162Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Chapter9
MarketPriceBehavior
.1

Outline

Learning Goals
I.

TechnicalAnalysis
A) PrinciplesofMarketAnalysis
B) UsingTechnicalAnalysis
C) MeasuringtheMarket
1. TheBigPicture
a. Dowtheory
b. Tradingactions
c. Confidenceindex
2. TechnicalConditionsWithintheMarket
a. Marketvolume
b. Breadthofthemarket
c. Shortinterest
d. Oddlottrading
3. TradingRulesandMeasures
a. AdvanceDeclineline
b. NewhighsNewlows
c. TheArmsindex
d. Mutualfundcashratio
e. Onbalancevolume
f. Investmentnewslettersentimentindex

163Gitman/JoehnkFundamentalsofInvesting,NinthEdition

4. Charting
a. Barcharts
b. Pointandfigurecharts
c. Chartformations
d. Movingaverages
ConceptsinReview
II.

RandomWalksandEfficientMarkets
A) ABriefHistoricalOverview
1. RandomWalks
2. EfficientMarkets
B) WhyShouldMarketsBeEfficient?

Chapter9MarketPriceBehavior164

C) LevelsofMarketEfficiency
1. WeakForm
2. SemiStrongForm
3. StrongForm
4. MarketAnomalies
a. Calendareffects
b. Smallfirmeffect
c. Earningsannouncements
b. P/Eeffect
D) PossibleImplications
1. ImplicationsforTechnicalAnalysis
2. ImplicationsforFundamentalAnalysis
E) SoWhoIsRight?
ConceptsinReview
III. BehavioralFinance:AChallengetoTheEfficientMarketsHypothesis
A) InvestorBehaviorandSecurityPrices
1. Overconfidence
2. BiasedSelfAttribution
3. LossAversion
4. Representativeness
5. NarrowFraming
6. BeliefPerseverance
B) BehavioralFinanceatWorkintheMarkets
1. StockReturnPredictability
2. InvestorBehavior
3. AnalystBehavior
C) ImplicationsforSecurityAnalysis
D) YourBehaviorasanInvestor:ItDoesMatter
ConceptsinReview

Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
9.1 RhettRunsSomeTechnicalMeasuresonaStock
9.2 DebTakesMeasureoftheMarket
ExcelwithSpreadsheets
TradingOnlinewithOTIS

165Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.2

Key Concepts

1.

Technicalanalysis,itsroleinitsroleinthesecurityanalysisandstockselectionprocess,andthe
variousmeasuresofmarketperformancethatmakeuptechnicalanalysis.

2.

Theideaofrandomwalksandefficientmarkets,particularlywithregardtohowtheefficientmarket
conceptexplainswhypricesmoverandomly,andtocautiontheinvestornottoexpecttoconsistently
outperformthemarket.

3.

Weak,semistrong,andstrongversionsoftheefficientmarkethypothesisandmarketanomalies.

4.

Behavioralfinanceasachallengetomarketefficiencyandhowpsychologicalfactorscaneffect
investorsdecisions.

.3

Overview

Theaccuracyofstockmarketpricesisconsideredinthischapter.Analyzingthevariousforcesatworkin
thestockmarketisknownastechnicalanalysis.Informationisdividedintothreecategoriespriceand
volume,fundamentaldata,andinformationknownonlytoinsiders.Marketefficiencyisexaminedateach
level,alongwithsomepiecesofinformationthatseemtoprovidereturnsinexcessofwhatwouldbe
expectedbasedsolelyonthebasisofrisk.Emotionsandothersubjectivefactorsplayaroleininvestment
decisions.Hence,thischapterincludesinformationonthenewareaofbehavioralfinance,sothatreaders
canappreciatetheongoingdebatebetweenbehavioristsandsupportsoftheEMH
1.

Onesetoftechnicalindicatorsprovidesinsighttogeneralstockmarketconditions.Dowtheory,
tradingaction,andConfidenceIndexmeasuresarepresented.

2.

Anothertechnicalanalysisapproachisthatofmeasuringvariablesthatdrivemarketbehavior.
Technicalindicatorssuchasmarketvolume,breadthofthemarket,shortinterest,oddlottrading,
andrelativepricelevelsshouldarecovered.

3.

Technicalanalystsdeveloptradingrulesbasedonmathematicalequationsandmeasuresasawayto
assessmarketconditions.Amongthemostwidelyusedtechnicalindicatorsaretheadvancedecline
line,newhighsnewlows,ArmsIndex,mutualfundcashratio,onbalancevolume,andinvestment
newslettersentimentindex.Itisusuallybesttobringcurrentlevelsofthesemeasuretoclass.

4.

Chartingisdiscussednext.Detailsaboutdifferenttypesofcharts(barcharts,pointandfigurecharts,
andchartformations)arebestexplainedwithvisualexamples.

5.

Therandomwalkandefficientmarkettheoriesarethendescribed.Thedifferentlevelsofmarket
efficiencybasedonthetypeofinformationthatisincorporatedintomarketpricesarealsodescribed.
Usuallystudentsarecurioustoknowwhichofthevarioustheoriesbestexplainstherealworld.
Theinstructormayexpectsomelivelyclassroominterchangeonthis,especiallyiftheimplications
fortechnicalandfundamentalanalysisarepresented.

6.

