CHAPTER 5

Efficient Capital
Markets, Behavioral
Finance, and
Technical Analysis

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posted to a publicly accessible website, in whole or in part.
5.1 Efficient Capital Markets

• An efficient capital market is one in which

security prices adjust rapidly to the arrival of
new information, which implies that the current
prices of securities reflect all information about
the security

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5.1.1 Why Should Capital Markets Be Efficient?

• An informationally efficient market:

• A large number of competing profit-maximizing
participants analyze and value securities, each
independently of the others
• New information regarding securities comes to
the market in a random fashion
• Profit-maximizing investors cause security
prices to adjust rapidly to reflect the effect of
new information

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5.1.1 Why Should Capital Markets Be Efficient?
(slide 2 of 2)
• The combined effect of:
• Information coming in a random, independent,
unpredictable fashion, and
• Numerous competing investors adjusting stock
prices rapidly to reflect this new information
means that:
• Security price changes should be independent and
random
• The security prices that prevail at any time should be
an unbiased reflection of all currently available
information
• In an efficient market, the expected returns implicit in
the current price of a stock should be consistent with
the perceived risk of the stock

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5.1.2 Alternative Efficient Market Hypotheses

• Random Walk Hypothesis

– Changes in security prices occur randomly
• Fair Game Model
• Current market price reflects all available
information about a security, and the expected
return based upon this price is consistent with
its risk
• Efficient Market Hypothesis (EMH)
• Divided into three sub-hypotheses depending
on the information set involved

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5.1.2 Alternative Efficient Market Hypotheses
(slide 2 of 4)
• Weak-Form EMH
• Current prices reflect all security-market
historical information, including the historical
sequence of prices, rates of return, trading
volume data, and other market-generated
information
• This implies that past rates of return and other
market data should have no relationship with
future rates of return
• In short, prices reflect all historical information

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5.1.2 Alternative Efficient Market Hypotheses
(slide 3 of 4)
• Semistrong-Form EMH
• Current security prices reflect all public
information, including market and non-market
information
• This implies that decisions made on new
information after it is public should not lead to
above-average, risk-adjusted profits from
those transactions
• In short, prices reflect all public information

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5.1.2 Alternative Efficient Market Hypotheses
(slide 4 of 4)
• Strong-Form EMH
• Stock prices fully reflect all information from public
and private sources
• This implies that no group of investors should be
able to consistently derive above-average,
risk-adjusted rates of return
• This assumes perfect markets in which all
information is cost-free and available to everyone
at the same time
• In short, prices reflect all public and private
information

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5.1.3 Tests and Results of Efficient Market
Hypotheses
• Like most hypotheses in finance and
economics, the evidence on the EMH is mixed
• Some studies have supported the hypotheses
and indicate that capital markets are efficient
• Results of other studies have revealed some
anomalies related to these hypotheses,
indicating results that do not support the
hypotheses

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 2 of 29)
• Weak-Form Hypothesis:
• Statistical tests of independence between
rates of return
• Risk–return results for trading rules that make
investment decisions based on past market
information relative to the results from a
simple buy-and-hold policy

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 3 of 29)
• Statistical Tests of Independence
• Autocorrelation tests
• Runs tests
• Tests of Trading Rules
• Testing constraints
▪ Use only publicly available data
▪ Include all transactions costs
▪ Adjust the results for risk
• Only better-known technical trading rules have
been examined
• Too much subjective interpretation of data
• Almost infinite number of trading rules
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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 4 of 29)
• Results of Simulations of Specific Trading
Rules
• Trades a stock when the price change
exceeds a filter value
• Studies of this trading rule have used a range of
filters from 0.5 percent to 50 percent
• When the pre-2000 trading costs were
considered, all the trading profits turned to losses.
The recent lower trading costs could have a
different result
• Testing results generally support the weak-form
EMH, but results are not unanimous
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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 5 of 29)
• Semistrong-Form Hypothesis: Tests and Results
• Two sets of studies:
1. Studies to predict future rates of return using
available public information beyond pure market
information considered in the weak-form tests
– Time-series analysis of returns or the cross-section
distribution of returns for individual stocks.
2. Event studies that examine how fast stock prices
adjust to specific significant economic events
– Studies test whether it is possible to invest in a security after
the public announcement of a significant event
– Security prices should adjust rapidly, such that it would not
be possible for investors to experience superior
risk-adjusted returns by investing after the public
announcement and paying normal transaction costs

