Technical Analysis & Market Efficiency

Chapter 9
Technical Analysis
&
Market Efficiency
Approaches to Equity Valuation
• Fundamental Approach
– Uses business cycle, valuation, industry
characteristics, and financial statements.
• Technical Approach
– Relies more heavily on charts and graphs of
internal market data to examine past trends to
forecast future.
– Uses prior prices and market volume data and
other market indicators.
Underlying Assumptions of
Technical Analysis
1. Market value is determined solely by interaction of
demand and supply
2. Despite minor fluctuations in the market, stock
prices tend to move in trends that persist for long
periods
3. Reversals of trends are caused by shifts in demand
and supply
4. Shifts in demand and supply can be detected
sooner or later in charts
5. Many chart patterns tend to repeat themselves
The Use of Charting
• The Dow Theory
– Three major movements in the market
• Daily fluctuations
• Secondary trend
• Primary trend
Market
Average Primary trend
Secondary
trend
Secondary
trend
Time
The Use of Charting
• The Dow Theory
– The primary trend cannot be manipulated
– The primary trend is either upward moving

(representing bullish trend) or downward
moving (representing bearish trend)
– The primary trend has an upward or

downward direction despite contradictory
movement in the secondary trend
The Use of Charting
• The Dow Theory
– For upward primary trend, each low in the
secondary trend is higher than the previous
low and each high is higher than the previous
high.
– The opposite is the case for a downward
primary trend
– The upward trend is broken down into several
rallies.
– The downward trend is broken down into
several sell-offs.
The Use of Charting
• The Dow Theory

– The pattern of primary trend continues for a
long period of time
– The analyst must not be confused by
fluctuations in the secondary trend.
– However upward primary trend must
ultimately end and a new pattern of downward
primary trend follows.
• Characterised by abortive recovery, i.e., the new
high fails to surpass the preceding high and a new
low penetrates the previous low.
– A change from bear to bull market would
require similar pattern.
The Use of Charting
• The Dow Theory

– Generally proved to be helpful to market
technicians
– There is a problem of false signals
• Not every abortive recovery is certain to signal the
end of a bull market.
• Investor has to wait long time to confirm a change
in the primary trend by which time, important
movements in the market may have occurred.
Support and Resistance levels
Stock price
Breakout
Resistance
Support
Time
The Use of Charting
• Support and resistance levels

– Stocks will generally trade within a price
range
– Support
• May develop each time a stock goes down to a
lower level of trading because investors who
previously passed up a purchase opportunity may
now choose to act.
• It is a signal that new demand is coming into the
market.
The Use of Charting
• Support and resistance levels

– Resistance
• May develop when a stock reaches the high side of
the range because some investors who bought on
an earlier high may view it as chance to get even.
Others may sell the stock jus t for profit.
– Breakout
• Occurs when a stock price rises above a resistance
point or below a support level
• Considered significant as this may follow a new
price range and signal a shift in the primary trend.
The Use of Charting
• Volume
– The amount of volume supporting a given
market movement is also considered,
• A new high on a heavily traded volume considered
bullish and positive,
• A new high on light volume may indicate
temporary move that may reverse.
• A new low on light volume may be considered
• A new low on heavy trade volume considered
bearish.
Efficient Market Hypothesis
– New information is processed very rapidly so
that securities are properly priced at any given
time.
– Large number of profit maximising participants
are concerned with the analysis and valuation
of securities.
– Information travels in a random, informal
fashion and that prices are unbiased reflection
of all currently available information
Forms of Efficient Market Hypothesis
• Weak form
• Semi-strong
• Strong
Forms of Efficient Markets
Weak Form of Efficient Market
• No relationship between past and

future prices of securities
– they are presumed to be independent
over time.
• There is little or nothing to be gained
from studying past stock prices.
Weak Form of Efficient Market
• Test of independence:
– Degree of correlation between stock prices over
time.
• Correlation found to be consistently small (-0.10 -
+0.10)
• Not statistically significant.
• Indicates that stock price movements are
independent.
Semi-Strong Form of Efficient Market
• All public information is already
impounded into the value of security
– Therefore one cannot use fundamental analysis
to determine whether a stock is undervalued or
overvalued.
• Supports the notion that there is no learning
lag in the distribution of public information
– When a company makes an announcement,
investors assess the information with equal
speed.
• Tests
– Researchers have tested the SS EMH by
determining whether investors who acted on the
basis of newly released public information have
been able to enjoy superior returns.
• If SS EMH holds good this information is already
impounded in the value of the security causing little or
no trading profits to the investors.
– i.e., one could not garner superior returns by trading on
public information about stock splits, earnings reports, or
other similar items.
– Investors are also able to see changes in the accounting
practices ( switch from accelerated depreciation, or from
LIFO to FIFO).
• Results indicate that the market is generally
efficient in the semi-strong form.
– Fama, Fisher, Jensen, and Roll indicated that all of the
market impact of a stock split occurs before a public
announcement and there is little to be gained from acting
on the announcement.
– Changes in accounting practices have little or no impact
on value of securities.
Strong Form of Efficient Market
• Stock prices reflect all information (public
and inside).
• Market hypothesised to be highly efficient
rather than perfect.
• No group of market participants or investors
have monopolistic access to information.
– So no group of investors can be expected to
show superior returns under any circumstances.
• Major test results do not support the S
EMH.
– Specialists on security exchanges have been
able to earn superior returns on invested capital.
• The book they keep on unfulfilled limit orders
appears to provide monopolistic access to
information.
• An SEC (US) found that specialists typically sell
above their latest purchase 83% of the time and buy
below their latest sell 81% of the time. Their
average return on capital is more than 100%.

• Corporate insiders (officers, board
members, substantial stockholders) also
benefit above market.
– They are able to make favourable transactions
before their announcements are made public via
SEC.
• However the presence of specialists and
corporate insiders are not large and they
cannot have an overwhelming impact on
stock prices.
THANK YOU

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Chapter 9

– The primary trend is either upward moving

– The primary trend has an upward or

• The Dow Theory

• The Dow Theory

• Support and resistance levels

• Support and resistance levels

• No relationship between past and

Strong Form of Efficient Market

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