On technical analysis

Technical analysis: The concept

Technical analysts believe that,
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: Classification

Charting
Sentiment Indicators
Flow of Funds Indicators
Market Structure Indicators
Miscellaneous

Charting

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 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 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 signal

Follow the movements of a stock or market index

4. Break up (above the bounce high)

2. Bounce

3. Pullback
1. Market low

Buy signals: Variations

Follow the movements of a stock or market index

4. Break up (above the bounce high)

2. Bounce

1. Market low
3. Pullback

A classic sell signal

Follow the movements of a stock or market index

1. Market high
3. Bounce
2. Pullback

4. Break down

Sell signals: Variations

Follow the movements of a stock or market index

3. Bounce

1. Market high

2. Pullback

4. Break down

The 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...

Source: equis.com

More on support and resistance levels...

Japanese candlesticks: Bullish signals

Long white (empty) line

Morning star

Hammer

Piercing line

Bullish engulfing lines

Bullish doji star

Japanese candlesticks: Bearish signals

Long black (filled-in) line

Bearish engulfing lines

Hanging Man

Evening star

Dark cloud cover

Shooting star

Voo-doo investing

Sentiment 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 Indicators

Short Interest could be an indicator of future latent demand for

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

Market 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.

Miscellaneous
The Superbowl Rule:
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 Rule:
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 Indicator:
Indicator
The market index tends to rise and descend with the hemline of
women's dresses.
Etc.

The 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 details

Between 1965 and 1990, the groups performed as predicted.
The average annual return of group 1 stocks was 22%.

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

Initial investment: $10,000

1965

1990

The 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:

Possible reasons for underperformance

High turnover = high transaction costs (the portfolio has to be

rebalanced every week):
- bid-ask spread
- brokerage fees

Fund overhead
However, (transaction costs + fund overhead)
overhead dont add up to
the difference

The Value Line Enigma:

More on possible reasons for underperformance
Measuring performance against prediction assumes the stock is purchased on Wednesday
at close, yet the fund re-balances the portfolio on Friday and the readers read the survey on
Friday morning.
morning
Group 1 stock
stock price

Group 1 stock
stock price
Group 1 is
being re-

The survey
reaches
the public

Group 1 is
being re-

evaluated

The survey
reaches
the public

evaluated

Wed

Thu

Fri
The VL
Centurion
Fund
rebalances its
portfolio

Sat

Sun

Mo

Tue

Wed

Thu

Fri
The VL
Centurion
Fund
rebalances its
portfolio

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

More 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
the 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 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.

Visualization

The survey
reaches the
public

$14

Some early
birds figure
out group 1

$10

Wed

Thu

Fri

Sat

A dramatization: Summary

Did the stock rise as predicted?

Yes, one-week return = 40%
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)

Etc.

To learn more:

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