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Technical
Analysis
Explained

The Successful Investor's Guide
to Spotting Investment Trends
and Turning Points

Fourth Edi...
library of Congress Cataloging-in-Publication Data

Pring.  Martin J. 
Technical analysis explained /  the successful inve...
Contents

Preface
Aclmowledgrmants

Introduction

Part I.  Trend-Determining Techniques
1 The Market Cycle Model
/2. Finan...
individual Momentum lndlutorl ll 30. Technical Analysis of Global Stock Markets
13. Candle Charts 31. Technical Analysis o...
M Preface

There is no reason why anyone cannot make a substantial amount of money
in the financial marjters but there are ...
xli Prnlaoe

previous editions have been left in deliberately to give the book some his
torical perspective.  These histor...
Acknowledgments

This book has evolved over the last 20 years and has grown from a text of
under 250 pages in the firs!  ed...
Todiria. tlAnaly§sExphlned

In practice,  of course.  it is impouible to buy and sell consistently at exact
turning points...
4 TechriiralAnalysisBq)lalned

major stockholders of a company) and New York Stock Exchange (NYSE)
members as a group have...
xv

Tet: hrikalAri. flyslsEt; ia| ned

themselves out in a period of l to 3 years and are a reflection of investors‘
>attit...
8 Teizlirilcalrkrialydslixpbilried

The reaccionofanymarkettonews evenuta_rilbemostiristr'ii“c")tivebe<ause
if the market,...
10 TedmloalAnalyskFA<plained

speedometer alone,  so techniml analysis looks further than the price trends
of the popular ...
PART I

Trend-
Determining
Techniques
The Market
Cycle Model

In the Introduction,  technical analysis was defined as the art of identifying
a trend reversal at ...
16 Put I:  Trend-Dd: -Inhlng Tedmiques

The Primary trend Lycle is operative for bonds - - ~
,  . .  equities.  and od, |-...
18 Part I:  Trend-Detarrilrilrg Technhues

on the downside in a bar market.  In other words,  rising short—terrn trends
wi...
20 Put 1: Tranr: l—De1n1nlrrlm Tnehnlqtns

_ trough progression (see Chan 1-1),  which relates to Charles Dow's original

...
22

Pan I:  1'mu—Damma-. gr. a.. .g, ,_, 

- A Peak-and-Trough Duemm. 

$cemsionaIll: ,s: a.l-arid-tgough prograsion becom...
24 Pm I:  TrInd—D¢lermlnlng Technuues

' "°_P’“¢m3 100 percent.  The consolidation prior to the breakout should con
:3‘-; ...
Financial

Markets and the
Business Cycle

Introduction

The basic ffif ~ .  , . 
ta concem o is book is the technical appr...
lllIIIIIlEEWE'§3

28 Put ll Ttvnr‘l-Determining Techniques

first.  This situation gives rise to are group rotation procex...
30 Put I:  Trend-Determ| n.1ngTechnlques

Following the bear market low in bond prlca.  economic activity begins
to contra...
32 Put l:  Trend-Determining Techniques

   
 

Equilibrium

figure 2-5 Hnanclal market peaks and troughs In a double cycle...
34 Pm li Trend-Deteriiiinlng Techniques

Chart 1-Z Three financial inarirm,  1980-1992. (From Inlu-market Review. )

Money ...
Dow Theory

.   Dow theory is the oldest and by far the most plriblrcized method of iden-
flfymg n_i3L_m trends in the sto...
38 Part 1: Trad-Deterrnlnirig Tedtnlqus

l.  The Averages Discount Everything

Changes in the daily closing pricu reflect ...
§%‘%T'§§'E§‘%%f'%'§§

40 Part I:  T  Tazhniqu-s

3.L| n¢slndicmeMovemait

Rhea defined a line as "a price movement 2 to 3 w...
42 Fun I:  Tiuid-Determining Techniques
Q~'f’— /  )5‘—‘xx5
fit of the doubt and adopt a more conservative position.  Remem...
44 Put 1: T  radunqm

vious low.  When prices push above the preceding rally a bull si al ' ‘

by the lndustrials at point...
. Table 3-1 DowTheoryAnalysls ohms-1 oawtr-em9s!9ruls.1953-195$ __f _
 : ___ H _.  __A__
Bwsi9nak' Sclioaalf M, 
_ 
Percen...
48
49 . 

Put 1: Tr¢nt'l~DeI2rmini'ng Techniques

DuwTheory

Chart 3-4 Dow theory signals,  1997-2001. The 1990 hull signa...
I I I I I I I I-

50

 

