Indicators with Economic Justification

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Investment Analysis & Portfolio Management (FIN630)

Lesson # 9

TECHNICAL ANALYSIS Contd...

Technical Indicators:

In addition to charts, most technical analysts use a collection of technical indicators. These

statistics, either calculated or directly observed, are alleged to have a relationship with the

future direction of overall stock market or with an individual security. Some indicators

might logically carry useful information; others are sufficiently far-fetched that only the

most creative analyst could develop a caused and effect relationship with the market.

Indicators with Economic Justification:

Some technical indicators are based on economic activity that is measurable and observable.

Fundamental analyst also monitor economic data, some economy based on technical

indicators receive special attention in the marketplace. Many of these based on logical

investment mangers behavior, especially the manager's likely reaction to prior events.. A

few of the most popular technical indicators discussed next.

Short Interest:

A person who sells stock short believes that the share price will decline. Eventually, they

must purchase stock in the open market to replace the shares previously burrowed. The

quantity of share sold short at anytime is periodically reported in the financial press and is

called short interest. Shares sold short must eventually be the covered (bought). It

logically follows that the higher the short interest figure, the larger is the potential demand

for shares.

The technical analyst believes that a large short interest figure is bullish because of the

potential demand for the shares. The short interest ratio is the number of days it would

take to cover the short interest if trading continued at the average daily trading volume of

the previous month.

Short interest can also be used as an aggregate market indicator. An indicator based on the

behavior of well-informed group of market participants is called a smart money indicator.

A technical indicator that prescribes actions opposing those of the marketplace is a

contrary opinion indicator.

Conversely, some people believe the small investor usually waits too long to make a

decision and consequently makes investment decision that lag optimum behavior. Odd lots

are associated with the small investor. If odd-lot short sales begin to rise relative to total

odd-lot transactions, it may signal the end of a market downturn and, therefore, be a bullish

signal. A technical indicator that prescribes actions opposing those of the marketplace is a

contrary opinion indicator.

Margin Loans:

Another contrary opinion indicator is the margin loan indicator. It measures the extent to

which market participants have borrowed money to finance their stock transaction.

Increased margin buying is historically associated with rising markets. Margin buying often

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speaks just before market declines. A technical analyst might view this rising debt as a

bearish signal.

Increased margin buying has historically been associated with rising markets.

Mutual Fund Cash Position:

Mutual funds hold an enormous quantity of stock in their port folio. As a group, the

investment activities of mutual fund managers can have a significant influence on the

direction of stock market prices. The mutual fund cash position measures the proportion

of total mutual fund assets currently held in cash-equivalent securities.

Many fund managers seek to time the market to some extent. In other words, they increase

their purchases when they believe conditions favor a market advance, and hold cash when

they believe the market is likely to decline.

Cash held by mutual funds represent potential demand for stock in much the same way short

interest does. Equity fund generally find generally invests most of its assets in common

stock, holding cash only temporarily. The logic of this technical indicator is that when the

mutual fund industry holds more cash than normal, the potential demand is bullish signal

about the future. Similarly, when mutual funds are essentially fully invested, the potential

demand is there, having already been satisfied in the marketplace.

Some analyst believes that the mutual fund cash position normally ranges between 5 percent

and 15 percent. Because of the need to satisfy shares redemption and because of the

constant arrival of new investment funds from account holders, a given mutual fund never

lets its cash balance get to zero. Five percent or so is an effective minimum in many cases.

The upper limit is subjective, as fund manager differ substantially on the percentage of

assets they are willing to temporarily remove from the equity market.

Mutual fund cash is potential demand for stock.

Confidence Index:

A confidence index is a ratio of yield on high grade bonds (usually AAA) to yield on a

lower grade bonds (usually BBB). Because investors are risk averse, riskier bonds yield

more than safer bond, so this ratio will always be less than 1.0. To the advocate of this ratio,

the important thing is how close the ratio is to the maximum value 1.0.

By definition, a BBB-rated bund carries more default risk than AAA-rated bond. An

investor's willingness to take on more risk is partially determined by the investor's

expectations about the future. Default is probably more likely when the economy is

expected to turn down, with the associated reduction in consumer demand and product

sales, conversely, a robust economy can help a company generate cash and overcome many

of its corporate owes. When the confidence index gets closer to 1.0, investors are more

likely to be bullish about the economy, and therefore about corporate earnings. A decline

index may foretell an economic downturn.

Advance-Decline Line:

Every trading day, some issues advances, some declines and some remains unchanged.

Advance-Decline Line is a graphical representation of the net advances over a period of

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time. Advances count as pluses, declines are minuses and unchanged securities count as

zero.

Relative Strength Ratio:

Relative Strength Ratio is a method of comparing one statistic to some benchmark

statistic.

Moving Average:

A Moving Average is a smoothed presentation of underlying historical data. Each data

point is the arithmetic average of a portion of the previous data. A ten-day moving average

measures the average over the previous ten days. Regardless of the time period used, each

day a new observation is included in the calculation and the oldest is dropped, so a constant

number of points are always being averaged.

Advocates of moving average in the stock selection believe that changes in the slope of the

line are important. A stock whose twenty-day moving average has been trending up might

become a candidate for sale if the line turns downward.

Closing Thoughts on Indicators:

Marketing statistics are an interesting topic. Tools such as the advance-decline line and

relative strength figures my help some people make decisions, but they should not be more

than that. Managers make decisions, not black boxes or technical indicators.

Fundamental analysts and technical analyst both use market indicators. Indicators can help

present data in a more intuitive way and may suggest areas for further investigation. It is

dangerous, thought, to believe that a collection of market indicators of any kind will

function as an oracle predicting future movements of a stock or of the overall market.

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