Coverageofthebehavioralfinancesegmentofthechapterisbestdonethroughadiscussionofthe
factorsthatstudentsseeimpactinginvestordecisions.Thosefrequentlymentionedinclude
overconfidence,biasedselfattribution,andlossaversion.Youwillwanttofollowthisupwitha
discussionoftheherdingbehaviorofsecurityanalysts.Thistendstobeoneofthechaptersthat
studentsgreatlyenjoy.

Chapter9MarketPriceBehavior166

.4

Answers to Concepts in Review

1.

Technicalanalysisinvolvesthestudyofthevariousforcesatworkinthemarketplace.Technical
analystsarguethatinternalmarketfactors,suchastradingvolumeandpricemovements,oftenreveal
themarketsfuturedirectionbeforethecauseisevidentinfinancialstatistics.Thus,byrevealingthe
marketsfuturedirection,technicalanalysisprovidesinsightthatissupposedtobehelpfulto
investorsintimingtheirinvestmentdecisions.Iftechnicalanalysisindicatesthemarketisaboutto
moveup,itsignalsagoodtimetobuy;ifitindicatesthemarketisabouttoturndown,itsignalsa
goodtimetosell.

2.

Themarketcandefinitelyhaveanimpactonthepricesofindividualsecurities,andasignificantone
atthat.Infact,studieshaveindicatedthatbetween20and50percentofstockpricebehaviorcanbe
tracedtomarketforces.Whenthemarketisbullish,stockpricesriseingeneral.Whenmarket
participantsbecomebearish,mostpricesfall.Thisisbecausestockpricesaresimplytheresultof
supplyanddemandforcesinthemarket.Sincethedemandforandsupplyofsecuritiesdependson
thegeneralconditionofthemarket,stockpricesareaffectedbythegeneralbehaviorofthe
marketplace.(Note:Toreallydrivethepointhome,justdiscusshowstocksbehavedonBlack
Monday,October19,1987.)

3.

Dowtheoryisatechnicalapproachbasedontheideathatthestockmarketsbehaviorcanbebest
describedbythelongtermpricetrendoftheDowJonesIndustrialIndexandtheDowJones
TransportationIndex.Ifthevaluesofbothindexesarerising,wesaythatweareinabullmarket.If
theDowJonesIndustrialAveragedeclinesandtheTransportationindexfollowssuit,wesaythatthe
marketshaveenteredintoabearishperiod.Theconfidenceindexistheratiooftheaverageyieldon
highgradecorporatebondstotheaverageyieldonlowgradecorporatebonds.Lowratedbonds
alwaysprovideahigheryieldthanhighgradebonds.Ifinvestorsarepessimisticaboutthefuture,
theywillrequireamuchhigheryieldonlowratedbonds,resultinginadeclineintheconfidence
index.Theuniquefeatureofthisindexisthatitusesbondyieldstojudgestockmarketperformance.

4.

Thebreadthofthemarketmeasurecontraststhenumberoffirmswithsharepriceadvancingtothe
numberoffirmswithsharepricedeclining.Wheninvestorsareoptimistic,thenumberofadvances
willgenerallyoutnumberthefrequencyofdecliningshareprices.
Shortinterestisameasureofthenumberofsharesinthestockmarketthathavebeensoldshort.
Becausesharessoldshortwillhavetobepurchasedbytheshortsellersinordertocovertheir
positions,theshortsalemeasureisanindicatoroffuturedemandfortheshares.Hence,theshort
interestmeasureprovidesinsighttothecurrentexpectationsregardingsharepricesandfuture
potentialdemand.
Oddlottradingisbasedonthecynicalassumptionthatsmallinvestorswillbethelasttoinvestina
bullmarketandlasttosellinabearmarket.Hence,asthenumberofoddlotpurchasesincreases,
thereissupposedlyanincreasingchanceofamarketdecline.Ifthenumberofoddlotsalesexceeds
thenumberofoddlotpurchasesbyanincreasingamountitisanindicationthattheleast
knowledgeablegroupisgivingup.Thesupplyofadditionalshareswillreducepricetosellers,but
increasethelikelihoodthatsubsequentpriceswillbehigher.

167Gitman/JoehnkFundamentalsofInvesting,NinthEdition

5.

Anadvancedeclinelineisthedifferencebetweenthenumberofsharesgoingupinpriceandthe
numbergoingdowninprice.TheNYSE,AMEX,andNasdaqpublishstatisticsonhowmanyoftheir
stocksclosedhigherandlowerthanthepreviousday.Eachdaysnetnumberisaddedto(or
subtractedfrom)therunningtotal,andtheresultisplottedonagraph.Ifthegraphisrising,then
advancingissuesaremorenumerousthandecliningissues,andthemarketisconsideredstrong.