Typical

Parameters for
Intermediate , 
Trends 

Some Basic Observations

Tl? ‘ ‘"9 PWWOUS Chapte...
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  1. 1. Technical Analysis Explained The Successful Investor's Guide to Spotting Investment Trends and Turning Points Fourth Edition Martin J. Pring McGraw-Hill New York Chicago SnnFranclwn Lisbon Landau M-drld Mexloo City Milan New Delhi Sun-luan Seoul Singapore Sydney Toronto
  2. 2. library of Congress Cataloging-in-Publication Data Pring. Martin J. Technical analysis explained / the successful investor‘: guide to spotting invcstrrierit u-ends and tuming points / by Martin Pr-ing. —4th ed. p. cm. ISBN 0-07-158198-7 1. Investment analysis. I. Title HG4529 . P75 2002 332.63'22—dr:21 200104498] McGraw-Hill X2 ADivI'. n'avIof'I‘lI¢McG1IwHflCovrtpwn'¢s To my son, Thomas William Pring Copyright ©2002 by McGraw-Hill. All rights reserved. Printed in the United States ofAmeria. Except as permitted under the United States Copyr-ightAct of 1976. no part of this publicafion may be reproduced or distributed in any fonn or by any means, or stored in a data base or retrieval system, without the prior written per- mission of the publisher. e7s9o Doc"/ Doc 0876 ISBN: oo7—1ss19s7 The sponsoring editor for this book was Stephen Isaam and the production super- visor was Clare Stanley. It was set in New Baskerville by Mauillister Publishing ‘‘ Services, LLC. Printed and bound by R. R. Donnelley 8: Sons Company. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal. accounting, or other professional service. Iflegal advice or other expert assistance is required, the ser- vices of a competent professional person should be sought. —FrtmI aDccIanzlI'arI ofPrt'ncI'pl¢sjai'vIlly adopted by a Committee afthe American Bar Association and a Comrnittae o[Pu1Ili. thers McGtaw-I-Iill books are available at special quantity discount: to use as premiums and sales promotions, or for use in corporate training programs. For more infor- mation, please write to the Director of Special Sales, Professional Publishing, MCC-raw-Hill, Two Penn Plaza, New York, NY 10121-2298. Or contact your local bookstore. This book is printed on recycled, acid-free paper containing a minimum of 50% recycled dc-inked fiber.
  3. 3. Contents Preface Aclmowledgrmants Introduction Part I. Trend-Determining Techniques 1 The Market Cycle Model /2. Financial Markets and the Business Cycle / 3. Dow Theory / 4. Typical Parameters for lntermediatefiends 5 Price Patterns . ~ 6. Smaller Price Patterns 7 One- and Two-Bar Price Patterns 8 Trendlines ' 9. Moving Averages 10. Momentum Principles 11. Individual Momentum Indicators I
  4. 4. individual Momentum lndlutorl ll 30. Technical Analysis of Global Stock Markets 13. Candle Charts 31. Technical Analysis of Individual Stocks 14. Point and Figure Charting Epilogue | 15. Miscellaneous Techniques for Determining Appendix The Elliott Wave Trends Glossary 16. The Concept of Relative Strength Bibliography 17. Putting the Indicators Together. The DJ Transports 1990-2001 Index Part 1]. Market Structure / 18. Price: The Major Averages / 19. Price: Group Rotation / 20. Time: Longer~Term Cycles 21. Practical Identification of Cycles / 22. Volume: General Principles / 23. Volume Oscillators / 24. Breadth Part III. Other Aspects of Market Behavior 25. Why Interest Rates Affect the Stock Market / 26. Sentiment Indicators 27. Applying Technical Analysis to the Theory of Contrary Opinion 28. Checkpoints for Identifying Primary Stock Market Peaks and Troughs 29. Automated Trading Systems
  5. 5. M Preface There is no reason why anyone cannot make a substantial amount of money in the financial marjters but there are many reasons why many people will not. As with most‘Eii ‘l'. ;; ('; i'S in life, the key to success is knowledge and action. This book ha been written in an attempt to shed some light on the internal workings of the markets and to help expand the lmawledgr compo- nent, leaving the action to the patience, discipline, and objectivity of the indi- vidual investor. The mid- to late 1980: saw the expansion of investment and trading opportunities to a global s _, _in terms of both the cash and the futures markets. In the 1990s, ixfiiovauoiis in the communications industry enabled anyone to plot data on an intraday basis for relatively little cost. Today, numerous charting sites have sprung up on the Internet, so virtually any- one now has the ability to practice technical analysis. As a consequence of the technological revolution, time horizons have been greatly shortened. I am not sure that this is a good thing because short-term trends experience more random noise than longer-term ones. This means that the technical indicators are not as effective. The fou edition of Technical Analysis Explained has been expanded and totally revised to keep abreast of many of these changes, and to include some technical innovations and cvolvement in my own thinking since the publication of the third edition. Every chapter has been thoroughly reworked and expanded. In the inter- est of cfiiciency, some have been dropped and others substituted. Considerable attention continues to be focused on the U. S. equity market. but many of the marketplace examples feature intcmational stock indexes, currencies, commodities, and precious metals. Special chapters also feature technical analysis of the credit markets and global equities. In most cases, the marketplace examples have been updated, but some older ones from
  6. 6. xli Prnlaoe previous editions have been left in deliberately to give the book some his torical perspective. These historiml examples also underscore the point that nothing has really changed in the last 100 years. The same true and tried principles are as relevant today as they always were. 1 have no doubt what- soever that this will continue to be so in the future. A Thus, technical analysis could be applied in New York in 1850, in Tokyo in 1950, and in Moscow in 2150. This is true because price action in finan- cial markets is a reflection of human nature, a. rrd human nature remains more or less constant. Technical principles can also be applied to any freely u-aded entity in any time frame. A trend reversal signal on a 5-minute bar chart is based on the same indicators as one on a monthly chart; only the significance is differenc Shorter time frames reflect shorter trends and are therefore less significant Several new chapter§, h_ave been added in this edition. One of the areas I become more imp1'*e€séd with the more it is the concept of one- and two-bar price reversals. They are also relevant for intraday and swing traders. Consequently, a brand new chapter on this subject has been intro- duced in this edition. In view of their growing popularity, candlesticks, pre- viously relegated to an Appendix, now receive full treatment. A third chapter has been added to the momentum section so that material on the Directional Movement System. the Chande Momentum Oscillator, the Relative Momentum Index. and the parabolic (not a true momentum indi- cator, but valuable nonetheless) could be included. In addition, the expan- sion of the momentum section has left room for some