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volume. Similarly, market reversals are considered more bearish when associated with higher
volume. The trin statistic is the ratio of the number of advancing to declining issues divided
by the ratio of volume in advancing versus declining issues.
Number advancing/Number declining
Trin
Volume advancing/Volume declining
This expression can be rearranged as
Volume declining/Number declining
Trin
Volume advancing/Number advancing
Therefore, trin is the ratio of average volume in declining issues to average volume in ad-
vancing issues. Ratios above 1.0 are considered bearish because the falling stocks would then
have higher average volume than the advancing stocks, indicating net selling pressure. The
Wall Street Journal reports trin every day in the market diary section, as in Figure 19.9.
Note, however, that for every buyer, there must be a seller of stock. Rising volume in a ris-
ing market should not necessarily indicate a larger imbalance of buyers versus sellers. For ex-
ample, a trin statistic above 1.0, which is considered bearish, could equally well be interpreted
as indicating that there is more buying activity in declining issues.

Odd-lot trading Just as short-sellers tend to be larger institutional traders, odd-lot
traders are almost always small individual traders. (An odd lot is a transaction of fewer than
100 shares; 100 shares is one round lot.) The odd-lot theory holds that these small investors
odd-lot theory
tend to miss key market turning points, typically buying stock after a bull market has already
The theory that net
run its course and selling too late into a bear market. Therefore, the theory suggests that when
buying of small
odd-lot traders are widely buying, you should sell, and vice versa.
investors is a bearish
signal for a stock. The Wall Street Journal publishes odd-lot trading data every day. You can construct an in-
dex of odd-lot trading by computing the ratio of odd-lot purchases to sales. A ratio substan-
tially above 1.0 is bearish because it implies small traders are net buyers.



F I G U R E 19.9
Market diary
Source: From The Wall Street
Journal, January 28, 2002.
Reprinted by permission of
Dow Jones & Company, Inc.
via Copyright Clearance
Center, Inc. © 2002 Dow
Jones & Company, Inc. All
Rights Reserved Worldwide.
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Fifth Edition




669
19 Behavioral Finance and Technical Analysis


Confidence index Barron™s computes a confidence index using data from the bond mar-
ket. The presumption is that actions of bond traders reveal trends that will emerge soon in the
stock market.
confidence index
The confidence index is the ratio of the average yield on 10 top-rated corporate bonds di-
vided by the average yield on 10 intermediate-grade corporate bonds. The ratio will always be Ratio of the yield of
below 100% because higher rated bonds will offer lower promised yields to maturity. When top-rated corporate
bond traders are optimistic about the economy, however, they might require smaller default bonds to the yield on
intermediate-grade
premiums on lower rated debt. Hence, the yield spread will narrow, and the confidence index
bonds.
will approach 100%. Therefore, higher values of the confidence index are bullish signals.


<
3. Yields on lower rated debt will rise after fears of recession have spread through the Concept
economy. This will reduce the confidence index. Should the stock market now be
CHECK
expected to fall or will it already have fallen?

Put/call ratio Call options give investors the right to buy a stock at a fixed “exercise”
price and therefore are a way of betting on stock price increases. Put options give the right
to sell a stock at a fixed price and therefore are a way of betting on stock price decreases.3
put/call ratio
The ratio of outstanding put options to outstanding call options is called the put/call ratio.
Typically, the put/call ratio hovers around 65%. Because put options do well in falling mar- Ratio of put options to
kets while call options do well in rising markets, deviations of the ratio from historical call options
norms are considered to be a signal of market sentiment and therefore predictive of market outstanding on a
stock.
movements.
Interestingly, however, a change in the ratio can be given a bullish or a bearish interpreta-
tion. Many technicians see an increase in the ratio as bearish, as it indicates growing interest
in put options as a hedge against market declines. Thus, a rising ratio is taken as a sign of
broad investor pessimism and a coming market decline. Contrarian investors, however, be-
lieve that a good time to buy is when the rest of the market is bearish because stock prices are
then unduly depressed. Therefore, they would take an increase in the put/call ratio as a signal
of a buy opportunity.

Mutual fund cash positions Technical traders view mutual fund investors as being
poor market timers. Specifically, the belief is that mutual fund investors become more bullish
after a market advance has already run its course. In this view, investor optimism peaks as the
market is nearing its peak. Given the belief that the consensus opinion is incorrect at market
turning points, a technical trader will use an indicator of market sentiment to form a contrary
trading strategy. The percentage of cash held in mutual fund portfolios is one common mea-
sure of sentiment. This percentage is viewed as moving in the opposite direction of the stock
market, since funds will tend to hold high cash positions when they are concerned about a
falling market and the threat that investors will redeem shares.


Flow of Funds
Short interest Short interest is the total number of shares of stock currently sold short short interest
in the market. Some technicians interpret high levels of short interest as bullish, some as bear- The total number of
ish. The bullish perspective is that, because all short sales must be covered (i.e., short-sellers shares currently sold
eventually must purchase shares to return the ones they have borrowed), short interest repre- short in the market.
sents latent future demand for the stocks. As short sales are covered, the demand created by
the share purchase will force prices up.


