CHAPTER 16TECHNICAL ANALYSISAnswers to Questions1.The principal contention of technicians is that stock prices move in trends that persist for long periods of time. Because these trends persist they can be detected by analyzing past prices.2.Technicians expect trends in stock price behavior because they believe that new information that causes a change in the relationship between supply and demand does not come to the market at one point in time - i.e., they contend that some investors get the information before others. Also, they believe that investors react gradually over time to new information. The result is a gradual adjustment of stock prices.3.The problems encountered when doing a fundamental analysis of financial statements are: (1) much of the information in financial statements is not useful; (2) there are comparability problems for firms using alternative accounting practices; and (3) there are important psychological factors not included in financial statements. Also, with technical analysis it is not necessary to invest until the move to a new equilibrium begins.4.The disadvantages of technical analysis are: (1) past price patterns may not be repeated in the future; (2) the intense competition of those using the trading rules will render the technique useless; (3) the trading rules require a great deal of subjective judgment; and (4) the values that signal action are constantly changing.5.The mutual fund cash position of 10 percent is relatively high. This would indicate a bullish market because: (1) the theory of contrary-opinion states that mutual funds are the odd-lot trader of the institutional market and typically make the wrong decision by holding excess cash near a trough when they should be fully invested; and (2) the large cash positions of mutual funds represent potential buying power.6.Credit balances result when investors sell securities and leave the proceeds with their broker with the intent of reinvesting the funds shortly. Therefore, they can be considered a source of potential buying power. Given this line of reasoning, a decline in credit balances would indicate a decline in potential buying power, which is bearish. Another line of reasoning is based on contrary opinion. It is assumed that these balances are generally maintained by small investors who draw them down to invest at the peak, so this is bearish for the contrary opinion technician.7.This index indicates what proportion of investment advisory services are bearish and 61 percent is a fairly high ratio. To a contrary opinion technician this is bullish because so many of the services are bearish.8.Debit balances represent borrowing by sophisticated investors, therefore higher debit balances indicate optimism on the part of these investors. The problem with the debit balance measure is that it only represents borrowing through brokers and it ignores the amount of borrowing from alternative sources.9.The Dow Theory contends that stock prices move in waves. Specifically, these waves may be grouped into three categories based upon the period of the wave: (1) major trends for long periods (tides); (2) intermediate trends (waves); and (3) short-run movements for very short periods (ripples). The major trend (the tide) is most important to investors. An intermediate reversal occurs when some investors decide to take profits.10.The direction of a price movement accompanied by high volume is more important than if the same price change is associated with light volume. If prices decline (advance) on heavy volume it is bearish (bullish) since it indicates numerous sellers (buyers).11.The breadth of the market index is a time series calculated as the cumulative number of net advances or net declines. It indicates a peak or trough in stock prices prior to the peak (or trough) in the aggregate price series by showing a broadly based decline in the majority of individual stocks. The technician would expect that at a turning point this decline (advance) in the breadth index would be moving in the opposite direction of a rising (falling) market price index series - i.e., the aggregate price series would still be rising (falling) when most individual stocks are beginning to decline (advance).12.Technicians following the breadth of market rules might interpret the event as indicative of a possible market peak. Since the DJIA is a value-weighted series confined to 30 large well-known stocks, the past trading period indicates that while the large stocks are still advancing, the majority of individual issues are declining. Due to the technical analysts belief that information is disseminated on an unequal basis, the technicians would interpret a net cumulative decline as a sign of a market turn that has not been interpreted yet by small investors who hold funds of the large, well-known stocks.13.A support level is a price range where considerable demand is expected,