of my own new ideas concerning momentum interpretation, such as extreme swings, mega- overboughts and mega~oversolds, and so on. The volume secdon also includes an additional chapter so thatindicators such as the Demand Index and Chaikin Money Flow could be covered. Greater emphasis is also placed on volume momentum. The concept of relative strength is a very important and underappreciated arm of technical analysis. It too has been upgraded to full chapter status. Finally, a new chapter on applying technical analysis to contrary opinion theory expands our coverage of the psychological aspects of trading and investing. Since the 19705, the time horizon of virtually all market participants has shrunk considerably As a result, technical analysis has become very popular for implementing short-term timing strategies. This use may lead to great dis- appointment: In my experience, there is a rough correlation between the reliability of the technical indicators and the time span being monitored. This is why most of the discussion here has been oriented toward inten-nediate and long-term trends. Even short-term traders with a 1- to 3-week time hori- zon need to have some understanding of the direction and maturity of the main or primary trend. This is because mistakes are usually made by taking xiii Preface on positions that go against the direction of the main trend lfla w ipsaw is going to develop, it will usually anse Etom a contratrend sigr: .m of T” bc succesfifl’ mfiininal should re aid: f several sci- i“3 ‘he ‘echniml p°sm°. n Ola Pamcular scc‘; lnty wir of the mechanistic entifically researched indicators. Althoug _fl13_ Y _ of ha“ _n map techniques described in this book offer reliable indrcationsm Cth 82:‘ and m an we ‘win ‘M %°"‘““? “ °“*~‘{. “': :“"f; ’.‘. ... .". ., flmmém w °f‘°n do’ fail '0 °Pe'. m.c Sam}-acmnly. This mm ‘u P ood working k“°“"1' the conscious‘? dlsaphned mv-csmr 0}. uadfr’ mm: a Ems in financial mar- edge °f the Pn"clP1cs. undedymg major Pncc 'mcaclwem'tion oifer a si1P'erior km; and a balanced view of the overall techm post framework within which to operate. ‘ _ f There is, after all, no substitute for independent thought. 'Thcfia‘: °:“‘: ’ the technical indicators illtutrates the underlying chamctensucs p to Yemcr . . - " e kel. and it is up to the 'r1I}1l31Y5‘fi"I° Ffm ‘he I-“aces °f the-llgsaw Pun E and develop a working ypo cs1s_- ' _ nfid m M by no W M» as W‘ :25: and arrogance‘ Charles H‘ ow’ me'fa"-her of ‘Cd thu downfaylsl df more men W0|’d-5 ‘° ‘be ‘$5’ ‘hat upnde °f °Plm°. n Fans‘ : C ether” This is true on Wall Street than all the other opinions pu l°8_ '_ n Normally because markets are essentially a reflection of people in Echo ~ 0 1: cm; . . ' . 5 such acnvity develops on a reasonably predictable patlhcl elltviatlg umx‘ _and d°—change um‘ ndmds’ Pace ‘Tends m lid: miuiis trouble investors. Pcaedly {mm their anuqpamd. cows: -' To scnohan cs in ihe techni- md especially traders, must 3d_]. |SI. their atutu es as c 8 ca] position emerge. . _ ab 31 x. .0 mm mm. a 9‘ *; .": ’*': :‘ . .:; ::_: .. much about human nature, both from °_"5"“ng ° C P mp mm m. “ _ from the aspect of self-development. As investors react to me coxilsl also lag] 31° mmugh which the markflwm undoybmdlyruf ‘bani’ hte‘zI: nll have been a “ma abom their own makeup, Washington rlimg EELS "Little minds are referring to this challenge of the markets when dc W. “ aimve it. ” taxed and subdued by misfortune but great mm s n Martin Pring
  7. 7. Acknowledgments This book has evolved over the last 20 years and has grown from a text of under 250 pages in the firs! edition to over 600 in the current one. The matenal for the fourth edition of this book has been gathered from a substantial number of sources, and I am deeply indebted to the many orga- nizations that have given their permission to reproduce charts and figures ¥: ‘hl<: Ii; whichdthis boolewoiild not have been possible. Special thnks go to yes an. Ned Davis at Ned Davis research for providing many of [hg charts on senument and flow of funds indicators. APP1"F‘Cl-‘NOD also goes to Danny Prlng who came up with the title for the fil'FIEhCadl; ls0;lls0f this book. It‘s a g-reatgtitle and has ‘followed it ever since. whose Zmdep‘ to plilglcgllgagues at Pring includingjimrnie Sigsway atmoSPhere ui'i: ii1terru C ldamili auowed my wnmfg to Progress m a sum: who has ex erienced Eh: bl; 'l: l?°nstmcu0n gems on around us--Anyone what I meal}: She is alwe re ui mg of a home/ ofiice complex will know Abe an -h ks a mother in law] the Chigem atngnfi go tofmy wife Lisa, who tirelessly -reconsuuctfgd most of simuhaneousl rom my pathetic PowerPoint illusttanons while . "““‘f"‘E a home. taking are of our son Thomas, maintain- mg °‘" web “-5 (P""8-C°m) and managing a major house renovation. Introduction To investors willing to buy and hold common stocks for the long term, the stock market has offered excellent rewards over the years in terms of both dividend growth and capital appreciation. The market is even more chal- lenging, fiilfilling, and rewarding to resourceful investors willing to leam the art of market timing through a study of technical analysis. The advantages of this approach over the buy-and-hold approagh meg}; particularly marked between 1966 and 1982. The market made no headway at all, as measured by the Dowjones Industrial Average (DjIA), in the 16 years between 1966 and 1982. Yet there were some substantial price fluctu- ations. Although the DJIA failed to record a net advance between 1966 and 1982, the period included five major advances totaling over 1500 Dow points. The potential rewards of market timing were therefore significant A long-term investor fortunate enough to sell at the five tops in l966, 1968, 1973, 1979, and 1931 and to reinvest the money at the troughs of 1966, 1970, 1974, 1980, and 1982 would have seen the total investment (exclud- ing transactions costs and capital gains tax) grow from a theoretical $1000 (that is, $1 for every Dow point) in 1966 to over $10,000 by October 1983. In contrast, an investor following a buy—and~hold approach would have real- ized a mere $250 gain over the same period. Even during the spectacular rise that began in August 1982, technical analysis would have proved use- ful, since that period witnessed a considerable variation in performance between difierent industry groups. A bull market, such as the one that occurred in the 19805 and 19905, is a once-in-a-generation affair. In fact, it was a record in 200 years of recorded U. S. stock market history. This implies that the opening decade of the twentyhfirst century will be a more difficult and challenging period, and that market timing will prove to be of crucial importance.
