Regarding the analysis of specific trading rules, as discussed in Chapter 6, numerous techni- cal trading rules exist that have not been or cannot be tested. Still, the vast majority of the results for the trading rules tested support the EMH.
An obvious challenge to technical analysis is that the past price patterns or relationships between specific market variables and stock prices may not be repeated. As a result, a technique that previ- ously worked might miss subsequent market turns. This possibility leads most technicians to fol- low several trading rules and to seek a consensus of all of them to predict the future market pattern.
Other critics contend that many price patterns become self-fulfilling prophecies. For example, assume that many analysts expect a stock selling at $40 a share to go to $50 or more if it should rise above its current pattern and “break through” its channel at $45. As soon as it reaches $45, enough technicians will buy to cause the price to rise to $50, exactly as predicted. In fact, some technicians may place a limit order to buy the stock at such a breakout point. Under such condi- tions, the increase will probably be only temporary and the price will return to its true equilibrium.
Another problem with technical analysis is that the success of a particular trading rule will encourage many investors to adopt it. It is contended that this popularity and the resulting com- petition will eventually neutralize the technique. If numerous investors focus on a specific tech- nical trading rule, some of them will attempt to anticipate the price pattern and either ruin the expected historical price pattern or eliminate profits for most traders by causing the price to change faster than expected. For example, suppose it becomes known that technicians who employ short selling data have been enjoying high rates of return. Based on this knowledge, other technicians will likely start using these data and thus accelerate the stock price pattern fol- lowing changes in short selling. As a result, this profitable trading rule may no longer be prof- itable after the first few investors react.
Further, as we will see when we examine specific trading rules, they all require a great deal of subjective judgment. Two technical analysts looking at the same price pattern may arrive at widely different interpretations of what has happened and, therefore, will come to different investment decisions. This implies that the use of various techniques is neither completely mechanical nor obvious. Finally, as we will discuss in connection with several trading rules, the standard values that signal investment decisions can change over time. Therefore, technical analysts must adjust the specified values that trigger investment decisions over time to conform to the new environ- ment. In other cases, trading rules are abandoned because it appears they no longer work.
TECHNICAL TRADING RULES AND INDICATORS
To help you understand the specific technical trading rules, Exhibit 16.2 shows a typical stock price cycle that could be an example for the overall stock market or for an individual stock. The graph shows a peak and trough, along with a rising trend channel, a flat trend channel, a declin- ing trend channel, and indications of when a technical analyst would ideally want to trade.
Challenges to Technical Trading Rules Challenges to Technical Analysis Assumptions
The graph begins with the end of a declining (bear) market that finishes in a troughfollowed by an upward trend that breaks through the declining trend channel. Confirmation that the trend has reversed would be a buy signal. The technical analyst would buy stocks that showed this pattern.
The analyst would then look for the development of a rising trend channel. As long as the stock price stayed in this rising channel, the technician would hold the stock(s). Ideally, you want to sell at the peakof the cycle, but you cannot identify a peak until after the trend changes.
If the stock (or the market) begins trading in a flat pattern, it will necessarily break out of its rising trend channel. At this point, some technical analysts would sell, but most would hold to see if the stock experiences a period of consolidation and then breaks out of the flat trend chan- nelon the upside and begins rising again. Alternatively, if the stock were to break out of the channel on the downside, the technician would take this as a sell signal and would expect a declining trend channel. The next buy signal would come after the trough when the price breaks out of the declining channel and establishes a rising trend. Subsequently, we will consider strate- gies to detect these changes in trend and the importance of volume in this analysis.
There are numerous technical trading rules and a range of interpretations for each of them, Almost all technical analysts watch many alternative rules and decide on a buy or sell decision based on a consensus of the signals, because complete agreement of all the rules is rare. This sec- tion discusses several well-known techniques. The presentation on domestic indicators is divided into four sections based on the attitudes of technical analysts. The first group includes trading rules used by analysts who like to trade against the crowd using contrary-opinion signals. The second group of rules attempts to emulate astute investors, that is, the smart money. The next sec- tion includes technical indicators that are very popular but not easily classified. The fourth sec- tion covers pure price and volume techniques, including the famous Dow Theory. The final sec- tions describe how these technical trading rules have been applied to foreign securities markets and bond markets.
Many technical analysts rely on technical trading rules that assume that the majority of investors are wrong as the market approaches peaks and troughs. Therefore, these technicians try to deter- mine when the majority of investors is either strongly bullish or bearish and then trade in the opposite direction.
