topic 6 investment analysis

� INTRODUCTION

In this topic, we will discuss another alternative to fundamental analysis of share evaluation. Technical analysis is about forecasting the direction of future share prices. Decisions are then made based on the forecast. Investors that rely solely on technical analysis are sometimes known as Technicians. This topic also discusses the Efficient Market Hypothesis.

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� Behaviour of Share Prices (Technical Analysis)

LEARNING OUTCOMES

By the end of this topic, you should be able to:

1. Explain the importance of Technical Analysis in forecasting thedissection of future share prices;

2. Analyse the trends of share price movements;

3. Explain the three levels of market efficiency; and

4. Discuss the implications of Efficient Market Hypothesis on SecurityAnalysis.

� TOPIC 6 BEHAVIOUR OF SHARE PRICES (TECHNICAL ANALYSIS) 92

BASIC CONCEPTS OF TECHNICAL ANALYSIS

It is based on these concepts as stated below:

(a) Share price is based on demand and supply.

(b) There are rational and irrational factors that will influence the demand and supply.

(c) The behaviour of prices tends to follow a trend that persists for a length of time. This is sometimes known as a momentum. Prices do not adjust suddenly and it will take some time before the price reaches its equilibrium. Technicians therefore will make a decision that is early enough before the price settles.

(d) Another important feature is that the behaviour of price follows a certain pattern. This pattern is thought to have happened in the past and is also likely to occur again in the future. Technicians therefore study the present and previous price behaviour.

TOOLS FOR TECHNICAL ANALYSIS

6.2

6.1

Technical Analysis is a process that involves the examination of past data such as share prices and volume of trading to forecast the direction of future prices.

In Topics 1 and 2, we were introduced to the concept of investment. Based on your understanding of the investment concept, why do people invest? What do they hope to achieve?

SELF-CHECK 6.1

We know that Technical Analysis is the process that involves the examination of past data such as share prices and volume of trading to forecast the direction of future prices. Based on earlier discussions in the previous topic, how do investors obtain information on share prices, trends, growth rates and others?

SELF-CHECK 6.2

TOPIC 6 BEHAVIOUR OF SHARE PRICES (TECHNICAL ANALYSIS) � 93

TechnicianÊs tools in technical analysis can be divided into two main categories:

(a) Market Statistics; and

(b) Charts.

6.2.1 Market Statistics

Market statistics are summaries of the behaviour of the market and the price movement of shares. Examples are as follows: (i) MMarket Volume Market Volume measures the amount of investorÊs interests in the market.

Volume is the number of shares traded in the market and itÊs a reflection of demand and supply. The market is considered to be strong if the volume is high in a rising market. It is also considered strong when the volume is low in a declining market. In the second situation technicians are expecting a turnaround. The market is considered weak if the volume traded is high in a declining market or low volume in a rising market.

(ii) BBreadth of the Market Breadth of the Market measures the strength of the market in terms of the

number of shares that experience increase, decrease or no change in price. The market is considered strong if the number of shares with increased price is higher than the number of shares with declined price. The market is weakening if the difference between the number of increase and decline is getting closer.

This measure can sometimes be used as an early indicator of the strength of

the market. If the market index is rising but the number of declines is higher than advances, then the rise in the index is not that strong. It may be an indication of a weakening market.

6.2.2 Charts

It is the most frequently used tool by technicians. It can provide early indications of developing trends and the future behaviour of the market.

Charts are visual summaries of the behaviour of the market and price movements of shares.


Charts are normally developed by registering the price of shares or index on a time graph. The trend line can then be analysed. The trends can be divided into: (i) PPrimary Trend The primary trend is a long-term indicator of the price trend. If it is taken in

the perspective of the market, a rising primary trend is known as a bull market while a declining primary trend is known as a bear market. (Please refer to Figure 6.1).

Figure 6.1: Primary trends

(ii) SSecondary Trends A secondary trend is a trend within the primary trend. In a rising primary

trend, there may be one or two secondary trends. Secondary trends occur when the market declines for a while before resuming its rise. Sometimes it is known as secondary movement.

The support line is a range of prices that analysts think will generate new demand from investors. When this new demand goes into the market, the share price will enjoy the next trend of price increase. Before this new demand, price may appear to be stable or decline a little.