  8. 8. Todiria. tlAnaly§sExphlned In practice, of course. it is impouible to buy and sell consistently at exact turning points, but the enormous potential of this approach still leaves plenty of room for error, even when oomminion costs and taxes are included in the mlculation. The rewards for identifying major marketjunctures and taking the appropriate action can be substantial. Originally, technical analysis was applied prindpally in the equity market, but its popularity has gradually expanded to embrace commodities, debt instruments, currencies, and other intcmational markets. In the days of the old market, participants had a fairly long time horizon, stretching over months or years. There have always been short-term under! and scalpers, but the technological revolution in communications has shortened the time horizon of just about everyone involved in markets. When holding periods are lengthy. it is possible to indulge in the luxury of fundamental analysis, but. when time is short, timing is everything. In such an environment, tech- nical analysis really comes into its own. To be successful, the technical approach involves taking a position con- trary to the expectations of the crowd. Tl-iis requires the patience, objectiv- ity, and discipline to acquire a financial amet at a time of depression and gloom, and liquidate it in an environment of euphoria and excessive opti- mism. The level of pessimism or optimism will depend on the ruming point Short—temi peaks and troughs are associated with more moderate extremes in sentiment than longer-tenn ones. The aim of this book is to explain the technical characteristics to be expected at all of these market turning points, particularly major ones, and to help to assas them objectively. Technical Analysis Defined During the course of the book when it is time to em important point. it will be highlighted in the followin phasize a specific but 8 W3)’: The technical a th in pproach to investment is essentially a reflection of the idea at prices move in trends that are determined by the changing attitudes of vestors toward a variety of economic, monetary, political, and psycholog- . . - - ~ an. " no edmaiwvvv-4 ical forces. The 3-la"-ly‘ns0,nf: ;t is anumillsu wag“ ‘WM mlnsalalarelallwlymufiu M"m, ,,-, ¢,1,11;eevidenceintliiscaseis gnu xhowr or prove: ‘lmd - ' . . -- ‘ ' d nbed in r6P! esented I7)’ the numerous rain“. /55¢“? demed mdlcawn at ‘his book ‘ more or less constant and tends to react to sim- H““““ mm‘ “"33"” - { ' market ilar situations in. consist: t;: z’h2Z; :l: ::| :.: }:: li: r::1:fi: fi:smfl: I:Fsmn help turning POXIIIS, It 15 post ‘ahniml a it M5” on to idenfify marlifl WP‘ and b°“°""“ -n'°r°f°"' . have Md, a, m,, W,'gn It will coma‘ la make the rum mulalm they Wm pm Hurr‘hi: ‘nper: plationshiP5’: : extremely ¢°mP‘= " ’“d "V" yer? ‘ "I , . - fl ' f eop e in in identical wmbl-nauomlirhe mark“, whIdcIda}'rel>iaitrteliee: :c°ill'r(: :nl: :e of sim- action. never duplicateeligachngdam to idemify juncture "*5 °“’''. ‘‘‘°"m-’nIsies indciicator has signaled. or indeed could firm! » = ""Y P°lnml'osout]t. :>errl“: ilh§1ical analysts have developed an arsenal of tools to help top or . isolate these points- Three Branches of Technical An/31931‘ _ . - csgenfial as: sentiment. Tcchmml anal? !“ can be bmkent: r:“'inntl1Iict: t:| rl: eData and iarldicators for all flow-of-funds, and market st: -'hucU S stock maxim. For other financial mar. three areas areavailableotzror :6“-cémfined ‘D me mlrkel “rucmm india. kets, the stansucs are m _ . 5 ‘es - - kets based in the United 13 2 mm The map‘ exmpuolu an fumres mfg]; 1‘ ll ' comments for which ‘h°""‘"m umlmem are I ‘t-cfhtleIe(ll; ‘.ms! t‘4Eck market. on sentiment and flow-of-funds indicators TC Sentiment Indicators . . . - ti nsof different mar- Scmimem or expemmqnal‘ iindlcalortlizllfnrlidlsrnlilariagee ac is and investors, and ket participants, such as insi eis, mu “ _ from one . - f clock conunually moves _ floor specialistséjlust 35 Sldaexeg (which monitor the emouons extreme toano CD90 3, r _ market bottom to ano e of investors) move from one extreme a: lawl‘>1¢i: ; than indium“ are based at a bull marl“! ‘°P- Th‘ ”’“"‘P“°" ° . - t. h ‘r actions at rn3_i°| ‘ is that difierent groups of investors are consistent in eik by”! or . . - - ‘ em market iuming poms. For examP1=- "“'d°“ (‘h‘“ "' '7 P
  9. 9. 4 TechriiralAnalysisBq)lalned major stockholders of a company) and New York Stock Exchange (NYSE) members as a group have a tendency to be correct at market turning points; in aggregate, their transactions are on the buy side toward market bottoms and on the sell side toward tops. Conversely, advisory services as a group are often wrong at market tuni- ing points, since they consistently become bullish at market tops and bear- ish at market troughs. Indexes derived from such data show that certain readings have historically corresponded to market tops, while others have been associated with market bottoms. Since the consensus or majority opin- ion is normally wrong at market turning points, these indicators of market psychology are a useful basis from which to form a contrary opinion. Flow-of-Funds Indicators The area of technical analysis that involves what are loosely termed flowof- funds indicators analyzes the financial position of various investor groups in an attempt to measure their potential capacity for buying or selling stocks. Since there has to be a purchase for each sale, the as post, or actual dollar balance between supply and demand for stock, must always be equal. The price at which a stock transaction takes place has to be the same for the buyer and the seller, so naturally the amount of money flowing out of the market must equal that put in. The flow-of-funds approach is therefore concemed with the before-the—fact balance between supply and demand, known as the or ante relationship. lfat a given price there is a preponderance of buyers over sellers on an ex ante basis, it follows that the actual (ex post) price will have to rise to bring buyers and sellers into balance. Flow-of-funds analysis is concemed, for example, with trends in mutual fund cash positions and those of other major institutions, such as pension funds, insurance companies, foreign investors, bank trust accounts, and cus- tomers‘ free balances, which are normally a source of cash on the buy side. On the supply side, flow~of-funds analysis is concerned with new equity oifer~ ings, secondary offerings, and margin debt. This money flow analysis also suffers from disadvantages. Although the data measure the availability of money for the stock market (for example, mutual fund C2/lslh position or pension fund cash flow), they give no indica- tion of the inclifiifion of market participants to use this money for the pur- chase of stocks, or of their elasticity or willingness to sell at a given price on the sell side. The data for the major institutions and foreign investors are not sufiiciently detailed to be of much use, and in addition they are reported well after the fact In spite of these drawbacks, flow-of-frmds statistics may be used as background material. Introduction 5 A superior approach to flow-of-funds analysis is derived from an exami- nation of liquidity trends in the banking system, which measures financial pressure not only on the stock market, but on_ the economy as well. Market Structure Indicators This area of technical analysis is the main concem of this book, embracing market 5:1-iu: trm or the character qf the market . These indicators mon- itor the trend of various price indexes, market brspggh, cycles, volume, and so on in order to evaluate the health