9 -- Part 3: Market Efficiency and Behavioral Finance
The market two weeks after the airline disaster is strong if the next advance in price on a given day exceeds the number that decline.
The strength of the market depends on the spread between normal and abnormal.
If the spread narrows.
Information on market volume, advances, and declines can be found easily on the web.
Pre-market and regional exchanges are included.
The calculations are delayed 15 minutes.
Sometimes investors sell a stock short when they anticipate a decline in the market.
They sell borrowed stock.
The higher the short interest, the more stocks that are sold short.
Future demand for the stock is ensured by a short sale because all short sales have to eventually be "cov ered".
When the level of short interest is high, the market is optimistic.
As shares are bought back to cover outstanding short sales, the demand will push stock prices up.
It is possible to show future market demand by keeping track of short interest.
Knowledgeable investors do short selling, and a significant increase or decrease in the level of short interest hints at the sentiment of sophisticated investors about the current state of the market or a company.
Small investors exhibit bad timing when the economy is going great.
It doesn't get out until late in a bear market.
The amount and type of odd lot trading is an indicator of the current state of the market.
Because many individual investors deal in transactions of less than 100 shares, their combined sentiment is captured in odd-lot figures.
The idea is to see what investors are doing.
The theory of contrary opinion holds that the market will probably continue along its current line if there is little or no difference in the spread between odd-lot purchases and sales.
A change in the balance of purchases and sales may be a sign that the bull or bear market is about to end.
The final stages of a bull market may be at hand if the amount of odd-lot purchases starts to exceed odd-lot sales by an ever-widening margin.
The usefulness of odd-lot trading as a market indicator has been diminished by two trends.
Transactions costs have fallen dramatically in recent decades, so the cost of trading in round lots has gone down.
Larger traders break their orders into smaller parts to hide their activities.
It used to be clear that an investor was behind an odd-lot trade, but that is no longer the case.
If the purpose of watching odd-lot trades is to assess the trading behavior of individuals rather than professionals, that is harder to achieve today than it used to be.
A variety of mathematical equations and measures are used to assess the underlying condition of the market.
The analysts use computers to plot the measures on a daily basis.
They use those measures to determine when to get into or out of the market.
Market measures are used to develop trading rules.
Technical analysts almost always use several market measures, rather than just one or two, because one measure rarely works the same way for all stocks.
They look for confirma tion of one measure by another.
Market analysts like to see three or four of these ratios and measures pointing in the same direction.
Although dozens of market measures and trading rules exist, we'll confine our discussion here to some of the more widely used technical indicators.
Each trading day, the New York Stock Exchange, the Amex, and the Nasdaq publish how many of their stocks closed higher on the day and how many closed lower.
To calculate it, you take the number of stocks that have risen in price and subtract the number that have fallen.
If 1,000 issues advanced on a day when 450 issues declined, the day's net number would be 550.
The net number would be -550 if 450 advanced and 1,000 declined.
The results are plotted on a graph when the net number is added to the running total.
The technical analysts conclude that the market is strong if the graph is rising as the advanced issues are dominating the declining issues.
As the market begins to weaken, the graph will turn down.
The A/D line is used as a signal by technicians.
Similar to the advance-decline line, this measure looks at price movements over a longer period of time.
A stock is defined as reaching a "new high" if its current price is at the highest level it has been over the past year.
If the stock's price is at the lowest level it has been in the past year, it's a new low.
You end up with a net number, which can be either positive or negative, just like with the advance-decline line.
The net number is added to a 10-day moving average and plotted on a graph to smooth out the daily fluctuations.
A strong market is indicated by a graph that's increasing over time, where new highs are dominating.
New lows are more common than new highs in a weak market.
When new highs dominate and there are more new lows than new highs, technicians will buy and sell stock.
They could use the indicator to put money into stocks when the market is strong or into cash or bonds when the market is weak.