Chapter9MarketPriceBehavior168

TheArmsindexbuildsontheadvancedeclinelinebyconsideringthevolumeinadvancingand
decliningstocks.Theratioofadvancingissuestodecliningissuesisdividedbythevolumeof
decliningissuestorisingissuestocreateatradingindex,orTRIN.ThehighertheTRINtheworse
themarketcondition.Abullishmarketwouldhavemoreadvancesthandeclinesandgreatervolume
intherisingstocksthanfallingones.
Onbalancevolume(OBV)isamomentumindicatorthatrelatesvolumetopricechange.Whenthe
securitycloseshigherthanthepreviousday,allthedaysvolumeisconsideredupvolumeandadded
totherunningtotal.Ifitcloseslower,allofthedaysvolumeisconsidereddownvolumeand
subtractedfromtherunningtotal.IfpricesarerisingandOBVmeasuresarerising,itisverybullish.
AbearishmeasurewouldconsistofbothpricesandOBVvaluesdeclining.Iftheyaregoingin
oppositedirections,evenifsharepricesarerising,technicalanalystswouldbeconcerned.
Therelativestrengthindex(RSI)isameasureoftheaveragepricechangeonupdaystotheaverage
pricechangeondowndays.Iftheaveragepricechangeisthesameonupanddowndays,theRSI
valuewillbe50.Iftheaveragepricechangeistwiceashighonupdaysasdowndays,theRSIvalue
willbe67.Highvaluesactuallysuggestthatthereismorebuyingthanthefundamentalswilljustify.
Movingaveragescomparecurrentsharepricetotheaveragesharepriceoveraspecifiedperiod.The
periodmight,forinstancebe200days.Everynewdayisaddedtotheaverageandtheoldestdayis
droppedfromtheaverage.Whencurrentsharepricesadvanceabovetheir200daymovingaverage,
sharepricesareexpectedtocontinuetorise.Whereas,whenstockpricesdropbelowtheirmoving
average,theyareexpectedtocontinuetodecline.
6.

Astockchartissimplyahistoricalrecord(orpicture)ofthebehaviorofastock,themarket,or
sometechnicalmeasure(likeshortinterest).Chartistsbelievethatpricepatternsevolveintochart
formulations,whichprovidesignalsaboutthefuturecourseofthemarketoraparticularstock.
(a) Inabarchart,prices(orsomeothermarketorsharestatistic)areplottedagainsttheverticalaxis
andtimeisplottedonthehorizontalaxis.Pricesarerecordedasverticalbarswhichdepictthe
high,low,andclosingprices.Apointandfigurechart,incontrast,hasnotimedimension,and
onlysignificantpricechangesarerecordedonthesecharts.
(b) Chartformationsaresaidtoresultbecauseofcertainsupplyanddemandforcesinthe
marketplace.Someinvestorsarguethathistoryrepeatsitself,andsochartformationsindicatethe
courseofeventstocome.Ofcourse,theformationsareoftennotveryclear,soidentificationand
interpretationcanbeamostdifficultjob.

7.

Therandomwalkhypothesisclaimsthatstockpricesfollowarandomorerraticpattern.Thatis,
peoplewhobelieveinthistheoryclaimthatpricemovementsareunpredictableandasaresult,
thereslittlethatyoucandotopredictfuturebehavior.Anefficientmarketisoneinwhichthemarket
priceofthesecurityalwaysfullyreflectsallavailableinformation,soitisdifficult,ifnotimpossible
toconsistentlyoutperformthemarketbypickingundervaluedstocks.Itisarguedthatinanefficient
market,randompricemovementssimplyreflectahighlycompetitivemarketwhereinvestorsquickly
useanddigestanynewinformation.Thiscompetitionholdssecuritypricesclosetotheircorrect
(justified)level;asnewinformationbecomesavailable(inarandommanner),adjustmentsinprice
arerandomandquicktofollow.

8.

Tooutperformthemarket,onemustconsistentlyearnmorethantherequiredrateofreturnon
securities.Inotherwords,onemustbeabletoconsistentlyfindstockssellingbelowtheirjustified
prices,andthenrealizetheexpectedreturnonthesecurity.Inanefficientmarket,currentprices
reflectallinformation,therefore,currentpricesequaljustifiedprices,andinvestorscanexpecttoearn
onlytherequired(riskadjusted)rateofreturn.

169Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(a) Efficientmarketsdonotmakehighratesofreturnunavailable,buttheymakeit(nearly)
impossibletoconsistentlyearnreturnshigherthantheratesofreturnrequiredfortherisklevels
ofthesecuritiespurchased.Henceastockwithhighratesofreturnwillalsobemorerisky.
(b) Investorscanearnhighratesofreturnthroughluck,orthroughacceptingstockswithhigher
risks.Theycanalsominimizetransactionandtaxexpenses,alongwithunnecessaryrisk,tomake
theirreturnsmoresatisfactory.
9.

Marketanomaliesaredeviationsfromwhatonewouldexpectinanefficientmarketandhencerefute
theefficientmarkethypothesis.Mostoftheseanomaliesareempiricalanomalies,suggestingthat
overaspecifiedperiodcertaininformationcouldhavebeenusedtoearnabnormal,riskadjusted
returns.Thereisnoguaranteethattheywillprovideanomalousreturnsinthefuture.Somepopular
onesare:
(a) TheJanuaryeffectisthetermappliedtothetendencyforsmallstockspricestogoupduringthe
monthofJanuary.
(b) TheP/EeffectusthetermappliedtothetendencyforlowP/EstockstooutperformhighP/E
stocks.
(c) Thesizeeffectisthetermappliedtothetendencyforinvestmentsinthecommonstockofsmall
firmstooutperforminvestmentinlargefirms.