of the prevailing trend. Indicators that monitor the trend of a price include moving averages, peak—and-trough analysis, price pattems, and treirdlines. Such techniques can also be applied to the sentiment and flowof-funds indicators discussed previously. This is because these indicators also move in trends. When the nrend of psychology, as reflected in these series, reverses, pnces are also likely to change direction. Most of the time, price and internal measures, such as markel bfeadmv momentum. and volume, rise and fall together, but toward the end of mar- kct movements, the paths of many of these indicators diverge from the price. Such divergences offer signs of technical deterioration during advances, and technical strength following declines. Through _! |.IdlCl0l1'5 observation of these signs of latent strength and weakness, technically on- ented investors are alerted to the possibility of a reversal in the trend of the market itself. _ ’ Since t. he technical approach is based on the theory that the pncc is a reflection of mass psychology, or the crowd in action, it attempts to forecast future price movements on the assumption that crowd psyCh°1°8l’ m°l’°’ between panic, fear, and pessimism on one hand and confidence. €XCB5flV9 optimism, and greed on the other. As discussed here, the art of technical analysis is concerned with identifying these changes at an early phase, since these swings in emotion take time to accomplish. Studying these market trends enables technically oriented investors and traders to buy or sell with a degree of Jqgnfidence in the principle that once a trend is set in motion. it will perpetuate itself. Classification of Price Movements Price movements may be classed as primary. interrnediate, and ‘short term- Majar move-rnnils, sometimes called primary or cyclzcal, typically work
  10. 10. xv Tet: hrikalAri. flyslsEt; ia| ned themselves out in a period of l to 3 years and are a reflection of investors‘ >attitudes toward the business cycle. lvucmudiale wiauevneutr usually develop over a period of 6 weeks to as many months, sometimes longer. Although not of prime importance, they are nevertheless useful to identify. It is clearly important to distinguish between an intermediate reaction in a bull market and the first dawrileg of a bear market, for example. Short-lain movements, which last lus than 5 or 4 weeks, tend to be random in nature. Secular or very long term trends embrsdng several primary trend movements and inttaday trends lasting a few minutes to a few hours round out the possi- bilities for price movements. Discounting Mechanism of the Market Aflpricemawmenuhaveone thingincommon: 77iayarearqIacu'onqfUietmid r'nlhehapes, fsa1s, lt1wwledg¢, optimisnt, aridgvesdq/ 'ma1t:1pa1¢idp¢nts. The sum total of these emotions is expressed in the price level, which is, as Garfield Drew noted, ‘never what they [stocks] are worth, but what people think they are worth. " _ This process of market evaluation was well exprssed by an editorial in The Wall Smd_]ou11ial: ’ The stock market consists of everyone who is ‘in the market" buy- ing or selling shares at a given moment, plus everyone who is not ‘in the market, ‘ but might be if conditions were right. In this sense, the stock market is potentially everyone with any personal savings. It is this broad base of participation and potential participation that gives the market its strength as an economic indicator and as an alloator of scarce capital. Movements in and out of a stock, or in and out of the market, are made on the margin as each investor digests new infonnation. This allows the market to incorporate all available information in a wa that no one person could hope to. Since its judgments are the czltiserisus of nearly everyone, it tends to outperform any single person or group. . . . [The market] mea- ‘Garfield Drew, NavM¢ilIod. t/avPItflli'-ti Iltlsladi Marin, Metulfe PIS, Boston 1968, p. l8. 'The Wnllsuujinavial, Oct. 20, 1977. Reprinted by PQI'l'lIl. ElDIl of the Wallfllldjoiavial Copyright Dowjones 8: Co. , Inc. 1977. All rights reserved. sures the after-tax profits of all the companies whose shifts are listed in the market, and it measures these cumttlaU. V€_P‘°‘: “‘ 5° into the future one might as well say the horizon is infinite. This cumulative mass of after-tax profits is then, as the economists will say, ‘discounted back to present value” by the market. A man does the same thing when he pays more for one razor blade than another, figuring he'll get more or easier shaves m the future with the higher-priced one. and figuring its present value on that buts. This future flow of earnings will ultimately be aflected by busi- ness conditions everywhere on earth. Little bits of informatlon are constantly flowing into the market from around the World I5 WC“ as throughout the United States, and the market is much more eflicient in reflecting these bits of news than are government sta- tisticians. The market relates this information to how much American business can earn in the future. Roughly speilunfiv ‘-he general level of the market is the present value of the capital stock of the U. S. that investors and traders are looking ahead ‘and taking action so that they can liquidate at a higher pricelwhen the an|3IC1P3'-ed new: or development actually takes place. If expectal-I91“ ‘3°‘f‘3°"‘“‘S 0“ ' opmem are better or worse than originally thought, then investors sell ei er sooner or later through the market mechanism, depending on the partic- ular circumstances. Thus, the familiar maxim sell on MW‘ ? PPl’°’ °_" when the good news is right on or below the market‘: (that is, the investor? ) expectations. If the news is good. but n°l 35 f3V°| "3bl¢. 35 €*PfC‘°d- 3 ‘l‘-“‘_3k reassessmentwill take place, and the market‘(other things being_ equal) "I" fall. lfthe news is better than antidpated, the possibilities 0bV|0“5lY favorable. The reve_rs_e ‘will. of course. be true in a_declining market. is process explains the'pa. radox of equity markets peaking wheneconornic con-6 ditions are strong, and fonning a bottom when the outlook is most gloomy. ’”. . . ' K. .. The principle of discounting is not confined to equities alone, but ‘in '99 fl applied to any freely traded entity. . 9 A, » r‘ " J "Z J’. 7