Suppose we are analyzing the S&P 500.
300 of these stocks rose in price and 200 fell in price on a given day.
Assume that the total trading volume in the rising stocks was 400 million shares and the total trading volume in the falling stocks was 800 million shares.
If the volume in up stocks was 700 million shares, then the volume in down stocks was 300 million.
Even though more stocks rose than fell, the trading volume in the falling stocks was much greater, which is thought to be bad for the market.
The idea is that a strong market is characterized by more stocks rising in price than falling, along with greater volume in the rising stocks than in the falling ones, as in the second example.
The indicator looks at the cash position of mutual funds.
The higher the MFCR, the stronger the market.
When mutual fund cash reaches 10% to 12% of assets, the ratio is considered very bullish.
When the ratio is less than 5% of assets, it is seen as bearish.
When fund managers hold a lot of cash, that's good news for the market because they will eventually have to invest that cash, buying stocks and causing prices to rise.
If fund managers don't have a lot of cash, investors might be concerned.
If most of the cash is already invested, there is less demand for stocks.
If the market takes a downturn, investors might want to withdraw their money.
Fund managers will have to sell some of their stock because they don't have a lot of cash.
The key measure of market activity is stock prices.
They consider trading volume to be a secondary indicator.
It tracks trading volume as a running total and uses trading volume in addition to price.
OBV indicates whether volume is flowing into or out of a security.
All of the day's volume is added to the running total when the security closes higher than its previous close.
All the day's volume is subtracted from the running total when a stock closes lower.
The OBV indicator can be used to confirm price trends.
When a stock's price is rising, you want to see a lot of volume because that would suggest that the stock will go even higher.
If prices are rising but OBV is falling, technical analysts would interpret it as a sign of weakness.
The direction or trend of OBV is more important than the actual value.
You can start OBV computation with an arbitrary number.
If you start with an OBV value of 50,000, you can calculate the OBV for a stock that closed yesterday at a price of $50 per share.
If the stock trades 80,000 shares today, it will close at $49.
We would add all of the 120,000 shares to the previous day's OBV if the stock closed at $52 per share.
Day after day, this process would continue.
The OBVs are plotted on a graph.
If the graph is moving up, it's bullish, if it's moving down, it's bearish.
When used for short trading periods, the RSI gives the best results.
It helps identify market extremes by signaling that a security is approaching its top or bottom.
The ratio of average price change on "up days" to average price change on "down days" is called the RSI.
Over a 9-, 14-, or 25-day period, the average price change in this formula is calculated.
Both price increases and price decreases are treated as positive values in the RSI calculation.
If a stock fell for 14 days in a row, the average price change on down days would be 0.05, and the same would hold if a stock rose for 14 days in a row.
Most RSIs fall between 30 and 70.
A possible trend reversal can be seen when the RSI crosses these points.
The 9-day RSI is more volatile than the longer-period RSIs and is often used with the wider 80-20 range.
80 is a better upper indicator than 70 in bull markets, and 20 is a better lower indicator in bear markets.
Different sectors and industries have different levels of RSI.
To use the RSI in their own trading, investors set buy and sell ranges, such as sell when the RSI crosses above 70 and buy when it moves below 30.
RSIs and stock charts can be compared.
A divergence between RSI and a price chart can be a good indicator of a changing trend.
Technical analysts use various types of charts to plot the behavior of the stock market, including moving averages and advance-decline lines.
Just about every type of technical indicator can be found in one form or another.
Charts give a visual summary of activity.
In the eyes of technicians, they contain valuable information about developing trends and the future behavior of the market.
A chart only tells you where the market or stock has been.
To chartists, those price patterns tell them what to expect in the future.
Chartists believe that history repeats itself, so they study the historical reactions of stocks to various formations, and come up with trading rules based on these observations.
It doesn't matter to chartists whether they follow the market or individual stock.
The formation matters more than the issue being plotted.