10. Randomwalksofferaseriouschallengetotechnicalanalysis.Ifpricefluctuationsarepurelyrandom,
chartsofpastbehaviorcannotproducesignificanttradingprofits.Ifthemarketisefficient,shiftsin
supplyanddemandoccursorapidlythattechnicalmeasuressimplymeasurethepastandhaveno
implicationsforthefuture. Whatsmore,inanefficientmarket,extremecompetitionamong
investorswillkeepsecuritypricesatorveryclosetotheirjustifiedlevels,sofundamentalanalysis
willnotleadtoreturnsabovethoserequiredbytheamountofriskexposure.
Ifmarketsareefficient,benefitsfromtechnicalanalysisareminimal.Fundamentalanalysisshould
stillbeutilized,however,toidentifyfundamentallystrong(andweak)firms.So,eveniffirmsarenot
undervalued,analysiscanbedirectedtoandusedintheselectionoffundamentallystrongstocks.
11. Beyondfirmfundamentals,behavioralfinanceadvocatesbelievethatinvestorsdecisionsareaffected
byanumberofpersonalbeliefsandpreferences.Consequentlyinvestorswilloverreacttosometypes
offinancialinformationandunderreacttoothers,resultinginpricingthatcannotbejustifiedonthe
basisofthefirmitself.Anunderstandingofthesebehavioralfactorscanimprovestockprice
predictionresultinginaninefficientmarketandlackofsupportfortheEMH.
12. (a) Sinceinvestorstendtoextrapolatepastbadnewsintothefuturetoanextentthatwouldnotbe
justifiedbasedontheinformationalone,oneshouldsellfirmsthathavedonepoorrecently(say
overthepast6to12months)andbuyfirmsthathavedonepoorlyoveralongerperiodoftime
(sayoverthepast3or5years).Also,investorstendtobeoverlyoptimisticaboutgrowthstocks,
resultinginlowersubsequentreturnsthanearnedonvaluestocks.
(b) Investorswhofeeltheyhavesuperiorinformationtendtotrademore,andconsequentlyearn
lowernetreturnsduetohighertransactionscosts.Investorstendtoexhibitlossaversion,by
hangingontosharesthathavedeclinedandsellingthosethathaveincreased.
(c) Analyststendtoexhibitherdingbehavior,byissuingsimilarrecommendationsorearnings
forecastsforstocks.Theyalsotendtobeoptimistic.Researchhasshownthathypedstockstend
tounderperformthemarket.
13. Listedbelowareseveralwaystousebehavioralfinancetoimprovestockreturns.
(a) Donthesitatetosellalosingstock.

Chapter9MarketPriceBehavior170

(b)
(c)
(d)
(e)

.5

Dontchaseperformance.
Behumbleandopenminded.
Reviewperformanceofyourinvestmentsonaperiodicbasis.
Donttradetoooften.

Suggested Answers to Investing in Action Questions

Finding Strong Stocks can be a Relative Proposition (p. 380)

Howdoesrelativestrengthhelpidentifypricetrends?
Answer:
Therelativestrengthindexmeasuresasecurityspricemomentum.Itmeasurestheaveragepricechangeon
updaysrelativetotheaveragepricechangeondowndays.Iftheaveragepricechangeisthesame,theRSI
valueis50(100(100/(1+1).Ifthemarketadvancestwiceasmuchonupdaysasdowndays,suggesting
thatthereisstrongerbuyingthanfundamentalsjustify,theRSIvalueis66.7(100(100(1+2)).ARSI
valueabove80isanindicationthatthemarketisoverboughtandthepricewilldecreaseinthefuture.
Whereas,anRSIvaluebelow20suggeststhatthesecurityisoversold,andpriceswillmoveupward.Note
thataveragepriceincreaseswouldhavetobe4timesaveragepricedecreases,beforetheRSIwouldreach80
andsuggestthatshareswereoverbought.
Valuesobtainedfromwww.stockcharts.comwillvarydaily.Studentscanindicatethenumberofdaysover
whichtheywanttheRSItobecalculatedatthesite.Thedefaultis14days.

Showdown at the EMH Corral (p. 396)

Wouldyouconsideryourselfarationaloranemotionalinvestor?HowwouldyouapplyEMHand
behavioralfinance?
Answer:
Answerstothesequestionswillvaryacrossstdents.Thearticlepointsoutthatthereissometruthinboth
sidesoftheEMHissue.Rationalinvestorsfullyanalyzeeachsituation,whileemotionalinvestorsemploy
instinctsaboutthefuture.Ironically,representativesfrombothcampsconcludethatindividualsshould
buildwelldiversifiedportfolios.TheEMHcampassertsthattheuseofindexfundsminimizesexpenses,
whilethebehavioralfinancecampassertsthetypicalinvestordoesnothavetheskillstobenefitfrom
behavioralfinancesinsights.

.6
1.

Suggested Answers to Discussion Questions

Technicalanalysisinvolvesthestudyofthevariousforcesatworkinthemarketplace.Technical
analystsarguethatinternalmarketfactors,suchastradingvolumeandpricemovements,oftenreveal
themarketsfuturedirectionbeforethecauseisevidentinfinancialstatistics.Thus,byrevealingthe
marketsfuturedirection,technicalanalysisprovidesinsightthatissupposedtobehelpfulto
investorsintimingtheirinvestmentdecisions.Iftechnicalanalysisindicatesthemarketisaboutto
moveup,itsignalsagoodtimetobuy;ifitindicatesthemarketisabouttoturndown,itsignalsa
goodtimetosell.

171Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2.