Contrary-Opinion Rules
Stock Price
Trough
Buy Point Peak
Trough Declining
Trend
Channel Buy Point
Sell Point Declining
Trend Channel
Flat Trend Channel
Rising Trend Channel
EXHIBIT 16.2 TYPICAL STOCK MARKET CYCLE
Mutual Fund Cash Positions Mutual funds hold some part of their portfolio in cash for one of several reasons. One reason is that they need cash to liquidate shares submitted by fund- holders. Another reason is that new investments in the mutual fund may not have been invested.
Third, the portfolio manager might be bearish on the market and want to increase the fund’s defensive cash position.
Mutual funds’ ratios of cash as a percentage of the total assets in their portfolios (the cash ratio or liquid asset ratio) are reported in the press, including monthly figures in Barron’s.2This percentage of cash has varied in recent years from a low point of about 4 percent to a high point near 11 percent, although there appears to be a declining trend to the series.
Contrary-opinion technicians believe that mutual funds usually are wrong at peaks and troughs. Thus, they expect mutual funds to have a high percentage of cash near a market trough at the time that they should be fully invested to take advantage of the impending market rise. At the market peak, technicians expect mutual funds to be almost fully invested with a low per- centage of cash when they should be selling stocks and realizing gains. Therefore, contrary- opinion technicians would watch for the mutual fund cash position to approach one of the extremes and act contrary to the mutual funds. Specifically, they would tend to buy when the cash ratio approaches 11 percent and to sell when the cash ratio approaches 4 percent.
A high cash position is also a bullish indicator because of potential buying power. Irrespective of the reason for the increase in cash balances, technicians believe these cash funds will eventu- ally be invested and will cause stock prices to increase. Alternatively, a low cash ratio would mean that the institutions have bought heavily and are left with little potential buying power.
Credit Balances in Brokerage Accounts Credit balances result when investors sell stocks and leave the proceeds with their brokers, expecting to reinvest them shortly. The amounts are reported by the SEC and the NYSE in Barron’s. Because technical analysts view these credit balances as potential purchasing power, a decline in these balances is considered bearish because it indicates lower purchasing power as the market approaches a peak. Alternatively, a buildup of credit balances is an increase in buying power and a bullish signal.
Investment Advisory Opinions Many technicians believe that if a large proportion of investment advisory services are bearish, this signals the approach of a market trough and the onset of a bull market. Because most advisory services tend to be trend followers, the number of bears usually is greatest when market bottoms are approaching. This trading rule is specific in terms of the ratio of the number of advisory services that are bearish/bullish as a percentage of the number of services expressing an opinion.3A 60 percent bearish and/or 20 percent bullish reading indicates a major market bottom (a bullish indicators), while a 60 percent bullish and/or 20 percent bearish reading suggests a major market top (a bearish signal). Exhibit 16.3 shows a time-series plot of the DJIA and both the bearish sentiment index and the bullish sentiment index. As of mid-2001, both indexes had moved away from the bearish boundary values back to the neutral territory.
OTC versus NYSE Volume This ratio of trading volume is considered a measure of specu- lative activity. Speculative trading typically peaks at market peaks. Exhibit 16.4 contains a time- series plot of the Nasdaq Composite Average and the OTC/NYSE volume ratio.
TECHNICALTRADINGRULES ANDINDICATORS 631
2Barron’s is a prime source for numerous technical indicators. For a readable discussion of relevant data and their use, see Martin E. Zweig, Understanding Technical Forecasting (New York: Dow Jones & Co., 1987).
3This ratio is compiled by Investors Intelligence, Larchmont, NY 10538. Richard McCabe at Merrill Lynch uses this series as one of his “Investor Sentiment Indicators.”
70.0 60.0 50.0 40.0 30.0 20.0 10.0
70.0 60.0 50.0 40.0 30.0 20.0 10.0 Bullish
Bearish Bearish
% Investment Services Bullish
% Investment Services Bearish
Dow Jones Industrial Average Investment Advisory Services
Bullish-Bearish
Bullish 70.0
60.0 50.0 40.0 30.0 20.0 10.0
70.0 60.0 50.0 40.0 30.0 20.0 10.0
PercentagePercentage
12000 10000 8000 6000 4000 2000
12000 10000 8000 6000 4000 2000 Year
2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990
Year
2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990
Year
2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990
EXHIBIT 16.3 TIME-SERIES PLOT OF DOW JONES INDUSTRIAL AVERAGE AND THE BULLISH AND BEARISH ADVISORY SERVICES
Source: Where the Indicators Stand (New York: Merrill Lynch, January 2002).
Source of data: Investors Intelligence, Larchmont NY 10538.
Notably, the interpretation of the ratio has changed—that is, the decision rules have changed.