Chartists believe they can see formations and buy and sell signals.
There are six formations in Figure 9.6.
When combined with the basic formations, the patterns form support levels and resistance lines that yield buy and sell signals.
Panel A is an example of a buy signal that occurs when prices break out above a resistance line.
A sell signal is said to occur when prices break out below a sup port level, as they do at the end of the formation in panel B.
A sell signal means that everything is in place for a big drop in the market.
The opposite is about to happen.
Each of these formations has meaning to chartists.
Identifying and inter preting them requires a lot of imagination.
One problem with daily price charts is that they may contain a lot of short-term price swings that mask the overall trend in prices.
As a result, technical M10_SMAR3988_13_GE_C09.indd 409 12 May 2016 5:26 PM analysts often use moving averages to highlight underlying trends.
Because they rate a stream of average values, moving averages will smooth out a data series and make it easier to spot trends.
The moving average is a popular technical indicator.
It can be used with both share prices and market indexes.
From 10 to 200 data points are used to calculate moving averages.
A 15-day moving average uses a series of 15 data points.
The length of the time period affects how the MA will act.
Shorter periods tend to be more closely tracked than longer ones.
The major trends are picked up by the longer periods of 100 to 200 days.
Other procedures give more weight to the most recent data points or apply more weight to the middle of the time period.
Using closing share prices as the basis of discussion, we can calculate the simple moving average by adding up the closing prices over a given time period and then dividing by the length of the time period.
The simple moving average is not more than the mean.
Using a 10-day moving average, we add up the closing prices for days 1 through 10 and divide them by 10 to get the total.
The closing price for the 10-day period was $5.80.
The process is repeated for days 2 through 11 and the total cost is $60.
A series of individual averages that are linked together form a moving average line when this procedure is repeated each day.
The line is plotted on a chart along with other market information.
The blue line is plotted against the daily closing prices for Facebook starting with its May 2012 IPO and continuing through June 2015.
The moving average provides a smooth line without all the short-term fluctuations, which shows the general trend in prices for this stock.
If the security's price starts moving above the moving average, it's a good time to buy because prices should drift up.
A sell signal occurs when the price moves below the moving average line.
There is a problem when the stock price is volatile.
In a single month, the red and blue lines cross 11 times for Facebook, resulting in six sell signals and five buy signals.
A lot of transactions costs would result from trading based on the moving average.
The actual daily closing prices for a stock are plotted along with the moving average lines.
They're also used with market indexes, such as the S&P 500, and with a variety of technical indicators.
Mention the feature that makes the confidence index unique.
Explain how each of the following is used in technical analysis.
M10_SMAR3988_13_GE_C09.indd 386 is what you should know after reading it.
When you need to practice, MyFinanceLab can help.
Professional investors did not consistently beat market averages.
Some market anomalies exist because investors make systematic errors, such as undervaluing stocks that have performed poorly, according to behavioral finance.
Video Learning Aid for factors in the marketplace that can affect the price theory of contrary opinion.
They test different indicators using historical price data to find those that generate profitable trading strategies, which are then developed into trading rules used to guide buy and sell decisions.
Log into MyFinanceLab, take a chapter test, and get a personalized study plan that tells you which concepts you understand and which ones you need to review.
The concept of an efficient market has been written about a lot.
Some of your classmates think the markets are efficient while others think they are not.
You can have a debate with your classmates to see if you can resolve the issue.
Discuss the three aspects: a.
Some fund managers earn much higher returns than the market average, and in some cases they do so without taking above average risk.
Explain how the following terms can affect investors' decisions.
Explain how biases in stock valuation can be caused by representativeness.
Technical analysis is used in the stock valuation process.
M10_SMAR3988_13_GE_C09.indd 398 was used by investors.
The market is technically strong if you define each of the following conditions.
The data is related to the corporate bond market.
Each of the four periods has a confidence index.