(a) Theconfidenceindexistheratiooftheaverageyieldonhighgradecorporatebondstothe
averageyieldonlowgradecorporatebonds.Lowratedbondsalwaysprovideahigheryieldthan
highgradebonds.Ifinvestorsarepessimisticaboutthefuture,theywillrequireamuchhigher
yieldonlowratedbonds,resultinginadeclineintheconfidenceindex.Theuniquefeatureof
thisindexisthatitusesbondyieldstojudgestockmarketperformance.
(b) TheArmsindexbuildsontheadvancedeclinelinebyconsideringthevolumeinadvancingand
decliningstocks.Theratioofadvancingissuestodecliningissuesisdividedbythevolumeof
decliningissuestorisingissuestocreateatradingindex,orTRIN.ThehighertheTRINthe
worsethemarketcondition.Abullishmarketwouldhavemoreadvancesthandeclinesand
greatervolume.
(c) Tradingactionsarepricepatternsthatseemtooccuroverlongperiodsoftime.Examplesinclude
thelikelihoodthataJanuarywithaboveaveragereturnsisgoingtobefollowedbyeleven
monthswithaboveaveragereturns,andpresidentialelectioncycleimpactsonthestockmarket.
(d) Oddlottradingisbasedonthecynicalassumptionthatsmallinvestorswillbethelasttoinvest
inabullmarketandlasttosellinabearmarket.Hence,asthenumberofoddlotpurchases
increases,thereissupposedlyanincreasingchanceofamarketdecline.Ifthenumberofoddlot
salesexceedsthenumberofoddlotpurchasesbyanincreasingamountitisanindicationthatthe
leastknowledgeableinvestorsaregivingup.Thesupplyofadditionalsharesarisingfromshort
sellingwillreducepricetosellers,butincreasethelikelihoodthatsubsequentpriceswillbe
higher.
(e) Chartingresultsinavisualsummaryofsharepriceovertime.Technicalanalystsbelievethe
chartsprovidevaluableinformationaboutdevelopingtrendsandthefuturebehaviorofthe
marketand/orindividualstocks.Thereareawidevarietyofpopularchartformations.
(f) Movingaveragescomparecurrentsharepricetotheaveragesharepriceoveraspecifiedperiod.
Theperiodmight,forinstancebe200days.Everynewdayisaddedtotheaverageandtheoldest
dayisdroppedfromtheaverage.Whencurrentsharepricesadvanceabovetheir200daymoving
average,sharepricesareexpectedtocontinuetorise.Whereas,whenstockpricesdropbelow
theirmovingaverage,theyareexpectedtocontinuetodecline.
(g) Onbalancevolume(OBV)isamomentumindicatorthatrelatesvolumetopricechange.When
thesecuritycloseshigherthanthepreviousday,allthedaysvolumeisconsideredupvolume
andaddedtotherunningtotal.Ifitcloseslower,allofthedaysvolumeisconsidereddown
volumeandsubtractedfromtherunningtotal.IfpricesarerisingandOBVmeasuresarerising,it
isverybullish.Iftheyaregoinginoppositedirections,evenifsharepricesarerising,technical
analystswouldbeconcerned.
Theconfidenceindex,armsindex,movingaverages,andonbalancevolumestatisticsrequire
sometypeofmathematicalequationorratio.

3.

(a) Breadthofthemarketdealswithadvancesanddeclines.Solongasthenumberofstocksthat
advanceinpriceonagivendayexceedsthenumbersthatdecline,themarketisconsidered
strong.
(b) Shortinterestdealswiththeamountofinvestorswhoborrowstockstosellinanticipationofa
weakmarket.Alowlevelofshortinterestwouldindicateastrongmarket.
(c) Therelativestrengthindex(RSI)istheratiooftheaveragepricechangeonupdaysversusdown
daysduringthesameperiod.DifferentsectorsandindustrieshavevaryingRSIthresholdlevels.
(d) Thetheoryofcontraryopinionisatechnicalindicatorthatusestheamountandtypeofoddlot
tradingasanindicatorofthecurrentstateofthemarket.
(e) Headandshouldersisachartformation.Whenpricesbreakoutaboveasupportlevel,abuy
signalhasoccurredindicatingthebeginningofastrongmarket.

Chapter9MarketPriceBehavior172

4.

Answerswillvarybystudent.Themainpointstoincludewouldbe:
(a) Anefficientmarketisoneinwhichsecuritiesfullyreflectallpossibleinformationquicklyand
accurately.Bothsidescanarguesecuritymarketsareorarenotefficientespeciallywhenit
comestothelevelsofefficiency.
(b) Marketpricesmaynotalwaysbecorrectlysetespeciallyinthesecuritiesmarketsofemerging
economieswherevolatilityiscommonandpersistent.Itisanopportunitytofindprofitablesales
orpurchases.
(c) Answerswillvarybystudent.Thekeyreasonforusingfundamentalanalysisarisesfromthefact
thatfirmsuccesswillbeafunctionofitsfinancialsuccess,itscompetitiveadvantage,andthe
macroeconomicenvironmentinwhichitcarriesonbusiness.

5.