Specifically, in 1996, the decision rules were increased to 112 percent (i.e., heavy speculative trading and an over-bought market) and 87 percent (i.e., low speculative trading and an over-sold market). The source of this rising drift in the decision rules was faster growth in OTC trading volume and dominance of the OTC market by a few large-cap stocks. Subsequently, it was decided to detect excess speculative activity by using the direction of the volume ratio as a guide.
As shown in Exhibit 16.4, the ratio peaked when the market peaked in early 2000.
The Chicago Board Options Exchange (CBOE) Put/Call Ratio Contrary-opinion technicians use put options, which give the holder the right to sell stock at a specified price for a given time period, as signals of a bearish attitude. A higher put/call ratio indicates a pervasive bearish attitude, which technicians consider a bullish indicator.
This ratio fluctuates between .60 and .40, and it has typically been substantially less than 1 because investors tend to be bullish and avoid selling short or buying puts. The current deci- sion rule states that a put/call ratio above .60—sixty puts are traded for every 100 calls—is con- sidered bullish, while a relatively low put/call ratio of .40 or less is considered a bearish sign.
TECHNICALTRADINGRULES ANDINDICATORS 633
5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000
2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 0.00
Year
Nasdaq Composite Average
Nasdaq Vol vs. NYSE Vol
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
EXHIBIT 16.4 TIME-SERIES PLOT OF NASDAQ COMPOSITE AVERAGE AND THE RATIO OF OTC VOLUME TO NYSE VOLUME (THREE-WEEK AVERAGE)
Source: Where the Indicators Stand (New York: Merrill Lynch, January 2002).
Futures Traders Bullish on Stock Index Futures Another relatively new contrary- opinion measure is the percentage of speculators in stock index futures who are bullish or bear- ish regarding stocks based on a survey of individual futures traders. These technicians would consider it a bearish sign when more than 70 percent of the speculators are bullish, and it is a bullish signal when this ratio declines to 30 percent or lower. The plot in Exhibit 16.5 shows that as of mid-2001 the series had been at the lower bound, which is bullish.
As shown, contrary-opinion technicians have several measures of how the majority of investors are investing, which prompts them to take the opposite action. They generally follow several of these series to provide a consensus regarding investors’ attitudes.
Some technical analysts have created a set of indicators that they expect to indicate the behavior of smart, sophisticated investors and create rules to follow them. In this section, we discuss some of these indicators.
The Confidence Index Published by Barron’s, the Confidence Index is the ratio of Bar- ron’s average yield on 10 top-grade corporate bonds divided by the yield on the Dow Jones aver- Follow the Smart
Money
13,000 12,000 11,000 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000
13,000 12,000 11,000 10,000 9,000 8,000 7,000
100 90 80 70 60 50 40 30 20 10 0 Year
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
Dow Jones Industrial Average
% of Bulls on Stock Index Futures
EXHIBIT 16.5 TIME-SERIES PLOT OF DOW JONES INDUSTRIAL AVERAGE AND THE PERCENTAGE OF FUTURES TRADERS BULLISH ON STOCK INDEX FUTURES
Source: Where the Indicators Stand (New York: Merrill Lynch, January 2002). Data courtesy of Market Vane.
age of 40 bonds.4This index measures the difference in yield spread between high-grade bonds and a large cross section of bonds. Because the yields on high-grade bonds always should be lower than those on a large cross section of bonds, this ratio should approach 100 as the spread between the two sets of bonds gets smaller.
Technicians believe the ratio is a bullish indicator because, during periods of high confidence, investors are willing to invest in lower-quality bonds for the added yield, which causes a decrease in the average yield for the large cross section of bonds relative to the yield on high-grade bonds.
Therefore, this ratio of yields, (the Confidence Index), will increase. In contrast, when investors are pessimistic, they avoid investing in low-quality bonds and this increases the yield spread between high-grade and average bonds, which causes the Confidence Index to decline.
Unfortunately, this interpretation assumes that changes in the yield spread are caused almost exclusively by changes in investor demand for different quality bonds. In fact, the yield differ- ences have frequently changed because of changes in the supply of bonds. For example, a large issue of high-grade AT&T bonds could cause a temporary increase in yields on all high-grade bonds, reduce the yield spread, and increase the Confidence Index without any change in investors’ attitudes. Such a change can generate a false signal of a change in confidence.
T-Bill–Eurodollar Yield Spread An alternative measure of investor attitude or confidence on a global basis is the spread between T-bill yields and Eurodollar rates. It is reasoned that, at times of international crisis, this spread widens as money flows to safehaven U.S. T-bills, which causes a decline in this ratio. The stock market typically experiences a trough shortly thereafter.