The resistance line is the reverse; it is a situation where investors are waiting to sell. Price may increase a little before this extra supply comes into the market. If price at this resistance level cannot be maintained, then price will continue to fall. Some commonly used charts in forecasting share price direction are: (i) TThe Bar Chart A Bar Chart is formed by taking share prices in a specified time period. The

bar is formed by taking the highest, lowest and closing prices for the day. The trend is then analysed. Figure 6.2 shows an example of the chart. We can forecast the direction of the shareÊs price by placing the resistance and the support line on the chart.

(ii) TThe Point and Figure Chart This chart does not relate price to time. It illustrates price changes or

reversals in the direction of the price. However, it requires the analyst to record the shareÊs closing price on a daily basis. Figure 6.3 shows an example of a point and figure chart. The chart is divided into columns. The analyst will record the closing price in each space within a column. If there is an increase in price, the record can be in a form of an X. If there is a decrease in price, then the analyst shifts to the next column and indicates the decrease with a 0 mark.


Based on the chart, analyse the behaviour and price movement ofshares in Bursa Malaysia. You can then refer to The Star dated 15December 2003 for the market analysis.

Source: The Star (2003).

ACTIVITY 6.1


Figure 6.2: A bar chart

If we begin at Day 1, and the price is RM2, the first X will be in Column a. The price continues to increase and peak at RM2.50 on Day 3. Then the price drops to RM2.4. This is when we shift to Column b. The price continues to drop until Day 9. It goes up again in Day 10 where we will shift to Column c. The price continues to increase until Day 20. The price drops to RM2.1 on Day 21. This will indicate a shift to the next column, and so forth. As in the case of bar charts, resistance and support lines can be placed on the point and figure chart to forecast price.


Figure 6.3: A point and figure chart

(iii) MMoving Averages A Moving Average line attempts to show a smooth general price trend. A

price trend can show a lot of volatility and offer a less meaningful insight. There are several moving averages that can be used. Examples are 200 days moving average or 200-MA. The 200-MA is determined by taking the average of the previous 200 daysÊ prices. Obviously, we need 200 days of prices before the first average can be calculated. Therefore, on the 201st day we calculate the average of the previous 200 prices. On the 202nd day, we take out the first dayÊs price from the calculation and include the 201st price, and so on. So each time we will use 200 days.

Apart from showing a smooth trend line, the MAs can be used as support

or resistance lines. If the price is on the decline, the MA line will be above the current price. If the price breaks through the MA line followed by heavy volume, this may indicate a strong buying trend and prices may go up. Figure 6.4 shows the trend for the Kuala Lumpur Composite Index (KLCI) as well as its 50 days MA, from January 1990 to July 2003.


Figure 6.4: Monthly KLCI and 50 A (January 1990 to July 2003)

6.2.3 Chart Formations

The effect of price changes due to demand and supply visualised in the form of charts will provide formations and patterns. For example, some of these patterns are given names like head and shoulders, pennants, scallops, and triangles. Description of these formations is beyond this module. Knowing them is one thing, interpreting them is another. And there is also no assurance that accurate forecasts can be made. Figures 6.5 and 6.6 show the charts for Yeo Hiap Seng. You are encouraged to make some observations.

Figure 6.5: Daily bar chart for YHS 100 days prior to 10 November 2003


Figure 6.6: Daily price trend and 50 days MA for YHS 100 days prior to

10 November 2003

EFFICIENT MARKET HYPOTHESIS

The Efficient Market Hypothesis (EMH) stems from the idea that share prices follow a random walk. This means share prices are unpredictable and performing a security analysis will not help to forecast future prices.

Prices will be adjusted based on new information. New information, however, is random and cannot be predicted. In an efficient market, there will be no opportunity to obtain abnormal returns. Investors will get returns from changes in prices. Prices will change due to new information entering the market. If the price adjustment is correct and rapid, then investors will not have the opportunity and the time to act. Therefore, there will be no abnormal returns.

6.3

Fama (1970) defines an efficient market as one in which prices fully reflect all information.


6.3.1 Assumptions of the Efficient Market Hypothesis (EMH)

There are three assumptions of the Efficient Market Hypothesis:

(a) There are a large number of investors competing against one another and analysing the value of securities.