Severalofthekeyassumptionsaboutinvestorbehaviorthatserveasabasisforbehavioralfinanceare
givenbelow.
(a) Lossaversionisthetendencyforindividualstodislikelossesmorethantheylikegains.Asa
consequence,investorsholdontolosingstocksinhopesthattheywillbounceback.
(b) Representativenessreflectsanindividualstendencytomakestrongconclusionsfromlimited
samples.Asuccessfulstockanalystoverthepastthreeyearsisnotnecessarilygoingtobe
correctagain.Acrossthethousandsofstockanalysttherearesomethatmakegooddecisionsby
randomchance.
(c) Investorsguiltyofnarrowframinganalyzeaninvestmentonitsownmeritswithoutconsidering
howthatsecuritycorrelateswiththeotherinvestmentsintheirportfolio.Theymightendupwith
anundiversifiedportfolio.
(d) Investorsmightbecomeoverconfidentintheirjudgments.Threeconsequencesarethatthey
mightunderestimatetheamountofrisk,makeundulypositiveforecasts,andparticipatein
excessivetrading.
(e) Investorsguiltyofbiasedselfattributionwilltakeunduecreditforgoodselectionsandblame
othersforbaddecisions.Iftheseinvestorspickanaboveaveragemutualfunditistotheir
supposedcredit,butifthemutualfunddoespoorlytheseindividualswillblametheportfolio
managerforbadselectionand/ortiming.Theseindividualsplacemorevalueoninformationthat
agreeswiththeirselections.

6.

Stockvaluationoftenisbasedonforecastsofdividendsanddiscountrates.Overlyoptimistic
investorswilloverstatetheexpecteddividendstreamandunderestimatetherisk(andhencediscount
rate).Methodstominimizeoptimismincludetheuseormoreconservativeestimatesorfuturecash
flowsandcomparisonofexpectationsforasinglefirmtotheexpectationsforcomparablefirms.
Anotheroptionisoneofhypothesizingavarietyofmarketconditionsandestimatehowthecompany
wouldperformineachofthesescenarios.

.7
1.

Solutions to Problems
TRIN(#ofupstocks/#ofdownstocks)/(Upvolume/Downvolume)
TRINDay1(350/150)/(850million/420million)2.33/2.021.15
TRINDay1(275/225)/(450million/725million)1.22/0.621.97
TRINDay1(260/240)/(850million/420million)1.08/2.020.53
Morestocksrosethanfellonallthreedays.Hencethenumeratorisalwaysgreaterthan1.0.On
Day2,however,thevolumeofdecliningissuesexceededthevolumeofincreasingissues,resultingin
adenominatorthatwaslessthan1.0.HigherTRINvaluesareinterpretedasbeingbadforthemarket,
becauseeventhoughmorestocksrosethanfell,thetradingvolumeinthefallingstockswasgreater.

173Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2.

UsingtheInvestmentNewsletterSentimentIndex,investorsshouldbuywhenlessthan40%ofthe
newsletterwritersarebullishandsellwhenover60%arebullish.Consequently,theinvestorsshould
bybeenbuyingsharesinJanuaryandFebruaryandsellingsharesinMay.Oneisessentiallydoing
theoppositeofwhatthesocalledmarketexpertsurgereaderstodo.

3.

OBVt+1OBVt+TotalVolumeifpricerose(orlessTotalVolumepricefell)
Day1:
Day2:
Day3

UpDay:
DownDay:
UpDay:

OBV50,000+70,000120,000
OBV120,00045,00075,000
OBV75,000+120,000195,000

Ingeneralthereisanupwardtrend.Therewaslowervolumeonthedaythestockpricefell.
4.

Oneapproachwouldsubtractthenumberofnewlowsfromthenumberofnewhighs.Resulting
valuesareaddedtogether,asshownbelow.
July
August
September
October
November
December

11722
9534
8441
6479
5398
19101

95
61
43
15
45
82

95
95+61156
156+43199
19915184
18445139
1398257

ThenumberofnewhighsexceededthenumberofnewlowsfromJulythroughSeptember.Starting
inOctober,newthenumberofstockswithnewlowsexceededthenumberwithnewhighs.Although
thecumulativetotalreachesahighof199,abearishtrendfollowswiththecumulativenumberfalling
toalevelbelowwhereitwasattheendofJuly.Overthisperiodtherewereonaverage9.5more
stockseachmonthreachingnewhighs.
5.

Foreverystockthatdeclined,1.2issuesadvanced.Or,putanotherway,foreveryfivestocksthat
declined,sixadvanced.

6.

Advancedeclinenumberofissuesadvancingminusnumberofissuesdeclining.
2,2001,0001,200.

7.

(a)
Day
1
2
3
4
5
6
7
8
9
10
Average

NewHighs NewLows NHNLIndicator

117
95
84
64
53
19
19
18
19
22

22
34
41
79
98
101
105
110
90
88

95
61
43
15
45
82
86
92
71
66
25.8

Chapter9MarketPriceBehavior174

(b)
Day

NewHighs NewLows NHNLIndicator

1
2
3
4
5
6
7
8
9
10
Average
8.

120
117
95
84
64
53
19
19
18
19

20
22
34
41
79
98
101
106
110
90

100
95
61
43
15
45
82
86
92

71
9.2

AmomentumbasedtraderwouldbebuyingbecausetheNHNLindicatorindicatesthatnewhighs
arenowoutpacingnewlowswithacontinuingstrongupwardtrend.

9.
A
B
A/B
Week
MutualFundCashPosition MutualFundTotalAssets MFCR
Mostrecent
$281,478,000.00
$2,345,650,000.00
12%
2
$258,500,000.00
$2,350,000,000.00
11%
3
$234,800,000.00
$2,348,000,000.00
10%
4
$211,950,000.00
$2,355,000,000.00
9%
5
$188,480,000.00
$2,356,000,000.00
8%
Conventionalwisdomsaysthatwhenthecashratioexceeds10to12%,theratioissendingabullish
signal.However,studentsmayalsoarguethat,giventhetrendandrecentthebuildupincashis,that
thesignalisbearishinthecurrenttimeframe.
10.
Day
1
2
3
4
5
6
7
8
9
10

ClosingPrice

Day

ClosingPrice

10Day
MovingAvg.

