Analysis of Investments and
Management of Portfolios
by Keith C. Brown & Frank K. Reilly
Technical Analysis
Chapter 15
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Underlying Assumptions
Advantages of Technical Analysis
Challenges to Technical Analysis
Technical Trading Rules and Indicators
Technical Analysis of Foreign Markets
Technical Analysis of Bond Markets
Underlying Assumptions
of Technical Analysis
• The market value of any good or service is
determined solely by the interaction of supply
and demand
• Supply and demand are governed by
numerous factors, both rational and irrational
• Disregarding minor fluctuations, the prices for
individual securities and the overall value of
the market tend to move in trends, which
persist for appreciable lengths of time
15-2
Underlying Assumptions
of Technical Analysis
• Prevailing trends change in reaction to shifts
in supply and demand relationships. These
shifts, no matter why they occur, can be
detected sooner or later in the action of the
market itself
• See Exhibit 15.1
– It shows the process wherein new information
causes a decrease in the equilibrium price for a
security but the price adjustment is not rapid
15-3
Exhibit 15.1
15-4
Advantages of Technical Analysis
• Technical analysis is not heavily dependent on
financial accounting statements. The
technician contends that there are several
major problems with accounting statements:
– Lack information needed by security analysts
– GAAP allows firms to select reporting procedures,
resulting in difficulty comparing statements from
two firms
– Non-quantifiable factors do not show up in financial
statements
15-5
Advantages of Technical Analysis
• Fundamental analyst must process new
information and quickly determine a new
intrinsic value, but technical analyst merely
has to recognize a movement to a new
equilibrium
• Technicians trade when a move to a new
equilibrium is underway but a fundamental
analyst finds undervalued securities that may
not adjust their prices as quickly
15-6
Challenges to Technical Analysis
• For Technical Analysis
– Empirical tests of Efficient Market Hypothesis
(EMH) show that prices do not move in trends
– The past may not be repeated
– A successful rule will gain followers and become
less successful
– Rules require a great deal of subjective
judgement
15-7
Technical Trading Rules & Indicators
• The Rationale
– A typical stock price cycle for the market or a stock
goes through a peak and trough as well as trends
– By analyzing the trend patterns (rising trend, flat
trend, declining trend) and the change in trend, a
technical analyst would be able to decide what trade
is needed (Exhibit 15.2)
• Trading Rules
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15-8
Contrary-Opinion Rules
Follow the Smart Money
Momentum Indicators
Stock Price and Volume Techniques
Exhibit 15.2
15-9
Contrary-Opinion Rules
• Many analysts rely on rules developed from
the premise that the majority of investors are
wrong as the market approaches peaks and
troughs
• Technicians try to determine whether investors
are strongly bullish or bearish and then trade
in the opposite direction
• These positions have various indicators
15-10
Contrary-Opinion Rules
• Mutual fund cash positions
– Buy when the mutual fund cash position is high,
sell when low
– Assumes that mutual fund managers are poor
judges of market turning points
• Credit balances in brokerage accounts
– Buy when credit balances increase, sell when
credit balances fall
• Investment advisory opinions
– Buy when advisory firms become more bearish
15-11
Contrary-Opinion Rules
• OTC versus NYSE volume
– If OTC volume increases relative to NYSE volume,
sell since speculation increases at peaks
• Futures traders bullish on stock index futures
– Sell when speculators are bullish
15-12
Follow the Smart Money
• While contrary-opinion rules assume that most
investors are not smart, these indicators seek
to follow the path of sophisticated, and
assumed smart, investors
• The Barron’s Confidence Index
– Measures the yield spread between high-grade
bonds and low grade bonds
– Declining (increasing) yield spreads increase
(decrease) this index, and are a bullish (bearish)
indicator
15-13
Follow the Smart Money
• T-Bill - Eurodollar yield spread
– Decreases in this spread indicates greater
confidence, and is a bullish indicator
• Debit balances in brokerage accounts
– Such balances represent buying on margin, which
is assumed to be done by largely sophisticated
investors
– Increases are a bullish signal
15-14
Momentum Indicators
• Breadth of market
– Measures the number stock prices increased and
the number of stock prices declined each day
– Bullish if Advances outnumber declines
– The advance–decline index is typically a cumulative