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 6 of 29)
• Adjustment for Market Effects
• Test results should adjust a security’s rate of
return for the rate of return of the overall
market during the period considered
• Abnormal rate of return
ARit = Rit - Rmt
where:
ARit = abnormal rate of return on security i during period t
Rit = rate of return on security i during period t
Rmt =rate of return on a market index during period t

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 7 of 29)
• Alternate Semistrong Tests
• Return Prediction Studies
• Predict the time series of future rates of return for
individual stocks or the aggregate market using
public information
• Predict Cross-Sectional Returns
• Look for public information regarding individual
stocks that will help predict the cross-sectional
distribution of future risk-adjusted rates of return
• Tests involve a joint hypothesis and are
dependent both on market efficiency and the
asset pricing model used

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 8 of 29)
• Results of Return Prediction Studies
• The time-series analysis assumes that in an efficient
market the best estimate of future rates of return will
be the long-run historical rates of return
• Tests attempt to determine whether any public
information will provide superior estimates of returns
for a short-run horizon (one to six months) or a
long-run horizon (one to five years)
• Risk Premium Proxies
• Short-horizon returns have limited results
• Long-horizon returns analysis has been quite successful
based on:
▪ Default spread
▪ Term structure spread

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 9 of 29)
• Quarterly earnings reports may yield
abnormal returns due to unanticipated earnings
change
• Earnings surprise
• Abnormal stock returns during the 13 or 26 weeks
following the announcement of a large
unanticipated earnings change
• Results indicate that the market does not
adjust stock prices to reflect the release of
quarterly earnings surprises as fast as
expected by the semistrong EMH

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 10 of 29)
• The January Anomaly
• Stocks with negative returns during the prior year
had higher returns right after the first of the year
• Tax selling toward the end of the year has been
mentioned as the reason for this phenomenon
• Such a seasonal pattern is inconsistent with the
EMH
• Several studies in foreign markets found abnormal
returns in January, but the results could not be
explained by tax laws

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 11 of 29)
• Other Calendar Effects
• All the market’s cumulative advance occurs
during the first half of trading months
• Monday/weekend returns were significantly
negative
• For large firms, the negative Monday effect
occurred before the market opened (it was a
weekend effect), whereas for smaller firms, most
of the negative Monday effect occurred during the
day on Monday (it was a Monday trading effect)

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 12 of 29)
• Predicting Cross-Sectional Returns
• Assuming an efficient market, all securities should have equal
risk-adjusted returns because security prices should reflect all
public information that would influence the security’s risk
• Studies typically examine the usefulness of alternative measures
of size or quality to rank stocks in terms of risk-adjusted returns
• All of these tests involve a joint hypothesis because they consider
the efficiency of the market but also depend on the asset pricing
model for the measure of risk used in the test
• If a test determines that it is possible to predict risk-adjusted
returns, these results could occur because the market is not
efficient, or they could be because the measure of risk is faulty
and, therefore, the measures of risk-adjusted returns are wrong

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 13 of 29)
• Price-Earnings Ratios
• Low P/E stocks experienced superior
risk-adjusted results relative to the market,
whereas high P/E stocks had significantly
inferior risk-adjusted results
• Publicly available P/E ratios possess valuable
information regarding future returns
• This is inconsistent with semistrong efficiency

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 14 of 29)
• Price-Earnings/Growth Rate (PEG) Ratios
• Studies have hypothesized an inverse relationship
between the PEG ratio and subsequent rates of
return
• Inconsistent with the EMH
• The results are mixed
▪ Several studies using either monthly or quarterly
rebalancing indicate an anomaly
▪ In contrast, a study with more realistic annual
rebalancing indicated that no consistent relationship
exists between the PEG ratio and subsequent rates of
return

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 15 of 29)
• The Size Effect
• Several studies have examined the impact of
size on the risk-adjusted rates of return
• The studies indicate that risk-adjusted returns
for extended periods indicate that the small
firms consistently experienced significantly
larger risk-adjusted returns than large firms
• Firm size is a major efficient market anomaly
• The small-firm effect is not stable from year to
year
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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 16 of 29)
• Neglected Firms and Trading Activity
• Firms divided by number of analysts following a
stock
• Small-firm effect was confirmed
• Neglected firm effect caused by lack of
information and limited institutional interest
• Neglected firm concept applied across size
classes
• Size effect was confirmed, but no significant
difference was found between the mean returns
of the highest and lowest trading activity
portfolios

