indicator valucs that are thought to be hearish or hullish signals can change over time.

LOS 12.(

Contrarian technical analysts are bullish when most stock market investors are bearish, as indicated by:

•Most investment advisory opinions are bearish.

•Over-the-counter stock volume is decreasing relative to NYSE volume.

•The CBOE put/call ratio is high.

•A low percentage of srock-index futures traders are bullish.

Contrarians are bearish when most investors arc bullish (mutual fund cash positions are less than normal, investor credit balances are falling, few advisors are bearish, aTe

volume is increasing relative to NYSE volume, pur/call ratio is low, a high percentage of index futures traders are bullish).

Smart-money technical analysts are bullish when they believe knowledgeable investors are bullish, and bearish when these investors are bearish. Smart-money indicators include:

•Barron's confidence index (ratio of high quality bond yields to the yields on average quality bonds) increases when bond investors arc bullish and buying lower quality bonds, and decreases when bond investors are bearish and shifting assets into higher quality bonds.

• The T-bill to Eurodollar yield spread (TED spread) widens during periods of crisis.

•Debit balances in brokerage accounts increase when margin buying (which tends to be done by more experienced investors) increases, and decreases when margin buying decreases.

Study Session 3

Cross-Reference to CFA Institute Assigned Reading #12 - Technical Analysis

Technical analysts use momentum indicators to read the direction of the market.

•The advance-decline line (advances less declines daily on the NYSE) indicates the

breadth of a market increase or decrease. If the line moves in the same direction as the market, the increase or decrease is broadly based, but a divergence signals a peak or trough.

•If the percentage of stocks selling above their 200-day moving averages is high I this indicates overbought market conditions, a bearish signal. If this percentage is low, the market is oversold, a bullish signal.

Priceand volume-based indicators used by technical analysts include:

•Dow Theory.

•Upside-to-downside volume ratio.

•Support and resistance levels.

•Moving average lines.

•Relative strength ratios.

•Bar charts and point-and-figure charrs.

Study Session 3

Cross-Reference to CFA Institute Assigned Reading #12 - Te~hnical Analysis

CONCEPT CHECKERS

1.Which of the following statements is least likely an advantage of technical analysis?

A.It teUs the analyst when ro buy.

B.It tells the analyst why investors are buying.

C.It incorporates psychological as well as economic reasons for price changes.

2.Which one of the following statements about technical analysis is most likely accurate? Technical analysis:

A.requires very little subjective judgment.

B.has been shown to outperform fundamental analysis.

C.is not heavily dependent on financial accounting statements.

3.When the investment advisory "sentiment" index exceeds a GO% negative

opinion rating. cOlltrary-opinion technicians will do which of the following?

A.Sell.

B.1~1I\'.

C. Hold.

4.\Xlhen the relative over-thc-counter (OTC) ro NYSE volume ratio is increasing, contrary-opinioll techniciam would do which of the following;

A.Hold.

B.Be bearish and sell.

C. Be bullish and buy.

5.If the Barron's confidence index (CI) increases (and the implied yield spread narrows), investors are doing which of the following?

A.Selling quality bonds.

B.Buying quality bonds.

C. Selling common stocks.

6. When investors are pessimistic. the CI will do which of the following?

A.Increase.

B.Decrease.

C.Remain constant.

7.When debit balances (i.e., margin debt) in brokerage accounts increase:

A.smart money technicians interpret this as a bearish sign.

B.smart money technicians interpret this as a bullish sign.

C.contrary-opinion technicians interpret this as a bullish sign.

8.Technicians feel that which of the following statements is most li!ee()' accurate?

A.Stock prices move in trends.

B.History tends to not repeat itself.

C.Prices adjust quickly to new information.

Study Session 3

Cross-Reference to CFA Institute Assigned Reading #12 - Technical Analysis

9.Which of the following would be a bullish sign ro a smarr money technician?

A.The Barron's confidence index increases.

B.The T-bill Eurodollar yield spread widens.

e.Debit balances in brokerage accoums decline.

10.If the relative suength ratio (stock price over market price) increases, the market index:

A.price increase equals the stock price increase.

B.price percemage increase is less than the srock price percemage increase.

e.price percemage increase is greater than the srock price percemage increase.

11.Which one of the following is a bearish signal to a smarr money technical analyst?

A.The T-bill Eurodollar yield spread narrows.

B.The Barron's confidence index increases.

e.Debit balances in brokerage accounts fall.

12.\'(!hich of the following is considered a bullish indicltor to a contrarian?

A.Low/Lilling credit balances in brokerage aCCOllIHS.

B.High aTe volume ratio.

e.High put/call ratio.