  11. 11. 8 Teizlirilcalrkrialydslixpbilried The reaccionofanymarkettonews evenuta_rilbemostiristr'ii“c")tivebe<ause if the market, as reflected by price, ignoru sufiedly bullish news and sells oil", it is certain that the eventwas well discounted, that is, already built into the price mechanism, and the reaction should therefore be viewed Ifa market reacts more’ favorably to bad news than might be expected, this in tum should be int‘e‘rpm’e”a as a podtive sign. There is a good deal ofwisr dam in the saying, “A bear argument known is a bear argument understood. ’ The Financial Markets and the Business Cycle The major movements in bond, stock, and commodity prices are caused by long-tenn trends in the emotions of the investing public. These emotions reflect the anticipated level and growth rate of future economic activity, and the anitude of investors toward that activity. For exariiple, there is a definite link between primary movements in the stock market and qclial movements in the economy because tends in cor- porate profitability are an integral part of the business cycle. If_ basic eco- nomic forces alone influence the stock market, the task of detemiining the changa in primary movements would be relatively simple. In practice, it is not, and this is due to several factors. First, changu in th direc ' n of the economy can take some time to mate- rialize. As the t.7cle! $i. (’ifo , ‘ other psychological considerations, such as political developments or purely intemal factors like a speculafive buying wave or selling pressure from margin calls, an affect the equity market and result in misleading rallies and reactions of 5 to 10 percent or more. Second, changes in the market usually precede changes in the economy by 6 to 9 months, but the id time can sometimes be far shorter or longer. In 1921 and 1929, the economy tumed before the market did. Third, even when an economic recovery is in the middle of its cycle, w'“ ‘ . doubts about its durability often arise. When these doubts c’o'ir{cid@ political or other adverse developments, sharp and confusing counter- cycliml price movemenu usually develop. Fourth, profits may increase, but investors‘ attitudes toward those profits may change. For example, in the spring of 1946 the DJIA stood at 22 times the price/ earnings mtio. By 1948, the comparable ratio was 9.5 when mea— sured against 1947 earnings. In this period, profits had almost doubled and pr-ice/ earnings ratios had fallen, but stock prices were lower. Changs in bond and commodity prices are linked much more directly to economic activity than are stock market prices, but even here, psycho- i — - . ~:‘v“~5 logical influencu on price are very important. Currencies dtil-I| |0al£lti; "'; llc‘f'; '-(: ~: bush-res cycle analysis, Although data reported several man :1 ' has been an very good at explaining currency movements. technical an ysrs “ends most useful for timely forecasts and the identification of ern€lE“‘8 ' Technical Analysis and Trend Determination , . . ' kets it is not . J Since technical analysis involves a study of the action of mar . ‘ 3‘ concerned with the difficult and subjective tasks of forecasLinS '‘°“d5 ‘“ an economy or assessing the attitudes of investors toward those chafl8°5- ’ _ , . . . . . I [ Technical maiyus me, (0 identify tumrng points in the markets assessmen of these factors. _ 1 d d Since technical analysis can be applied successfiIl'l)7ol<:1:1lc); ’If_: ::‘(}; :s“a: d entity such as stocks, market averages. €0fl’1m°d"-‘C52 . “ '84,» Er, /éicfilé. an so on, I will frequently use the term seciml)! 35 3 8‘"°_"_° ‘m em 3 of these entidcs, el‘Bl7}’ 3V0idl1'|8 “nn¢C°5““'Y "P°"_°°“‘ _ -he «ms» ii : ." “: ;:: ::: :.: ::: ::: ':. tions of techniml analysis. The vanoirs techniques use to d D ("minim and identify their reversals will be examined in Part I. "lie" ‘. 9 3 Techniques " which deals with price patterns. Y-Tfifldllnesv m°""‘g avenge: (MAs), momentum, and so on. . I _ , m U. S. equity market, although examples using othplr secuncablc A" that is *0 d¢m°"*"'*“° E1‘ 9" P""°'P‘°‘ ? " “’. ‘“'°m Y app d ' ‘r d ex la- , -cqug, -ed are me appropriate data. This section offers a more ea c mnPbe nation of the various indicators and indexes, It also shoinp hf)‘; meelgmemal combined to build a framework for determining the qua Kenton: of tech- 5"“‘3'“"’ °f '1" market“ A study oimarkel dlamcmr 5-3 co ia es are almost niml analysis, since reversals of pnce trends in the I"I"ll_]0I‘ av; ‘ élmlcmm Just away’ Preceded by mu“ sucngm or weakness in the marfc car from the as a careful driver does not Judge the performance o a
  12. 12. 10 TedmloalAnalyskFA<plained speedometer alone, so techniml analysis looks further than the price trends of the popular averages. Trends of investor confidence are responsible for price movements, and this emotional aspect is examined from four view- points or dimensions, namely, price, time, volume, and breadth. Changes in prices reflect changes in investor attitude, and price, the first dimension, indicates the level of that change. Time, the second dimension, measures the recurrence and length of cycles in investor psychology. Changes in confidence go through distinct cycls, some long and some short, as investors swing from excesses of optimism toward deep pessimism. The degree of price movement in the market is usu— ally a function of the time element. The longer it takes for investors to move from a bullish to a bearish extreme, ‘the greater the ensuing price change is likely to be. The examples in the two chapters on time relate mainly to the U. S. stock market, but much of this material is equally valid for com» modities, bonds, or currencies. Volume, the third dimension, reflects the intensity of changes in investor attitudes. For example, the level of enthusiasm implied by a price rise on low volume is not nearly as strong as that implied by a similar price advance accompanied by very high volume. The fourth dimension, breadth, measures the extent of the emotion. This is important because as long as stocks are advancing on a broad front the trend in favorable emotion is dispersed among most stocks and industries, indicating a healthy and broad economic recovery and a widely favorable attitude toward stocks in particular. On the other hand, when interest has narrowed to a few bluechip stocks. the quality of the trend has deteriorated, and a continuation of the bull market is highly suspect Technical analysis measures these psychological dimensions in a number of ways. Most indicators monitor two or more aspects simultaneously; for insmnce, a simple price chart measures both price (on the vertical axis) and time (on the horizontal axis). Similarly. an advance/ decline line measures breadth and time. Part Ill, “Other Aspects of Market Behavior, ” deals with more specialized aspects. These include interest rates and the stock market, sentiment, auto- mated trading systems, individual stock selection, and techniml analysis as applied to global markets. Conclusion Financial markets move in trends caused by the changing attitudes and expectations of investors with regard to the business cycle. Since investors continue to repeat the same type of behavior from cycle to cycle, an under- ll 'l‘|1sMsrketOycleModel . . - - ‘ 'ce averages and standing of the historical relationships ‘between C= |"3_-‘“ P“ ‘ 1 _ndica_ market indicators can be 10 1dm“fY£‘'m‘“§ P°'s: ‘;: :;1:t§fi: l‘m use tor an ever be expected to 318331 3“ “'5' "Va 5313’ th b 'ld u a consensus. _ a I"['u| ::; bae; :p: fo: :iIi1s Esygreio reri-etaliis ii-ifallilile, but a careful, patient, and Objec- . . - - odds f success ‘i"° "Se °f the Pmmpm if technical m<lia1ymh? ii. §:t ltiireates meow Princi- vcfy much in favor of the investor or tn erw VP ples into an overall strategy.
  13. 13. PART I Trend- Determining Techniques