(b) Information that comes into the market is not predictable. The information is random and there is no connection between one set of information and another. This information must also be freely available to all investors.

(c) Investors will react to the information rapidly and correctly.

6.3.2 Categories of Information

The above assumptions are almost similar to a perfect competition in terms of receiving information. No one can prevent information from entering the market. Therefore, the kind of information that is considered for analysis purposes can be categorised into three types.

(a) Previous market information. Previous price data, volumes traded in the market, trends and charts.

(b) Public information including company annual reports, economic and industry reports and company news.

(c) All information that is public and non-public. This will include all the above plus all information that has not yet been made public. Examples of non-public news are company strategies, mergers, and news on financially distressed firms. This news is sometimes known as inside information, because only the management of the companies know this information. Any inside information that is obtained illegally and used to make profit is an offence. This kind of practice is known as insider trading. In the Bursa Malaysia and in most other stock exchanges, insider trading is illegal.

Visit the Bursa Malaysia website at http://www.bursamalaysia.comand find more information about insider trading:

(a) What is insider trading?

(b) What is the punishment for it?

ACTIVITY 6.2


6.3.3 Levels of Efficiency

In line with the three categories of information discussed in the previous section, the market can be categorised into three levels of efficiency. (a) WWeak Form At this level of efficiency, prices of securities are said to reflect past

information. This means that analysing previous information is useless. Investors studying previous prices, volumes traded and other market information can make no abnormal profit.

(b) SSemi-strong Form At this level, prices of securities fully reflect all publicly available

information from the past as well as the present. This level will encompass the weak form level. This means that a market has to be in weak form before it can be semi-strong. All information is reflected correctly and quickly by the price. As such, although an investor has this information, he is unable to make extra profit as the information is publicly known.

(c) SStrong Form At this level, prices will fully reflect all information whether public or non-

public. This information includes all company information that has not been made public. Investors who have this information will not be able to take advantage of it in order to get extra returns.

6.3.4 Efficient Market Hypothesis Implications

The EMH implies that if the market is efficient, it is pointless to perform any security analysis. Technical analysis will be a useless exercise if the market is in weak form efficiency since prices have fully reflected previous price behaviour. If the market is in a semi-strong form, all economic and company events would have been reflected in the price. Therefore, there is no point in performing a fundamental analysis. Another implication is that no investor will obtain extra returns without incurring extra cost and risks. However, the fact that price must fully reflect all information and that this information needs to be analysed shows that there is still a need to perform analysis. By performing an analysis, the investor will also be able to separate companies that are fundamentally strong from the weaker ones. Investors can use this information to reduce their exposure to risk. In addition, there will be investors who are willing to take risks. These investors need to perform analysis and incur the extra cost.


1. The data below shows closing price for YHS for 60 days up till 10 November 2003. Prepare a point and figure chart of the prices. Prepare a simple chart price against time and discuss it against the point and figure chart.

1.80 1.90 1.83 1.81

1.84 1.90 1.82 1.81

1.82 1.83 1.83 1.80

1.82 1.82 1.83 1.80

1.80 1.84 1.78 1.79

1.82 1.85 1.83 1.86

1.82 1.88 1.81 1.83

1.82 1.86 1.82 1.82

1.86 1.86 1.81 1.90

1.89 1.83 1.84 1.91

1.86 1.83 1.85 1.90

1.88 1.84 1.83 1.90

1.89 1.88 1.82 1.90

1.88 1.90 1.82 1.89

1.86 1.92 1.80 1.90 2. Price will fully reflect all information. What will happen to the

price of a stock if the company declares a rise in dividends? 3. Based on Question 2, when will the price begin to respond to the

news? Answer with respect to each level of the EMH.

EXERCISE 6.1

10 November 2003


� Technical Analysis is a process that involves the examination of past data such

as share prices and volume of trading to forecast the direction of future prices. � The Efficient Market Hypothesis (EMH) stems from the idea that share prices

follow a random walk are are unpredictable, and performing a security analysis will not help to forecast future prices.

� There are three levels of efficiency. They are:

(a) Weak Form;

(b) Semi-strong Form; and

(c) Strong Form.

topic 6 investment analysis

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