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 17 of 29)
• Book Value–Market Value Ratio
• Significant positive relationship found
between current values for this ratio and
future stock returns
• Results inconsistent with the EMH
• Size and BV/MV dominate other ratios such
as E/P ratio or leverage
• This combination only works during
expansive monetary policy

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 18 of 29)
• Results of Event Studies
• Stock split studies
• Show that splits do not result in abnormal gains
after the split announcement, but before
• Initial public offerings
• Seems to be underpriced by almost 18 percent, but
that varies over time, and the price is adjusted
within one day after the offering
• Exchange listing
• Listing of a stock on an national exchange such as
the NYSE may offer some short-term profit
opportunities for investors
• Exhibit 5.1
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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 19 of 29)

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 20 of 29)
• Unexpected world events and economic
news
• Stock prices quickly adjust to unexpected world
events and economic news and hence do not
provide opportunities for abnormal profits
• Announcements of accounting changes
• Are quickly adjusted for and do not seem to
provide opportunities
• Corporate events
• Stock prices rapidly adjust to corporate events
such as mergers and offerings

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 21 of 29)
• Summary on the Semistrong-Form EMH
• Evidence from tests of the semistrong EMH is
mixed
• Hypothesis receives almost unanimous support
from the numerous event studies on a range of
events
• Mixed results come from exchange listing
studies
• Numerous studies on predicting rates of return
over time or for a cross section of stocks
presented evidence counter to semistrong
efficiency
• Results for cross-sectional predictors indicated
anomalies counter to market efficiency
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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 22 of 29)
• Strong-Form Hypothesis: Tests and Results
• Strong-form EMH contends that stock prices
fully reflect both public and private
• This implies that no group of investors with
private information will consistently earn
above-average profits
• Testing Groups of Investors
• Corporate insiders
• Security analysts
• Professional money managers

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 23 of 29)
• Corporate Insider Trading
• Corporate insiders include major corporate
officers, directors, and owners of 10 percent or
more of any equity class of securities
• Insiders must report to the SEC each month on
their transactions in the stock of the firm for which
they are insiders
• Corporate insiders generally experience
above-average profits, especially on purchase
transactions
• Implies that many insiders had private information
from which they derived above-average returns on
their company stock

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 24 of 29)
• Security Analysts
• Tests have considered whether it is possible
to identify a set of analysts who have the
ability to select undervalued stocks
• The analysis involves determining whether,
after a stock selection by an analyst is made
known, a significant abnormal return is
available to those who follow their
recommendations

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 25 of 29)
• The Value Line Enigma
• Value Line (VL) publishes financial information on
about 1,700 stocks
• The report includes a timing rank from 1 down to 5
• Firms ranked 1 substantially outperform the market
• Firms ranked 5 substantially underperform the market
• Changes in rankings result in a fast price adjustment
• Some contend that the Value Line effect is merely the
unexpected earnings anomaly due to changes in
rankings from unexpected earnings

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 26 of 29)
• Analysts Recommendations
• There is evidence in favor of existence of
superior analysts who apparently possess
private information
• Analysts appear to have both market timing
and stock-picking ability
• Consensus recommendations do not contain
incremental information, but changes in
consensus recommendations are useful
• The most useful information consisted of
upward earning revision
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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 27 of 29)
• Performance of Professional Money
Managers
• Trained professionals, working full time at
investment management
• If any investor can achieve above-average
returns, it should be this group
• If any non-insider can obtain inside information, it
would be this group due to the extensive
management interviews that they conduct

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 28 of 29)
• Most tests examine mutual funds
• New tests also examine trust departments,
insurance companies, and investment
advisors
• While it is difficult to do a specific comparison
between “universes” and the benchmarks, the
overall results seem to indicate, at best, some
weak support for the strong-form EMH

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5.1.3 Tests and Results of Efficient Market
Hypotheses (slide 29 of 29)
• Conclusions Regarding the Strong-Form EMH
• Tests of the strong-form EMH have generated mixed results
• Results for corporate insiders did not support the hypothesis
• Results for Value Line rankings have changed over time and
currently tend toward support for the EMH
• Individual analysts’ recommendations and changes in overall
consensus estimates seem to contain significant information
• Historical performance by professional money managers
provided support for the strong-form EMH
• Because money managers are similar to most investors
who do not have access to inside information, these recent
results are more relevant to the hypothesis
• Therefore, there is positive support for the strong-form EMH
as applied to most investors

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5.2 Behavioral Finance

• It is concerned with the analysis of various

psychological traits of individuals and how these
traits affect the manner in which they act as
investors, analysts, and portfolio managers
• The emphasis has been on identifying portfolio
anomalies that can be explained by various
psychological traits
• Three “Tributaries”
• Psychology
• Social psychology
• Neurofinance