3
Puts and calls were defined in Chapter 2, Section 2.5.
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670 Part SIX Active Investment Management


The bearish interpretation of short interest is based on the fact that short-sellers tend to be
larger, more sophisticated investors. Accordingly, increased short interest reflects bearish sen-
timent by those investors “in the know,” which would be a negative signal of the market™s
prospects.

Credit balances in brokerage accounts Investors with brokerage accounts will
often leave credit balances in those accounts when they plan to invest in the near future. Thus,
credit balances may be viewed as measuring the potential for new stock purchases. As a result,
a buildup of balances is viewed as a bullish indicator for the market.


Market Structure
Moving averages The moving average of a stock index is the average level of the index
over a given interval of time. For example, a 52-week moving average tracks the average in-
dex value over the most recent 52 weeks. Each week, the moving average is recomputed by
dropping the oldest observation and adding the latest. Figure 19.10 is a moving average chart
for Microsoft. Notice that the moving average plots (the colored curves) are “smoothed” ver-
sions of the original data series (dark blue curve) and that the longer moving average (the 200-
day average) smooths the data more than the shorter (50-day) average.
After a period in which prices have generally been falling, the moving average will be
above the current price (because the moving average “averages in” the older and higher
prices). When prices have been rising, the moving average will be below the current price.




F I G U R E 19.10
Moving average for Microsoft
Source: Yahoo!, February 5, 2002.
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19 Behavioral Finance and Technical Analysis


When the market price breaks through the moving average line from below, as at point A in
Figure 19.10, it is taken as a bullish signal because it signifies a shift from a falling trend (with
prices below the moving average) to a rising trend (with prices above the moving average). Con-
versely, when prices fall below the moving average as at point B, it™s considered time to sell. (In
this instance, however, the buy sell signal turned out to be faulty.)
There is some variation in the length of the moving average considered most predictive of
market movements. Two popular measures are 200-day and 53-week moving averages.
A study by Brock, Lakonishok, and LeBaron (1992) actually supports the efficacy of mov-
ing average strategies. They find that stock returns following buy signals from the moving av-
erage rule are higher and less volatile than those after sell signals. However, a more recent
paper by Ready (1997), which uses intraday price data, finds that the moving average rule
would not be able to provide profits in practice because of trading costs and the fact that stock
prices would already have moved adversely by the time the trader could act on the signal.


Consider the following price data. Each observation represents the closing level of the Dow
Jones Industrial Average (DJIA) on the last trading day of the week. The five-week moving av-
EXAMPLE 19.1
erage for each week is the average of the DJIA over the previous five weeks. For example, the
first entry, for week 5, is the average of the index value between weeks 1 and 5: 9,290, Moving Averages
9,380, 9,399, 9,379, and 9,450. The next entry is the average of the index values between
weeks 2 and 6, and so on.

5-Week 5-Week
Moving Moving
Week DJIA Average Week DJIA Average

1 9,290 11 9,590 9,555
2 9,380 12 9,652 9,586
3 9,399 13 9,625 9,598
4 9,379 14 9,657 9,624
5 9,450 9,380 15 9,699 9,645
6 9,513 9,424 16 9,647 9,656
7 9,500 9,448 17 9,610 9,648
8 9,565 9,481 18 9,595 9,642
9 9,524 9,510 19 9,499 9,610
10 9,597 9,540 20 9,466 9,563


Figure 19.11 plots the level of the index and the five-week moving average. Notice that
while the index itself moves up and down rather abruptly, the moving average is a relatively
smooth series, since the impact of each week™s price movement is averaged with that of the
previous weeks. Week 16 is a bearish point according to the moving average rule. The price
series crosses from above the moving average to below it, signifying the beginning of a down-
ward trend in stock prices.


breadth
Breadth The breadth of the market is a measure of the extent to which movement in a
The extent to which
market index is reflected widely in the price movements of all the stocks in the market. The
movements in broad
most common measure of breadth is the spread between the number of stocks that advance
market indexes are
and decline in price. If advances outnumber declines by a wide margin, then the market is reflected widely in
viewed as being stronger because the rally is widespread. These breadth numbers also are re- movements of
ported daily in The Wall Street Journal (see Figure 19.9). individual stock prices.
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Fifth Edition




672 Part SIX Active Investment Management
Dow Jones Industrial Average




9,700
9,600
9,500
9,400
9,300 DJIA
Moving average
9,200
9,100
9,000
1 3 5 7 9 11 13 15 17 19
Week




F I G U R E 19.11
Moving averages



Cumulative
TA B L E 19.4 Day Advances Declines Net Advances Breadth
Breadth
1 802 748 54 54
2 917 640 277 331
3 703 772 69 262
4 512 1122 610 348
5 633 1004 371 719

Note: The sum of advances plus declines varies across days because some stock prices are unchanged.


Some analysts cumulate breadth data each day as in Table 19.4. The cumulative breadth for
each day is obtained by adding that day™s net advances (or declines) to the previous day™s to-

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