On technical analysisOn technical analysis

Technical analysis: The conceptTechnical analysis: The concept

Technical analysts believe thatTechnical analysts believe that, in the long run, prices move towards their fundamentals.

The flow of information is random, however, the market is slow to respond, thus, generating recurring patterns.

It pays to exploit these patterns before others can identify them, provided we can recognize them as they emerge.

Recurring patterns tend to self-destruct.

Technical analysis: ClassificationTechnical analysis: Classification

• Charting

• Sentiment Indicators

• Flow of Funds Indicators

• Market Structure Indicators

• Miscellaneous

ChartingCharting

The Dow Theory:

Primary trends, intermediate trends, minor trends, support levels, and resistance levels are analyzed to produce buy or sell signals.

The wisdom behind the Dow TheoryThe wisdom behind the Dow Theory

On January 31st,1901 Charles H. Dow wrote in the Wall Street Journal:

"A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned.

This method holds good in watching and determining the flood tide of the

stock market."

The Six CommandmentsThe Six Commandments

1. The Averages Discount Everything. • An individual stock's price reflects everything that is known about the security

2. The Market Is Comprised of Three Trends: Primary trend, Secondary trends, and Minor trends.

3. Primary Trends Have Three Phases.• The First phase is made up of aggressive buying by informed investors in anticipation of economic recovery and

long-term growth.

• The Second phase is characterized by increasing corporate earnings and improved economic conditions

• The Third phase is characterized by record corporate earnings and peak economic conditions

4. The Averages Must Confirm Each Other.• Ex: The Industrials and Transports must confirm each other in order for a valid change of trend to occur.

5. The Volume Confirms the Trend.

6. A Trend Remains Intact Until It Gives a Definite Reversal Signal.Source: equis.com

A classic buy signalA classic buy signal

Follow the movements of a stock or market index

3. Pullback

2. Bounce

1. Market low

4. Break up (above the bounce high)4. Break up (above the bounce high)

Buy signals: VariationsBuy signals: Variations

Follow the movements of a stock or market index

3. Pullback

2. Bounce

1. Market low

4. Break up (above the bounce high)4. Break up (above the bounce high)

A classic sell signalA classic sell signal

Follow the movements of a stock or market index

3. Bounce 2. Pullback

1. Market high

4. Break down4. Break down

Sell signals: VariationsSell signals: Variations

Follow the movements of a stock or market index

3. Bounce

2. Pullback

1. Market high

4. Break down4. Break down

The Dow Theory: Support and ResistanceThe Dow Theory: Support and Resistance

“Think of security prices as the result of a head-to-head battle between a bull (the buyer) and a bear (the seller).

The bulls push prices higher and the bears push prices lower.

The direction prices actually move reveals who is winning the battle.”

Source: equis.com

More on “support” and “resistance” levels...More on “support” and “resistance” levels...

Source: equis.com

More on “support” and “resistance” levels...More on “support” and “resistance” levels...

Japanese candlesticks: Bullish signalsJapanese candlesticks: Bullish signals

Bullish doji starMorning star Bullish engulfing lines

Piercing lineHammerLong white (empty) line

Japanese candlesticks: Bearish signalsJapanese candlesticks: Bearish signals

Hanging Man Dark cloud cover

Bearish engulfing lines

Long black (filled-in) line

Evening star Shooting star

Voo-doo investingVoo-doo investing

Sentiment IndicatorsSentiment Indicators

Trin Trin = Vol(declining)/Vol(advancing)][Number(declining)/Number(advancing)]

If 1 market is bearish (reported in the Wall Street Journal)

Odd-lot ratio odd-lot-ratio = odd-lot buys/odd-lot sales

Odd-lot traders are believed to miss key market turning points; hence when they buy it is likely that the bull market has already missed its course.

A ratio > 1 is a bearish signal. (reported in the Wall-Street Journal) Barron's Confidence Index

BCI= avg yield on high grade bonds/avg. yield on top ten intermediate grade bonds;

An increase in the index signals a bull market, a decrease of the index signals a bear market; The index is always less than one

Put/Call ratio PCR= outstanding put options/outstanding call options

A ratio over one signals a bearish market

Mutual fund cash positions Measure the sentiment among investors who are believed to be poor market timers.

An increase in these cash positions shows the funds concerned about falling markets, hence, sending a bullish signal.