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5.2.1 Explaining Biases
• Prospect Theory
▪ Contends that utility depends on deviations from
moving reference point rather than absolute
wealth
• Overconfidence (confirmation bias)
▪ Look for information that supports their prior
opinions and decision
• Noise Traders
▪ Influenced strongly by sentiment, they tend to
move together, which increases the prices and
the volatility
• Escalation Bias
▪ Put more money into a bad investment

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5.2.2 Fusion Investing
• Integration of two elements of investment
valuation-fundamental value and investor
sentiment
• During some periods, investor sentiment is
rather muted and noise traders are inactive, so
fundamental valuation dominates market returns
• In other periods, when investor sentiment is
strong, noise traders are very active and market
returns are more heavily impacted by investor
sentiments

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5.3 Implications of Efficient Capital Markets

• Overall, the results of many studies indicate the

capital markets are efficient as related to
numerous sets of information
• On the other hand, there are substantial
instances in which the market fails to rapidly
adjust to public information

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5.3.1 Efficient Markets and Fundamental
Analysis
• Fundamental analysts believe that there is a
basic intrinsic value for the aggregate stock
market, various industries, or individual
securities, and these values depend on
underlying economic factors
• Investors should determine the intrinsic value of
an investment at a point in time and compare it
to the market price

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5.3.1 Efficient Markets and Fundamental
Analysis (slide 2 of 7)
• If you can do a superior job of estimating
intrinsic value, you can make superior market
timing decisions and generate above-average
returns
• Intrinsic value analysis involves:
• Aggregate market analysis
• Industry and company analysis

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5.3.1 Efficient Markets and Fundamental
Analysis (slide 3 of 7)
• Aggregate Market Analysis with Efficient
Capital Markets
• EMH implies that examining only past
economic events is not likely to lead to
outperforming a buy-and-hold policy because
the market adjusts rapidly to known
economic events
• Merely using historical data to estimate
future values is not sufficient
• You must estimate the relevant variables that
cause long-run movements

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5.3.1 Efficient Markets and Fundamental
Analysis (slide 4 of 7)
• Industry and Company Analysis with
Efficient Capital Markets
• Wide distribution of returns from different
industries and companies justifies industry
and company analysis
• Must understand the variables that effect
rates of return and
• Do a superior job of estimating future values
of these relevant valuation variables, not just
look at past data

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5.3.1 Efficient Markets and Fundamental
Analysis (slide 5 of 7)
• Important relationship between expected
earnings and actual earnings
• Accurately predicting earnings surprises
• Strong-form EMH indicates likely existence
of superior analysts
• Studies indicate that fundamental analysis
based on E/P ratios, size, and the BV/MV
ratios can lead to differentiating future return
patterns

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5.3.1 Efficient Markets and Fundamental
Analysis (slide 6 of 7)
• How to Evaluate Analysts or Investors
• Examine the performance of numerous securities
that this analyst or investor recommends over time
in relation to the performance of a set of randomly
selected stocks of the same risk class
• Stock selections of a superior analyst or investor
should consistently outperform the randomly
selected stocks
• Consistency requirement is crucial because you
would expect a portfolio developed by random
selection to outperform the market about half the
time

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5.3.1 Efficient Markets and Fundamental
Analysis (slide 7 of 7)
• Conclusions about Fundamental Analysis
• Estimating the relevant variables is as much
an art and a product of hard work as it is a
science
• Successful investor must understand what
variables are relevant to the valuation process
and have the ability and work ethic to do a
superior job of estimating these important
valuation variables

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5.3.2 Efficient Markets and Portfolio
Management
• Portfolio Managers with Superior Analysts
• Concentrate efforts in mid-cap stocks that do
not receive the attention given by institutional
portfolio managers to the top-tier stocks
• The market for these neglected stocks may be
less efficient than the market for large
well-known stocks

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5.3.2 Efficient Markets and Portfolio
Management (slide 2 of 4)
• Portfolio Managers without Superior Analysts
• Determine and quantify your client's risk
preferences
• Construct the appropriate portfolio
• Diversify completely on a global basis to eliminate
all unsystematic risk
• Maintain the desired risk level by rebalancing the
portfolio whenever necessary
• Minimize total transaction costs

