Page 194 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 6: Technical Analysis

Notes

Task What do you see as the limitation of Charts. Discuss.

6.9 Technical Indicators

Most of the technical indicators make sense when examined individually but when one examines
many technical indicators simultaneously, the interpretation of their collective meaning is
often contradictory and confusing. Once technical analyst issued the following report:

The breadth of the market remains pretty bearish, but the odd-lot index is still in balance and is
more bullish than bearish. While the short interest is not bearish, brokers loans are at a
dangerously high level. Business indices are beginning to turn sharply upward and most
psychological indicators are generally uptrend. The index of 20 low-priced stocks remains in a
general upward trend, but the confidence index still is in a long-term downtrend. The Canadian
gold price index is still in a downtrend, which normally implies a higher stock market ahead.
Professional and public opinion remains cautiously optimistic, which is also an indication of a
higher stock market, but on a decline below 800, the Dow Jones Industrial averages would emit
a definite sell signal.
The author of this technical report presented numerous technical indicators that collectively add
up to organized confusion. Some of the major technical indicators are described in the following
sections. Each indicator makes sense by itself, but interpreting all of them at the same time may
yield the same type of confusion found in the passage quoted above.
1. The Short Interest Ratio Theory: The short interest ratio is derived by dividing the reported
short interest or the number of shares sold short, by the average volume for about 30 days.
When short sales increase relative to total volume, the indicator rises. A ratio above 150%
is considered bullish, and a ratio below 100% is considered bearish.
The logic behind this ratio is that speculators and other investor sell stocks at high price in
anticipation of buying them back at lower prices. Thus, increasing short selling is viewed
as a sign of general market weakness, and short covering (as evidenced by decreasing
short positions) as a sign of strength. An existing large short interest is considered a sign
of strength, since the cover (buying) is yet to come; whereas an established slight short
interest is considered a sign of weakness (more short sales are to come).
2. Confidence Index: It is the ratio of a group of lower-grade bonds to a group of higher-
grade bonds. According to the theory underlying this index, when the ratio is high,
investors' confidence is likewise high, as reflected by their purchase of relatively more of
the lower-grade securities. When they buy relatively more of the higher-grade securities,
this is taken as an indication that confidence is low, and is reflected in a low ratio.
3. Spreads: Large spreads between yields indicate low confidence and are bearish; the market
appears to require a large compensation for business, financial and inflation risks. Small
spreads indicate high confidence and are bullish. In short, the larger the spreads, the lower
the ratio and the less the confidence. The smaller the spreads, the greater the ratio, indicating
greater confidence.

4. Advance - Decline ratio: The index-relating advance to decline is called the advance decline
ratio. When advances persistently outnumber declines, the ratio increases. A bullish
condition is said to exist, and vice versa. Thus, an advance decline ratio tries to capture the
market's underlying strength by taking into account the number of advancing and declining
issues.

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