The latest confidence index is 86.83% and the yield spread between high- and average-grade corporate bonds is 85 basis points.
TheOBV is the level of on-balance volume for the next five days.
The beginning price of OBV is $35.
The advance/decline ratio was 1.2 according to the market analyst.
At the end of a trading day on the New York Stock Exchange, 2,200 stocks advanced and 1,000 stocks declined.
The NH-NL indicator is used for a stock exchange market.
For each week, calculate the MFCR.
Data on a stock's closing price and its price change for the last 14 days appears below.
An avid market technician and active stock trader,Brett runs some technical measures on a stock.
He got into technical analysis about 10 years ago, and although he now uses the Internet for much of his analytical work, he still enjoys running some of the numbers himself.
A serious stock trader who relies on technical analysis for some, but not all, of the information he uses to make an investment decision, unlike some market technicians, he does not completely ignore a stock's fundamentals.
He's been following a stock for the past three or four months and right now he's got his eye on it.
A mid-sized high-tech company that has been around for a number of years has a demonstrated ability to generate profits year-in and year-out.
The price of the stock is a bit erratic due to the fact that the earnings tend to bounce up and down from year to year.
The stock's volatile prices allow him to move in and out of the stock over short periods of time.
He doesn't worry about the basic soundness of the stock because it has "decent" fundamentals.
He can focus on the technical side of the stock.
He wants to run some technical measures on the market price behavior of the security.
The table below shows the recent closing prices on the stock.
The market interest in the shares is considerable.
The relative strength index is calculated using the closing share prices in the table above.
You computed two RSI measures.
Use a 10-day time frame to calculate the individual average values from the above closing share prices.
Plot a moving-average line using the individual average values computed earlier.
Deb put the money in a savings account because she wasn't sure what to do with it.
She took a course in investments at the university.
The class just completed this chapter of the textbook that was used for the course.
Excited about what she has learned in class, Deb wants to invest in stocks.
She wants to use her new knowledge in technical analysis to determine if this is a good time to enter the market.
After considerable effort, Deb is able to put together the accompanying table of data.
For each of the four measures listed above, calculate a value based on the data presented in the table.
Discuss each measure individually and note what it means for the market.
The method of charting is used to identify and project price trends.
The Bollinger Band is a well-known technical indicator.
One above and one below the price performance of a stock is created.
The upper band is a level that the stock is unlikely to rise to.
The price of a stock is unlikely to fall below a support level.
The stock price will fall in the immediate future if you see a break in the upper band.
A break in the lower band indicates that the security is going to rise in value.
A unique investment strategy will be dictated by either of these occurrences.
The price performance graph for Amazon stock should show up.
The graph should cover the first six months of 2015.
The use of financial ratios, stock valuation models, and efficient market concepts are some of the topics covered in the sample questions.
The objective is to answer 8 of the 11 questions in 16 1/2 minutes if you give yourself 1 1/2 minutes for each question.
There is a rationale for the P/S approach.
Sales are more volatile than earnings.
The earnings of a company tend to track the economy.
A company that earned $4.00 per share paid a $1.00 dividend last year.
Over the years, the firm has maintained a consistent payout ratio, and analysts expect this to continue.
The firm is expected to earn $4.40 per share next year, and the stock is expected to sell for $30.00.
12% is the required rate of return.
A stock has a current dividend of $1 and an expected one next year.
A firm has total revenues of $187,500, net income of $15,000, total current liabil ities of $50,000, total common equity of $75,000, and total assets of $150,000.
A stock pays a dividend.
For the next three years, the expected growth of the dividend is 20%.
The required rate of return is 15%.
The current value of the stock is a.
The expected inflation is b.
The ability to sell short.
There is a tendency for investors to focus on the information that confirms their prior opinions and actions.
Transactions costs are high.
Positive long-term abnormal returns can be found in low P/E stocks.
The strong-form efficient market hypothesis assumes that no one has an advantage.
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