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5.3.2 Efficient Markets and Portfolio
Management (slide 3 of 4)
• The Rationale and Use of Index Funds and
Exchange-Traded Funds
• Efficient capital markets and a lack of superior
analysts imply that many portfolios should be
managed passively (so their performance
matches the aggregate market and minimizes the
costs of research and trading)
• Institutions created market (index) funds, which
duplicate the composition and performance of a
selected index series

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5.3.2 Efficient Markets and Portfolio
Management (slide 4 of 4)
• Insights from Behavioral Finance
• Opportunities to derive abnormal rates of return by acting on
some of the deeply ingrained biases of investors
• Findings support the notion that the stocks of growth
companies typically will not be growth stocks because
analysts become overconfident in their ability to predict
future growth rates and eventually derive valuations that
either fully value or overvalue future growth
• Supports the notion of contrary investing, confirming the
notion of the herd mentality of analysts
• Important to recall the loss aversion and escalation bias
• Recognize that market prices are a combination of
fundamental value and investor sentiment

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5.4 Technical Analysis

• Technical analysts see no need to study the

multitude of economic, industry, and company
variables to arrive at an estimate of future value
because they believe that past price and volume
movements or some other market series will
signal future price movements
• Technicians also believe that a change in the
price trend may predict a forthcoming change in
some fundamental variables, such as earnings
and risk, before the change is perceived by most
fundamental analysts

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5.4.1 Underlying Assumptions of Technical
Analysis
1. The market value of any good or service is determined
solely by the interaction of supply and demand
2. Supply and demand are governed by numerous rational and
irrational factors. Included in these factors are economic
variables considered by the fundamental analyst as well as
opinions, moods, and guesses. The market weighs all these
factors continually and automatically
3. 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
4. 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
• Exhibit 5.2

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posted to a publicly accessible website, in whole or in part.
5.4.1 Underlying Assumptions of Technical
Analysis (slide 2 of 2)

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posted to a publicly accessible website, in whole or in part.
5.5 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:
1. Lack information needed by security analysts
2. GAAP allows firms to select reporting
procedures, resulting in difficulty comparing
statements from two firms
3. Psychological factors and other nonquantifiable
variables do not show up in financial statements

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posted to a publicly accessible website, in whole or in part.
5.5 Advantages of Technical Analysis (slide 2 of
2)
• 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

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posted to a publicly accessible website, in whole or in part.
5.6 Challenges to Technical Analysis
• Those who doubt the value of technical
analysis for investment decisions question the
usefulness of this technique in two areas:
• They challenge some of its basic
assumptions
• They challenge some specific technical
trading rules and their long-run usefulness

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posted to a publicly accessible website, in whole or in part.
5.6.1 Challenges to the Assumptions of
Technical Analysis
• Empirical tests of Efficient Market Hypothesis
(EMH) show that prices do not move in trends
• For technical trading rules
• The past may not be repeated
• Patterns may become self-fulfilling
prophecies
• A successful rule will gain followers and
become less successful
• Rules require a great deal of subjective
judgment
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posted to a publicly accessible website, in whole or in part.
5.6.2 Challenges to Specific Trading Rules
• The past relationships between specific market
variables and stock prices may not be repeated
• Price patterns become self-fulfilling prophecies
• The success of a particular trading rule will
encourage many investors to adopt it
• Most trading rules require a great deal of
subjective judgment
• With several trading rules, the standard values
that signal investment decisions can change
over time

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posted to a publicly accessible website, in whole or in part.
5.7 Technical Trading Rules and Indicators

• 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

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posted to a publicly accessible website, in whole or in part.
5.7 Technical Trading Rules and Indicators
(slide 2 of 3)
• 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
• Exhibit 5.3

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posted to a publicly accessible website, in whole or in part.
5.7 Technical Trading Rules and Indicators
(slide 3 of 3)

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posted to a publicly accessible website, in whole or in part.
5.7.1 Contrary-Opinion Rules
• Mutual Fund Cash Positions
• Buy when the mutual fund cash position is
high, sell when low
• Credit Balances in Brokerage Accounts
• Buy when credit balances increase, sell when
credit balances fall
• Investment Advisory Opinions
• When a large proportion of investment advisory
services are bearish, this signals a market
trough and the onset of a bull market
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posted to a publicly accessible website, in whole or in part.
5.7.1 Contrary-Opinion Rules (slide 2 of 2)
• Chicago Board Options Exchange (CBOE)
Put-Call Ratio
• A higher put-call ratio indicates that investors
are bearish, which technicians consider a
bullish indicator
• Futures Traders Bullish on Stock-Index
Futures
• A bearish sign when more than 70 percent of
the speculators are bullish and a bullish sign
when this ratio declines to 30 percent or lower