Flow of Funds IndicatorsFlow of Funds Indicators

Short Interest could be an indicator of future latent demand for

stock, or it could signal "informed" selling by institutional investors.

Market Structure IndicatorsMarket Structure Indicators

Moving averages

They signal a bear market when they go above current market prices, or a bull market

when going below current market prices.

Market breadth

It measures the extent to which movements in the market index is representative of the individual stock price movements.

MB = Number of advancing - Number of declining.

Relative strength

It measures the extent to which a security has outperformed its industry or the market.

MiscellaneousMiscellaneous

The Superbowl RuleThe Superbowl Rule:

In a year that an original NFL team wins the Superbowl the mrket is likely to rise for the rest of the year. The opposite is true when a AFC team wins the Superbowl.

The Presidential Cycle RuleThe Presidential Cycle Rule:

In the second year of the presidential term, the market is likely to fall, and in the third year it is likely to rise.

The Hemline IndicatorThe Hemline Indicator:

The market index tends to rise and descend with the hemline of women's dresses.

Etc.

The Value Line EnigmaThe Value Line Enigma

Each week, Value Line Investment Survey reviews almost 1,700 traded companies.

Stocks are ranked into five groups, according to their expected price appreciation:group 1: the best expected performers

group 5: the worst expected performers

The ranking is done with a use of a formula that takes into account:

Earnings momentum

Stock's relative price

Relative strength

The Value Line Enigma: The Devil is in the detailsThe Value Line Enigma: The Devil is in the details

Between 1965 and 1990, the groups performed as predicted.

The average annual return of group 1 stocks was 22%.

1965 1990

Initial investment: $10,000

$1,500,000(dividends and transaction costs excluded).

The Value Line Enigma: The Devil is in the detailsThe Value Line Enigma: The Devil is in the details

The Value Line Centurion Fund which manages a portfolio made of

group 1 stocks has underperformed group 1 by 1,100 bp !

The Value Line Enigma:The Value Line Enigma:

Possible reasons for underperformancePossible reasons for underperformance

High turnoverHigh turnover = high transaction costs (the portfolio has to be rebalanced every week): - bid-ask spread

- brokerage fees

Fund overheadFund overhead

However, (transaction costs + fund overheadtransaction costs + fund overhead) don’t add up to

the difference 

The Value Line Enigma:The Value Line Enigma:More on possible reasons for underperformanceMore on possible reasons for underperformance

Measuring performance against prediction assumes the stock is purchased on WednesdayWednesday at close, yet the fund re-balances the portfolio on FridayFriday and the readers read the survey on Friday morningFriday morning.

Wed Thu Fri Sat Sun Mo Tue Wed Thu Fri

Group 1 is being re-

evaluated

The bulk of the price increase in group 1 stocks takes place between Thursday and Friday.between Thursday and Friday.

The survey reaches the public

The VL Centurion Fund rebalances its portfolio

Group 1 is being re-

evaluated

The survey reaches the public

The VL Centurion Fund rebalances its portfolio

Group 1 stock stock price

Group 1 stock stock price

More on possible reasons for underperformanceMore on possible reasons for underperformance

The US Postal Service could be moving fast in some parts of the country; hence some readers might get their subscription on Thursday.

Smart investors anticipate the change in ranking in advance. They know They know the formulathe formula and watch closely group 2 stocks. If earning reports come in better than expected, some of them will move up.

On Friday morning, everyone will want to buy into the same stocks, thus pushing the price very high.

A dramatizationA dramatization

A stock sells for $ 10 on Wednesday at close.

Value Line forecasts it will rise in value over the next weeks or so.

However, the information does not reach the market effectively until Friday morning.

At the opening bell, there are hundreds of buy orders for that stock.

As a result, the stock goes to $ 14. 

VisualizationVisualization

Wed Thu Fri Sat

$10

$14

The survey reaches the public

Some early birds figure out group 1

A dramatization: SummaryA dramatization: Summary

Did the stock rise as predicted? Did the stock rise as predicted?  Yes, one-week return = 40%

Did investors make a good return?Did investors make a good return? No, the majority of them bought at $ 14, (minus transaction costs) Some early birds made a return of 27% (minus transaction costs)

To learn more:

http://www.equis.com/[[]] http://www.stockcharts.com/education/What/MarketAnalysis/dowtheory1.html#intro

Etc.Etc.