$25.25
$26.00
$27.00
$28.00
$27.00
$28.00
$27.50
$29.00
$27.00
$28.00

11
12
13
14
15
16
17
18
19
20

$30.00
$30.00
$31.00
$31.50
$31.00
$32.00
$29.00
$29.00
$28.00
$27.00

$27.75
$28.15
$28.55
$28.90
$29.30
$29.70
$29.85
$29.85
$29.95
$29.85

Basedonthedata,thepricefellbelowthe10daymovingaverageonday17,providingasellsignal.
Basedonthe10dayaverage,thestockshouldbesold.Longeraveragesaregenerallyused,suchas
50dayand200day,forthispurpose.

175Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.8

Solutions to Case Problems

Case 9.1 Rhett Runs Some Technical Measures on a Stock

(a) RSI100[100/(1+APCupdays/APCdowndays)]
APCaveragepricechange
Dayof
Perod
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
Average

9/30/0410/31/04
Advance
0.55
0.10
0.15
0.20
0.10

Decline

0.18
0.37
1.05

0.25
0.25
0.25
0.25
0.05

0.40

0.65
0.35
0.07
0.09
0.231

0.375

11/30/0412/31/04
Advance
0.25
0.50
1.05
1.25
0.75
0.90
0.10
0.75
0.75
0.75
0.75
0.25
0.60
0.25
0.50
0.05
0.591

Decline
0.75
0.75

0.30
0.25

0.10

0.430

RSI(October):100[100/(1+(0.231/0.375))]10061.938.1
RSI(December):100[100/(1+(0.591/0.430))]10042.157.9

1. TheRSIisgettingbigger,suggestingthatNautilusNavigationisreachingapointwhereitis
overpriced.ThiswouldbebadforshareholdersofNautilus,becauseitsuggeststhattherewillbea
reductioninshareprice.
2. ThehigherRSIvaluesuggestthatpriceswilldecline.Assuch,itisgivingasellsignal.However,
theRSIhasnotyetreached70(or80).Hence,thesellsignalisweakatthispoint.

Chapter9MarketPriceBehavior176

(b) 1. Tendaymovingaveragesandrespectivesharepricearegivenbelow.
Price
17.20
18.00
18.00(9/30)
18.55
18.65
18.80
19.00
19.10
18.92
18.55
17.50
17.50
17.25
17.00
16.75
16.50
16.55
16.15
16.80
17.15
17.22

Moving
Average
15.85
16.25
16.62
17
17.32
17.60
17.90
18.20
18.35
18.48
18.51
18.46
18.38
18.23
18.04
17.81
17.56
17.27
17.06
16.92
16.89

Price
17.31(10/31)
17.77
18.23
19.22
20.51
20.15
20
20.21
20.25
20.16
20.00
20.25
20.50
20.80
20
20
20.25
20
19.45
19.20
18.25(11/30)

Moving
Average
16.87
16.92
17.04
17.29
17.69
18.05
18.44
18.78
19.09
19.38
19.65
19.90
20.12
20.28
20.23
20.22
20.24
20.22
20.14
20.04
19.87

Price
17.50
16.75
17
17.50
18.55
19.80
19.50
19.25
20.00
20.90
21
21.75
22.50
23.25
24
24.25
24.15
24.75
25
25.50
25.55(12/31)

Moving
Average
19.60
19.22
18.84
18.59
18.44
18.4
18.35
18.33
18.41
18.68
19.02
19.52
20.08
20.65
21.20
21.64
22.10
22.66
23.16
23.62
24.07

2. AttheendofAugust,thepriceisabovethemovingaverage.Fromthatpointforward,thereare
sixtimeswhenthepricecrossesthemovingaveragevalue,assignifiedbythearrowsigns.There
wouldhavebeenasellsignalwhenthepricedroppedto$17.50,$20.00,and$20.00shortly
thereafter.Buysignalswouldhavebeenprovidedwhenthepricewasat$17.15,$20.25,and
$18.55.InonlythelastinstancedidoneactuallyrepurchasesharesinNautilusNavigationata
pricebelowwhattheyhadsoldtheirshares.
3. Themovingaveragesignalasof12/31/04wouldbetobuyshares,sinceitscurrentshareprice
exceedsthe10daymovingaverage.However,thosefaithfullyusingthe10daymovingaverage,
wouldhavepurchasedshares17daysearlier,atapriceof$18.55.BoththeRSIandmoving
averageindicatorssuggestthatconcernaboutacorrectioninsharepriceiswarranted,thoughnot
officiallypredictedatthispointintime.

177Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(c) 1. Thepointandfigurechart,givenbelow,showsthatNautilusNavigationssharesarefollowingan
upwardtrend.