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posted to a publicly accessible website, in whole or in part.
 5.7.2 Follow the Smart Money
• Confidence Index
• Measures the yield spread between high-grade bonds and
intermediate grade bonds
• Declining (increasing) yield spreads increase (decrease) this
index and are a bullish (bearish) indicator
• T-Bill/Eurodollar Yield Spread
• Decreases in this spread indicates greater confidence and is
a bullish indicator
• Debit Balances in Brokerage Accounts (Margin Debt)
• Such balances represent buying on margin, which is assumed
to be done by largely sophisticated investors
• Increases are a bullish signal

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posted to a publicly accessible website, in whole or in part.
5.7.3 Momentum Indicators
• Breadth of Market
• Measures the number of issues increased, and the
number of issues declined each day
• The advance–decline index is typically a cumulative
index of net advances or net declines
• Exhibit 5.4
• 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
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posted to a publicly accessible website, in whole or in part.
5.7.3 Momentum Indicators (slide 2 of 2)

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5.7.4 Stock Price and Volume Techniques

• 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 5.5

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posted to a publicly accessible website, in whole or in part.
5.7.4 Stock Price and Volume Techniques (slide
2 of 12)

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5.7.4 Stock Price and Volume Techniques (slide
3 of 12)
• 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
• Technicians also use a ratio of upside–downside
volume as an indicator of short-term momentum
for the aggregate stock market

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posted to a publicly accessible website, in whole or in part.
5.7.4 Stock Price and Volume Techniques (slide
4 of 12)
• 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
• Exhibit 5.6
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posted to a publicly accessible website, in whole or in part.
5.7.4 Stock Price and Volume Techniques (slide
5 of 12)

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posted to a publicly accessible website, in whole or in part.
5.7.4 Stock Price and Volume Techniques (slide
6 of 12)
• Moving Average Lines
• MA lines are meant to reflect the overall trend for
the price series
• Shorter MA lines (the 50-day versus 200-day)
reflect shorter trends
• If prices reverse and break through the
moving-average line from below accompanied by
heavy trading volume, most technicians would
consider this a positive change, and vice versa
• If the 50-day MA line crosses the 200-day MA
line from below on good volume, then this would
be a bullish indicator
• Exhibit 15.7
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posted to a publicly accessible website, in whole or in part.
5.7.4 Stock Price and Volume Techniques (slide
7 of 12)

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posted to a publicly accessible website, in whole or in part.
5.7.4 Stock Price and Volume Techniques (slide
8 of 12)
• Relative Strength
• The relative strength (RS) ratio is defined as
the price of an individual stock or an industry
index divided by some stock market indexes
like S&P 500
• If this ratio increases over time, then it would
be considered a bullish sign

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posted to a publicly accessible website, in whole or in part.
5.7.4 Stock Price and Volume Techniques (slide
9 of 12)
• Bar Charts
• For a given interval, a technical analyst plots the
high and low prices and connects the two points
vertically to form a bar
• Candlestick Charts
• In addition to high, low, and closing prices for
each trading day, they also include the opening
and closing price and indicate the change from
open to close by shading whether the market or
individual stock went down (black shading) or up
(white bar) for the day
• Exhibit 5.9

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posted to a publicly accessible website, in whole or in part.
5.7.4 Stock Price and Volume Techniques (slide
10 of 12)

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posted to a publicly accessible website, in whole or in part.
5.7.4 Stock Price and Volume Techniques (slide
11 of 12)
• Multiple Indicator Charts
• Technicians include as many price and volume
indicators as are reasonable on one chart and
then, based on the performance of several
technical indicators, arrive at a consensus about
the future movement for the stock
• Point-and-figure Charts
• A point-and-figure chart includes only significant
price changes, regardless of their timing
• The technician determines what price interval to
record as significant (one point, two points, and
so on) and when to note price reversals

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posted to a publicly accessible website, in whole or in part.
5.7.4 Stock Price and Volume Techniques (slide
12 of 12)

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posted to a publicly accessible website, in whole or in part.
5.7.5 Efficient Markets and Technical Analysis

• Assumptions of technical analysis directly oppose the

notion of efficient markets
• The belief patterns of price adjustment directly
contradicts advocates of the EMH who believe that
security prices adjust to new information very rapidly
• If the capital market is weak-form efficient as
indicated by most of the results, then prices fully
reflect all relevant market information so technical
trading systems that depend only on past trading data
cannot have any value

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