index of net advances or net declines
– See Exhibit 15.5
• Stocks above their 200-day moving average
– 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
15-15
Exhibit 15.5
15-16
Stock Price and Volume Techniques
• The Dow Theory
– The oldest technical trading rule
– Stock prices as moving in trends analogous to the
movement of water
– Three types of price movements over time
• Major trends are like tides in the ocean
• Intermediate trends resemble waves
• Short-run movements are like ripples
– Exhibit 15.7 shows the typical bullish pattern
15-17
Exhibit 15.7
15-18
Stock Price and Volume Techniques
• Importance of Volume
– Technicians watch volume changes along with
price movements as an indicator of changes in
supply and demand
– The technician looks for a price increase on heavy
volume relative to the stock’s normal trading
volume as an indication of bullish activity
– Conversely, a price decline with heavy volume is
considered bearish
15-19
Stock Price and Volume Techniques
On Balance Volume
- Tracks the volume to price change relationship as
a running total
- Up-volume occurs when stock closes higher and
is added to running total; down-volume occurs
when stock closes lower and is subtracted from
running total
- Direction of indicator is more important than
actual value
- Used to confirm price trends
- Bullish when OBV values are higher
- Bearish when OBV values are lower
15-20
Stock Price and Volume Techniques
• Support and Resistance Levels
– A support level is the price range at which the
technician would expect a substantial increase in
the demand for a stock
– A resistance level is the price range at which the
technician would expect an increase in the supply
of stock and a price reversal
– It is also possible to envision a rising trend of
support and resistance levels for a stock
15-21
Stock Price and Volume Techniques
The Trading Index (TRIN)
- Combines price movement with trading volume
- Used as signal to buy or sell stocks
TRIN 
Number of up stocks
Volume in up stocks
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Number of down stocks Volume in down stocks
- Bullish when TRIN values are lower
- Bearish when TRIN values are higher
15-22
Stock Price and Volume Techniques
• Moving Average Lines
– MA lines are meant to reflect the overall trend for
the price series
– The shorter MA line (the 50-day versus 200-day)
reflecting shorter trends
– If prices reverse and break through the movingaverage line from below accompanied by heavy
trading volume, most technicians would consider
this a positive change; and vice verse
– If the 50-day MA line crosses the 200-day MA line
from below on good volume, this would be a bullish
indicator
– See Exhibit 15.9
15-23
Exhibit 15.9
15-24
Stock Price Charting
Charting
- Shows visual summary of stock activity
over time
- Easy to use and to understand
- Use to spot developing trends
-Major types
Line Chart
Bar Chart
Candlestick Chart
Point-and-figure Charts
15-25
Line Chart
15-26
Bar Chart
15-27
Market Anomalies
• Calendar Effects
– Stocks returns may be closely tied to the time of
year or time of week
– Questionable if really provide opportunity
– Examples: January effect, weekend effect
• Small-Firm Effect
– Size of a firm impacts stock returns
– Small firms may offer higher returns than larger
firms, even after adjusting for risk
15-28
Market Anomalies (cont’d)
• Earnings Announcements
– Stock price adjustments may continue after
earnings adjustments have been announced
– Unusually good quarterly earnings reports may
signal buying opportunity
• P/E Effect
– Uses P/E ratio to value stocks
– Low P/E stocks may outperform high P/E stocks,
even after adjusting for risk
15-29
Investor Behavior and Security Prices
Overconfidence
Investors tend to be overconfident in their judgment,
leading them to underestimate risks
Biased Self-Attribution
Investors tend to take credit for successes and
blame others for failures
Investors will follow information that supports their
beliefs and disregard conflicting information
15-30
Investor Behavior and Security Prices (cont’d)
Loss Aversion
Investors dislike losses much more than gains
Investors will hang on to losing stocks hoping they
will bounce back
Representativeness
Investors tend to draw strong conclusions from
small samples
Investors tend to underestimate the effects of
random chance
15-31
Investor Behavior and Security Prices (cont’d)
Narrow Framing
Investors tend to analyze a situation in
isolation, while ignoring the larger context
Belief Perseverance
Investors tend to ignore information that
conflicts with their existing beliefs
15-32
The Internet Investments Online
• http://www.mta.org
• http://www.bigcharts.marketwatch.com
• http://www.stockcharts.com
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