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
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Outline
Old Puzzles and New Developments
Fibonacci Numbers
Dow Theory
Kondratev Wave Theory
Chaos Theory
Neural Networks
The Future of Technical Analysis
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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.
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Charting: Types of Charts
The technical analyst uses many types of
charts:
line charts
bar charts
point and figure charts
candlestick charts
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Linear Scale Line Chart
Insert Figure 9-1 here.
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Logarithmic Y-Axis Line Chart
Insert Figure 9-2 here.
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Bar Chart
Insert Figure 9-3 here.
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Point and Figure Chart
Insert Figure 9-4 here.
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Candlestick Chart
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Charting: Other Chart Annotations
Chartists believe investors remember missed
opportunities and look for them to return.
support level
resistance level
congestion area
breakout
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Charting: Other Chart Annotations
Insert Figure 9-6 here.
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Technical Indicators
These statistics, either calculated or directly
observed, are alleged to have a relationship
with the future direction of the overall stock
market or with an individual security.
Indicators with economic justification are
based on economic activities that are
measurable and observable.
Indicators of the witchcraft variety have no
logical connections between the
measurements and what the
measurements purport to show.
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Indicators with Economic Justification
The higher the short interest figure, the
larger is the potential demand for the
shares.
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Short Interest
Insert Table 9-1 here.
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Indicators with Economic Justification
Increased margin buying has historically
been associated with rising markets.
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Margin Loans
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Indicators with Economic Justification
Cash held by mutual funds represents
potential demand for stock.
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Mutual Fund Cash Position
Insert Figure 9-8 (Mutual Fund
Cash Position Rule) here.
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Mutual Fund Cash Position
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Indicators with Economic Justification
When the confidence index gets closer to
1.0, investors are more likely to be bullish
about the economy, and therefore about
corporate earnings.
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Confidence Index
Insert Figure 9-10 here.
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Indicators with Economic Justification
An advance-decline line is a graphical
representation of the net advances over a
period of time.
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Advance-Decline Line
Insert Figure 9-11 (Market Breadth)
here.
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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.
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Relative Strength Ratio
Insert Table 9-3 here.
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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.
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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.
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The Super Bowl Indicator
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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.
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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.”
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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.
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Old Puzzles and New Developments
Insert Figure 9-12 (The Dow Theory) here.
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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.
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Old Puzzles and New Developments
Insert Figure 9-13 (Investment-
Style Topography) here.
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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.
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Review
Charting
The Underlying Logic
Types of Charts
Other Chart Annotations
Technical Indicators
Indicators with Economic Justification
Indicators of the Witchcraft Variety
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Review
Old Puzzles and New Developments
Fibonacci Numbers
Dow Theory
Kondratev Wave Theory
Chaos Theory
Neural Networks
The Future of Technical Analysis
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