Pointandfigurecharts(alongwithothercharts)areusedbychartiststoploteverythingfromthe
DowJonesaveragetothesharepricemovementsofindividualstocks.Chartistsbelievethey
containvaluableinformationaboutdevelopingtrendsandthefuturebehaviorofboththemarket
asawholeandindividualstocks.(Theinstructorshouldperhapsreviewthepopularchart
formationsanddiscusstheimplicationschartistsfindinthem.)
(d) ThetechnicalindicatorsareingeneralsendingRhettapositivesignal.TheRSIindexsuggeststhatthe
sharepricesmaybeinforacorrection,buttheRSIforDecemberisovertenpointsbelow70.The
firmssharepricesarecomfortablyabovetheir10daymovingaverage.Meanwhile,thepointand
figurechartindicatesthatthepriceofNautilusNavigationhasmovedupdramatically,withonly
short,relativelyminorcorrections.

Case 9.2 An Analysis of a High-Flying Stock

Answer:
(a) DowTheory.StudentsshouldgraphtheDOWaverages.Thegraphispresentsasfollows:

StudentsshouldrecognizethattheupwardtrendintheDowIndustrialsisconfirmedbytheDow
TransportationIndexinperiod4,andcontinuesinperiod5.Thiswouldbeapositivesignthatthe
markethasturnedbullish.

Chapter9MarketPriceBehavior178

(b) AdvanceDeclineLine.TheAdvanceDeclinechartbasedonthedatafromthetable:
AdvancingIssues(NYSE)
DecliningIssues(NYSE)

1,120
2,130

1,278
1,972

1,270
1,980

1,916
1,334

1,929
1,321

Advance/DeclinePlot
PlotPoint

(1,010)
(1,010)

(694)
(1,704)

(710)
(2,414)

582
(1,832)

608
(1,224)

TheAdvanceDeclineLine,addingthenetadvance/declinefrompreviousperiod(PlotPoint):

BasedontherisingAdvance/Declineline,itappearsthemarkethasturnedbullish.Manymorestocks
areclosingupthandownsinceperiodthree.ThisconfirmsthereadingfromtheDowTheoryabove.
(c) NewHighsNewLows(theNHNLindicator):
NewHighs

68

85

85

120

200

NewLows
NHNL

75
(7)

60
25

80
5

75

45

20

180

TheproblemstatesthatthecurrentNHNL10daymovingaverageis0andthatthepast10periods
were0.Therefore,studentsshouldbeginwithzeroandaddeachperiodwhilesubtractingzeroforthe
movingaverage.Thegraphpresentsasfollows:

TheNHNLIndicatorisverypositive.Thisisfurtherconfirmationofthebullishtrendbecausemany
morestocksareclosingatnewhighsthanatnewlowssinceperiodthree.Thetrendhasacceleratedin
period5.

179Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(d) TheArmsIndex,orTRIN,iscalculatedasfollows:
TRIN[(#ofupstocks)/(#ofdownstocks)]/[(volumeinupstocks)/(volumeindownstocks)].
AdvancingIssues(NYSE)
DecliningIssues(NYSE)
Advances/Declines
Volumeup
Volumedown
Up/Down
TRIN

1,120
2,130
0.53
600,000,000
600,000,000
1.00
0.52

1,278
1,972
0.65

1,270
1,980
0.64

836,254,123 275,637,497
263,745,877 824,362,503
3.17
0.33
0.20

1.92

1,916
1,334
1.44

1,929
1,321
1.46

875,365,980 1,159,534,297
424,634,020 313,365,599
2.06
3.70
0.70

0.39

HigherTRINvaluesareinterpretedasbadforthemarket,whilelowerTRINvaluesareinterpretedas
abullishsign.Hereagain,itappearsthatthemarketswungintoabullishtrendinafterthethird
period,asevidencedbythedecliningTRIN.Thisisfurtherconfirmationofthebullishtrend.
(e) TheMutualFundCashRatioiscalculatedasfollows:
MFCRMutualFundCashPosition/TotalAssetsUnderManagement.
MutualFundCash(Tril.$)
$0.31 $0.32 $0.47 $0.61 $0.74
TotalAssetsManaged(Tril.$) $6.94 $6.40 $6.78 $6.73 $7.42
MFCR
4.5%
5.0% 7.0% 9.0% 10.0%
TheMFCRisalsopositive,againconfirmingthebullishtrend.Fundsareholdingalargeamountof
cashinperiod5at10%oftotalassets.Therecouldbepentupdemandforstocksevenwiththeother
positiveindicatorsalreadyinplay.Inaddition,ifthemarketturnsdownandinvestorsliquidatemutual
fundpositions,thefundswillhaveavailablecashandwillnotbeforcedtosellsecuritiestoraisecash.
Thisproblemhasbeendesignedtogivestudentsapositiveexperiencewithmarketanalysisandget
themexcitedaboutit.Assuch,thetrendsareallup,up,andaway.Studentsshouldcertainlyconclude,
basedonthedatapresented,thatallsignspointtoabullishmarketandnowwouldbeagoodtimeto
investinthemarket.
TimePeriodComment:Somestudentsmaypointtochangesinthetrendsoverthe5periodtime
horizonandexpressconcernthattheymayhavemissedthetrend.Thisishealthyskepticismand
shouldbeencouraged.Sincethetimeperiodsarenotdefined,thiscouldbeavalidobservation.One
waytoaddressthisissueistodiscussthetimeperiodasanissue,andconcludethatifthetime
intervalswerelongperiods,thestudentwouldwanttousemoreandshorterintervalstogainamore
accuratereading.If,ontheotherhand,thetimeintervalswererelativelyshort,studentsmaywant
furtherconfirmationbeforejumpingin.