CHAPTER NINE TECHNICAL ANALYSIS Practical Investment Management Robert A Strong Outline Charting The Underlying Logic Types of Charts Other Chart Annotations Technical Indicators Indicators with Economic Justification Indicators of the Witchcraft Variety South-Western / Thomson Learning © 2004 9-2 Outline Old Puzzles and New Developments Fibonacci Numbers Dow Theory Kondratev Wave Theory Chaos Theory Neural Networks The Future of Technical Analysis South-Western / Thomson Learning © 2004 9-3 Charting: The Underlying Logic The technical analyst believes that charts can be used to predict changes in supply and demand and investor behavior Market participants seldom wait for things to completely unfold They try to anticipate events rather than merely react to them South-Western / Thomson Learning © 2004 9-4 Charting: Types of Charts The technical analyst uses many types of charts: line charts bar charts point and figure charts candlestick charts South-Western / Thomson Learning © 2004 9-5 Linear Scale Line Chart Insert Figure 9-1 here South-Western / Thomson Learning © 2004 9-6 Logarithmic Y-Axis Line Chart Insert Figure 9-2 here South-Western / Thomson Learning © 2004 9-7 Bar Chart Insert Figure 9-3 here South-Western / Thomson Learning © 2004 9-8 Point and Figure Chart Insert Figure 9-4 here South-Western / Thomson Learning © 2004 9-9 Candlestick Chart South-Western / Thomson Learning © 2004 - 10 Advance-Decline Line Insert Figure 9-11 (Market Breadth) here South-Western / Thomson Learning © 2004 - 24 Indicators with Economic Justification A high relative strength ratio, such as a high relative PE, means that investors are willing to pay more for the past earnings of a company than average South-Western / Thomson Learning © 2004 - 25 Relative Strength Ratio Insert Table 9-3 here South-Western / Thomson Learning © 2004 - 26 Indicators with Economic Justification Advocates of moving averages in stock selection believe that changes in the slope of the line are important Market indicators can help present data in a more intuitive way and may suggest areas for further investigation However, they cannot always predict the future movements of a stock or of the overall market South-Western / Thomson Learning © 2004 - 27 Indicators of the Witchcraft Variety The super bowl indicator states that the stock market will advance the following year if the super bowl football game is won by a team from the original National Football League South-Western / Thomson Learning © 2004 - 28 The Super Bowl Indicator South-Western / Thomson Learning © 2004 - 29 Indicators of the Witchcraft Variety Increased sunspot activity every eleven years leads to better weather for an improved harvest, leading in turn to a stronger economy, and finally to higher stock prices Hemline indicator : As shorter dresses for women become the fashion, the market advances, and vice versa South-Western / Thomson Learning © 2004 - 30 Old Puzzles and New Developments Fibonacci Numbers 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, Fibonacci numbers occur frequently and inexplicably in nature 1.618, the golden mean of the numbers, is used to calculate the Fibonacci ratios Many Fibonacci advocates in the investment business use the first two ratios, 0.382 and 0.618, to “compute the retracement levels of a previous move.” South-Western / Thomson Learning © 2004 - 31 Old Puzzles and New Developments Dow Theory The Dow theory holds that there are three components in the movement of stock prices: The primary trend is the long-term direction of the market and is the most important The secondary trend refers to a temporary reversal in the primary trend Daily fluctuations in the stock price are meaningless and contain no useful information South-Western / Thomson Learning © 2004 - 32 Old Puzzles and New Developments Insert Figure 9-12 (The Dow Theory) here South-Western / Thomson Learning © 2004 - 33 Old Puzzles and New Developments The Kondratev wave theory states there is a 50-60 year business cycle The Chaos theory sees systematic behavior amidst apparent randomness A neural network is a trading system in which a forecasting model is trained to find a desired output from past trading data South-Western / Thomson Learning © 2004 - 34 Old Puzzles and New Developments Insert Figure 9-13 (InvestmentStyle Topography) here South-Western / Thomson Learning © 2004 - 35 The Future of Technical Analysis Technical analysis has persisted for more than 100 years, and it is not likely to disappear from the investment scene anytime soon Improved quantitative methods coupled with improved behavioral research will continue to generate ideas for analysts to test South-Western / Thomson Learning © 2004 - 36 Review Charting The Underlying Logic Types of Charts Other Chart Annotations Technical Indicators Indicators with Economic Justification Indicators of the Witchcraft Variety South-Western / Thomson Learning © 2004 - 37 Review Old Puzzles and New Developments Fibonacci Numbers Dow Theory Kondratev Wave Theory Chaos Theory Neural Networks The Future of Technical Analysis South-Western / Thomson Learning © 2004 - 38 ... mean of the numbers, is used to calculate the Fibonacci ratios Many Fibonacci advocates in the investment business use the first two ratios, 0.382 and 0.618, to “compute the retracement levels