8 8 C h a p t e r Stock Price Behavior and Market Efficiency Stock Price Behavior and Market Efficiency second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D.Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 8 - 2 One of the Funny Things about the Stock Market One of the funny things about the stock market is that every time one man buys, another sells, and both think they are astute – William Feather © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 8 - 3 Stock Price Behavior and Market Efficiency Our goal in this chapter is to discuss bull markets, bear markets, as well as other market phenomena and psychology. We will also consider if anyone can consistently “beat the market.” Goal © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 8 - 4 Technical Analysis Technical analysts essentially search for bullish (positive) and bearish (negative) signals about stock prices or market direction. Technical analysis Techniques for predicting market direction based on (1) historical price and volume behavior, and (2) investor sentiment. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 8 - 5 Dow Theory The Dow theory is a method of interpreting and signaling changes in the stock market direction based on the monitoring of the Dow Jones Industrial and Transportation Averages. The Dow theory identifies three forces: c a primary direction or trend, d a secondary reaction or trend, and e daily fluctuations. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 8 - 6 Daily fluctuations are essentially noise and are of no real importance. Dow Theory The primary direction is either bullish or bearish, and reflects the long-run direction of the market. Secondary trends are temporary departures from the primary direction. Corrections are reversions back to the primary direction. Time Prices DJIA DJTA If a departure in one is followed by a departure in the other, then this is viewed as a confirmation that the primary trend has changed. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 8 - 7 Support and Resistance Levels A support level is a price or level below which a stock or the market as a whole is unlikely to go, while a resistance level is a price or level above which a stock or the market as a whole is unlikely to rise. Resistance and support areas are usually viewed as psychological barriers - bargain hunters help “support” the lower level, while profit takers “resist” the upper level. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 8 - 8 Support and Resistance Levels A “breakout” occurs when a stock (or the market) passes through either a support or a resistance level. Technical Indicators 8 - 9 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 8 - 10 Technical Indicators Notes: The “advance/decline line” shows, for some period, the cumulative difference between advancing and declining issues. “Closing tick” is the difference between the number of shares that closed on an uptick and those that closed on a downtick. “Closing arms” or “trin” (tr ading index) is the ratio of average trading volume in declining issues to average trading volume in advancing issues. “zBlock trades” are trades in excess of 10,000 shares. [...].. .8 - 11 Charting Relative strength charts measure the performance of one investment relative to another Month 1 2 3 4 5 6 McGraw Hill / Irwin Stock A (4 shares) $100 96 88 88 80 76 Stock B (2 shares) $100 96 90 80 78 76 Relative Strength 1.00 1.00 0. 98 1.10 1.03 1.00 © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 12 Charting Moving average charts... McGraw-Hill Companies, Inc All rights reserved 8 - 31 Stock Price Behavior and Market Efficiency The day -of- the-week effect refers to the tendency for Monday to have a negative average return Average Daily S&P 500 Returns by Day of the Week July 1962 - December 1994 Dividends Not Included Weekday: Mon Tue Wed Thu Fri Avg return: – 0 78% 035% 0 98% 026% 063% McGraw Hill / Irwin © 2002 by The McGraw-Hill... McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 15 Charting McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 16 Charting McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 17 Charting Point-and-figure charts are a way of showing only major price moves and their direction A “major” upmove is marked... McGraw-Hill Companies, Inc All rights reserved 8 - 35 Chapter Review Technical Analysis Dow Theory Support and Resistance Levels Technical Indicators Charting • • • • Relative Strength Charts Moving Average Charts Hi-Lo-Close and Candlestick Charts Point-and-Figure Charts Chart Formations Other Technical Indicators McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 36... every time there is a change in direction McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 18 Charting McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 19 Charting McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 20 Chart Formations Once a chart is drawn, technical analysts examine it for various... McGraw-Hill Companies, Inc All rights reserved 8 - 25 What Does “Beat the Market” Mean? The excess return on an investment is the return in excess of that earned by other investments having the same risk “Beating the market” means consistently earning a positive excess return McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 26 Forms of Market Efficiency Weak-form... calculated using a fixed number of previous days’ prices or levels, updated each day Since the price fluctuations are smoothed out, such charts are used to identify short- and long-term trends, often along the lines suggested by Dow theory McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 13 Charting Prices DJIA 50-day moving average 200-day moving average Time McGraw... and volume figures are of no use in beating the market Semistrong-form efficient market A market in which publicly available information is of no use in beating the market Strong-form efficient market A market in which information of any kind, public or private, is of no use in beating the market McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 27 Why would a Market... McGraw-Hill Companies, Inc All rights reserved 8 - 14 Charting A hi-lo-close chart is a bar chart showing, for each day, the high price, low price, and closing price A candlestick chart is an extended version of the hi-lo-close chart It plots the high, low, open, and closing prices, and also shows whether the closing price was above or below the opening price McGraw Hill / Irwin © 2002 by The McGraw-Hill... One example is the head-and-shoulders formation When the stock price “pierces the neckline” after the right shoulder is finished, it’s time to sell McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 21 Chart Formations McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 8 - 22 Other Technical Indicators The “odd-lot” indicator looks at . Strength 1 $100 $100 1.00 296961.00 388 900. 98 488 801.10 580 781 .03 676761.00 © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 8 - 12 Charting Moving average charts. Hill / Irwin Slides by Yee-Tien (Ted) Fu © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 8 - 2 One of the Funny Things about the Stock Market One of the funny. Irwin 8 - 14 Charting A hi-lo-close chart is a bar chart showing, for each day, the high price, low price, and closing price. A candlestick chart is an extended version of the hi-lo-close