Debit Balances in Brokerage Accounts (Margin Debt) Debit balances in brokerage accounts represent borrowing (margin debt) by knowledgeable investors from their brokers.
Hence, these balances indicate the attitude of sophisticated investors who engage in margin transactions. Therefore, an increase in debit balances implies buying and is considered a bullish sign, while a decline in debit balances would indicate selling by these sophisticated investors and would be a bearish indicator.
Monthly data on margin debt are reported in Barron’s. Unfortunately, this series does not include borrowing by investors from other sources such as banks. Also, because it is an absolute value, technicians would look for changes in the trend of borrowing.
In addition to contrary opinion and smart money signals, there are several indicators of overall market sentiment that are used to make aggregate market decisions.
Breadth of Market Breadth of market measures the number of issues that have increased each day and the number of issues that have declined. It helps explain the cause of a change of direction in a composite market series such as the DJIA. As discussed in Chapter 5, most stock market series are heavily influenced by the stocks of large firms because the indexes are value weighted. Therefore, a stock market series can increase, while the majority of the individual issues will not, which means that most stocks are not participating in the rising market. Such a divergence can be detected by examining the advance-decline figures for all stocks on the exchange, along with the overall market index.
The advance-decline series is typically a cumulative series of net advances or net declines.
Specifically, each day major newspapers publish figures on the number of issues on the NYSE that advanced, declined, or were unchanged The figures for a five-day sample, as would be reported in Barron’s, are shown in Exhibit 16.6. These figures, along with changes in the DJIA Other Market
Environment Indicators
TECHNICALTRADINGRULES ANDINDICATORS 635
4Historical data for this series are contained in the Dow Jones Investor’s Handbook (Princeton, N.J.: Dow Jones Books, annual). Current figures appear in Barron’s.
at the bottom of the exhibit, indicate a strong market advance because the DJIA was increasing and the net advance figure was strong, indicating that the market increase was broadly based.
Even the results on Day 3, when the market declined 15 points, were encouraging since it was a small decline and the individual stocks were split just about 50-50, which points toward a fairly even environment.
Short Interest The short interest is the cumulative number of shares sold short by investors and not covered. This means the investor has not purchased the shares sold short and returned them to the investor from whom they were borrowed. A relative measure of this activity is the short-interest ratio equal to the outstanding short interest divided by the average daily volume of trading on the exchange. For example, if the outstanding short interest on the NYSE was 5,000 million shares and the average daily volume of trading on the exchange was 1,200 million shares, the short-interest ratio would be 4.17 (5,000/1,200). This means the outstanding short interest equals about four days’ trading volume.
Technicians probably interpret this ratio contrary to your initial intuition. Because short sales reflect investors’ expectations that stock prices will decline, one would typically expect an increase in the short-interest ratio to be bearish. On the contrary, technicians consider a high short-interest ratio bullish because it indicates potential demand for the stock by those who pre- viously sold short and have not covered the short sale.
A technician would be bullish when the short-interest ratio approached 5.0 and bearish if it declined toward 3.0. The short-interest position is calculated by the stock exchanges and the NASD as of the 20th of each month and is reported about two days later in The Wall Street Jour- nal. Notably, this ratio—and any ratio that involves short selling—has been affected by new techniques for short selling such as options and futures.
Stocks above Their 200-Day Moving Average Technicians often compute moving averages of a series to determine its general trend. To examine individual stocks, the 200-day moving averageof prices has been fairly popular. From these moving-average series for numer- ous stocks, Media General Financial Services calculates how many stocks currently are trading above their 200-day moving-average series, and this is used as an indicator of general investor sentiment. The market is considered to be overbought and subject to a negative correction when more than 80 percent of the stocks are trading above their 200-day moving average. In contrast, if less than 20 percent of the stocks are selling above their 200-day moving average, the market is considered to be oversold, which means investors should expect a positive correction. As shown DAILY ADVANCES AND DECLINES ON THE NEW YORK STOCK EXCHANGE
DAY
1 2 3 4 5
Issues traded 3,608 3,641 3,659 3,651 3,612
Advances 2,310 2,350 1,558 2,261 2,325
Declines 909 912 1,649 933 894
Unchanged 389 379 452 457 393
Net advances (advances minus declines) +1,401 +1,438 –91 +1,328 +1,431
Cumulative net advances +1,401 +2,839 +2,748 +4,076 +5,507
Changes in DJIA +40.47 +43.99 –15.25 +60.50 +71.40
EXHIBIT 16.6
Sources: NYSE Fact Book 2001, New York Stock Exchange; and Barron’s, 21 July 2001, Dow Jones & Co., Inc. Reprinted with permission.