  14. 14. The Market Cycle Model In the Introduction, technical analysis was defined as the art of identifying a trend reversal at a relatively early stage and riding on that trend until the weight of the evidence shows or proves that the trend has reversed. In order to identify a reversal, we must first know what a trend is. This chapter explains and categorizes the various trends, and concludes with a discussion of one of the basic trend-determining techniques, peak-and-trough pro- gression. It is one of the simplest, and perhaps the most efiective, t. rend-iden- tification techniques used in technical analysis and forms a building block for many of the other techniques discussed later. Three Important Trends - A mud is a time measurement of the direction in price levels covering dif- ferent time spans. There are many trends, but the three t. hat are most widely followed are primary, intermediate, and short term. Primary The primary trend generally lasts between 9 months and 2 years and is a rcflection of investors‘ attitudes toward unfolding fundamentals in the busi- ness cycle. The business cycle extends statistically from trough to trough for approximately 3.6 years, so it follows that rising and falling primary trends (bull and bear markets) last for 1 to 2 years. Since building up takes longer than tearing down, bull markets generally last longer than bear markets. 15
  15. 15. 16 Put I: Trend-Dd: -Inhlng Tedmiques The Primary trend Lycle is operative for bonds - - ~ , . . equities. and od, |- lJCS- Phlnary’ . trends also apply to cunencien. but since cunencifsmrlvrflect investors ‘attitudes toward the interrelationship of two different economies, 3" 3“31Y5'5 Of Cuflcncy relationships dos not fit neatly into the business CF19 3PP. I'0acb discussed in Chapter 2. ‘T119 u'end is illustrated in Fig. 1-1 by the thickest line. In an ide- , ‘““‘“°“- ‘he P"-"1317 upcrend (bull market) is the same size as the pnntiary downtrend (bar market), but in reality, of course, their magnitudes : .:: ::: ::: :°: "s= .n =5 v= ~ uvwmns «» mm (M. ..) g ml) tnvestments in the direction of the main trend, a sig- of this book is concemed with identifying reversals in the pri- Intermediate lknyonevwho has looked at a price chart will notice that prices do not move m 3 “"”5|" I-‘“°~ A P"i“‘-'“'Y_“P5Wihg is irlterrupted by several reactions along the way. These countercycltml trends within the coming; of; rim bull market are known as mawmeyu; Th 13“ P “y 6 weeks to as long as 9 months sometimes even longzr butmsrhtfizm ' I I’. lntennediate-term trends of the stock market are examine ' . . d in greater dew] "‘ ch“P'-5|” 4. and are shown as a thin solid line in Fig. 1-1. rumuuzpus Appwxltnslely 4 years Hum 1-1 'l'l1enIarltelq; dcmodg| #iP1edhanmHaafimbrqghtwmyattmnmbyhns. NodeydYehmPeal. RH9efieH, 'I'heMarlraO}c| eMadel 17 It is important to have an idea of the direction and maturity of the pri- mary trend, but an analysis of intermediate trends is also helpful for irnprov- ing succes rates in trading, as well as for determining when the primary movement may have run its course. ' Short Term Short-tenn trends typically last from 2 to 4 weeks, sometimes shorter and sometimes longer. They interrupt the course of the intennediate cycle, just as the intermediate-term trend interrupts primary price movements. Short- term trends are shown in the market cycle model (see Fig. 1-1) as a dotted line. They are usually influenced by random news events and are far more difiicult to identify than their intermediate or primary counterparts. The Market Cycle Model It is apparent by now that the price level of any market is influenced simul- taneously by several different trends, and it is important to understand which type is being monitored. For example, if a reversal in a short-tenn trend has just taken place, a much smaller price movement may be expected than if the primary trend had reversed. Long-tenn investors are principally concerned with the direction of the primary trend, and thus it is important for them to have some perspective on the maturity of the prevailing bull or bear market. However. long-term investors must also beawarzafinlenrwdiate term and, la a laserartent, shart-term trends. This is because an important step in the analysis is an examination and understanding of the relationship between sl1ort- and intermediate- terrn trends. and how they afl'ect the primary trend. Also, if it is concluded that the long-term n'end has just reversed to the upside, it may pay to wait before committing capital because the short-term trend is overextended on the upside. A lack of knowledge of the short-tenn trend's position by an investor could therefore prove costly at the margin. Shari-term traders are principally concemed with smaller movements in price, but they also and to know the direction q/ ‘the inlemwdiate and primary trends. This is because surprises occur on the upside in a bull market and ‘. ‘., ‘spen"of the'. trend. -the easier ltls to identify reversal. Malor Tedniileal, IHA. -Q A rule, time
  16. 16. 18 Part I: Trend-Detarrilrilrg Technhues on the downside in a bar market. In other words, rising short—terrn trends within the confines of a bull market are likely to be much greater in mag- nitude than short-tenn downtrends and vice versa. A tnding loss usually hap- pens because the trader is positioned in a countercycliml position against the main trend. In efiect. aIlmariidpa1tidpanLirieadloIiavesom¢kx'ndafwort- Eng knowledge afall thm hands, although the emphasis will depend on whether their orientation comes from an invesmient or a short-term trad- ing perspective. lnhaday Trends In recent years. computers and real-time trading have enabled traders to identify hourly and even ticli—by~tick movements. The principle: of lerrlinical anaé/ siiapplyequauywthesewryshan-iemmawwnuandwejitunrwlidlhem are two main dilferences. First. reversals in the intraday charts have only a very short term implication and are not significant for longer-tenn price reversals. Second, extremely short-tenn price movements are much more influenced by psychology and instant reactions to news alents than are longer-term ones. Decisions therefore have a tendency to be emotional, ltneejerlr. reactions. Inn-aday price action is also more susceptible to manip- ulation. As a consequence, price data used in very short-term charts are much more erratic and generally less reliable than those that appear in the longer-term charts. The Secular Trend The primary trend consisu of several intermediate cycles, but the secular. or very long-term, trend is constructed from a number of primary trends. This super cycle, or long wave, extends over a substantially greater period, usually lasdng well over 10 years, and often as long as 25 years. Itis discussed more fully in Chapter 2. A diagram of the interrelationship between a sec- ular and a primary trend is shown in Fig. 1-2. It is certainly very helpful to understand the direction of the secular trend. Just as the primary trend influences the magnitude of the intermediate-term rally relative to the coitnterqclical reaction, so the secular trend influences the magnitude and duration of a primary trend rally or reaction. For exam- ple. in a rising secular uend, primary bull markets will be of greater mag- nitude than primary bear markets. In a secular downtrend, bear markets will be more powerful and will take longer to unfold than bull markets. mMuiuQrdeMode| 19 . :5e-4-av. -soiv-r-um. -£"—#""M: ' Boot markets are law! ’ l" "mu w W“ ocular am. Mon r-igmi-2 1imai. uonshrpbemanhneo. nsrandpnnuvvIr¢rid= - Bull markets are longer In Peak-and-Trough Progression Technical analysis. as pointed out before. is the art of identifying a (price) wend reversal based on the weight of the evidence. As in a court of law, 3 trend is presumed innocent until proven guilty. The evidence is the.0b. l°‘3‘ live element in technical analysis. It consists of a series of scientifiwlll’ derived indicators or techniques thatlwork well mostnf :1: identification process. The art. consists of combining 95‘ “£1 3 a market an overall picture and recognizing when that picture resein 9 3|: h. PcWid: s:i? e:Ei use of computers has led to the development of some very; sophisticated trend-identification techniques in marltIe1t1an: ‘y‘Si| I5I-| ’:l°s1e"a¢r‘f-‘h these indicators work rmsonablywell. but mt. ‘-'5‘ d° “°'- ° C ominue but it for the -Ho1y Gmil, ‘ or perfect indicator, will undoubtelgly Ci“! wt“. news is unlikely that such a technique will ever be discoveittl. YB“ uldv d of in discovery would soon be diseminated and the indicator wo gm - ually be discounted. _ _ . _ In the quest for sophisticated mathematical techniques. :05" yfrlizixz plest and most basic techniques of technical analysis are 0 I? '0 ‘land: One simple, but basic technique that has been underuse 15 PC
  17. 17. 20 Put 1: Tranr: l—De1n1nlrrlm Tnehnlqtns _ trough progression (see Chan 1-1), which relates to Charles Dow's original obsenration that a rising market moves in a series of waves, each rally and reaction being higher than its predecessor. When the series of rising peaks and troughs is interrupted, a trend reversal is signaled. To explain this approach, Dow used an analogy with the ripple efiect of waves on a seashore. He pointed out that just as it was possible for someone on the beach to iden- city the turning of the u'de by a reversal of receding wave action at low tide, so the same objective could be achieved in the market by observing the price action. In Fig. l-3, the price has been advancing in a series of waves, with each peak and trough reaching higher than its predecessors. Then, for the first time, a rally fails to move to a new high, and the subsequent reaction pushs it below the previous trough. This occurs at point X and gives a signal that the trend has reversed. Figure 1-4 shows a similar situation, but this time the trend reversal is from a downtrend to an uptrend. The idea of the interruption of a series of peaks and troughs is the basic building block for both Dow theory (see Chapter 3) and price pattem anal)» sis (see Chapter 5). Qlrtl. -1 Moody'sAAAboridyldt‘kardpeak-and-hu. ighurdysB.1TwsolHEmaboveflw yleHcmespor: kwduprvmwbrdlmdbearmarkes.11wsawsolrishgqpBm| pedsud troughscxtendedlttxntheendofworflwarllurttlll9Bl. 'l'hkwnsalongperlod, evarby seaflarsmridards. hl981day1eHpeakadardamw. dmmuardseuJarwa-aibugan 15 Moody: MA Bond Yields 21 1inMa-iur0s= |=M°'“ Flynn]-3 Reversalolrislfl9P“k5°"‘“’°"9hs‘ sum or oncnnir-0 . / mu um rmqru . it Itabovs ,3?” trlgh tor , / out our run- “it o-are i°. =' . 4‘ is bl " reactions in<l“'°5“°“ ‘n a series of 2 to 3 weeks to complete each WRVC I . ' m-mediate one, since mud mlrisr: lf: r’| s1:rir": s:. itIir‘ort-terrn <2’ 1° 5'"°‘’‘‘) tion of a series of falling ‘inter-rnbeetilral-‘:3’ eversal from a puma-TY For example. ifit takes rallies and reaction» th= imu-me. -1i; t,e price movements con fluctuations. Sirnilarlfv ‘he ""‘°rmP, peaks and troughs by a rising one signals 3 I’ 3 primary bull market.
  18. 18. 22 Pan I: 1'mu—Damma-. gr. a.. .g, ,_, - A Peak-and-Trough Duemm. $cemsionaIll: ,s: a.l-arid-tgough prograsion becomes more complimtcd dun adwnfiamcin Pin a Inf 1-3 and 1-4. In Fig. I-5(a). the market has been 3 . “cf ° "5“'E. Pealu and troughs. but following the highest peak, ‘ the pnce declines at point X to is level that is below the previous 19,, - A1 the seris of rising troughs has been broken. but not the senes of rising peaks. In other words. at point X, only halfa signal has been generated. The complete signal of a reversal of both rising peak, and in - - . . 1:2‘: -lged anscsm Po pomt Y. when the pnce slips below the level previously mt; Point -there is quite a dilemma because the trend should 5:51] be ch, Len ialianddyet the very fact that the‘ series of rising trough: ha, hand we are prese": e:3‘_‘d‘I “"d°"lY“'*S_ technical weakness. On the one - P n wt half a beansh signal, while on the other hand, waiting for point Y would mean ' ' 5, ‘ its earned during the bull markegiivlng up a 3“ mm“! amount of the prof- n“'" 1'5 H3V'159T| u| reversals. 'l‘h¢Marlwt0}ckModnl 23 The dilemma is probably best dealt with by referring back to the second half of the definidon of technical analysis given at the beginning of this chapter, “and riding that trend until the weight oflha widenushows or proves that it has been reversed. “ ' In this case, if the “weight of the evidence‘ from other technical indica- tors, such as moving averages (MAs) . volume. momentum, and bradth (dis- cussed in later chapters), overwhelmingly indicates a trend reversal, it is probably safe to anticipate a change in trend. even though peak-and-trough progression has not completely confirmed the situation. It is still awise pol- icy, though. to view this signal with some degree of skepticism until the rever- sal is confirmed by an interruption in both series of rising peaks as well as troughs. Figure 1-5(b) shows this type of situation for a reversal from a bear to bull trend. The same principles of interpretation apply at point X. as in Fig. I-5(a). Occasionally, the determination of what constitutes a rally or reac- tion becomes a subjective process. One way around this problem is to choose an objective measure such as categorizing rallies greater than. say. 5 percent This can be a tedious process, but some software programs (such as Metastock with its zigzag tool) enable the user to establish such benchmarks almost instantly in a graphic format What Constitutes a Legitimate Peak and Trough? Most of the time. the various rallies and reacdons are self-evident, so it is easy to detemiine that these tuming points are legitimate peaks and trought Techniml lore has it that a reaction to the prevailing trend should retrace one-third to two—thirds of the previous move. Thus, in Fig. 1-6 the first rally from the trough low to the subsequent pealt is 100 percent. The ensuing reaction appears to bejust over a half or a 50 percent retracement of the previous move. Occasionally, the retiacement can reach 100 percent. Technical analysis is far from precise, but if a retracement move is a good deal less than the minimum onethird, then the pealt or trough in question is held to be suspect You can appreciate that a line is a fairly controlled period of profit tak- ing or digestion of losses. The depth of the trading range can fall Short Of the minimum ‘approximate onethird retracement' requirement and, in such instances, the correction qualifies more on the basis of time than mag- nitude. A rule of thumb might be for the correction to last at least one-third to two-thirds of the time taken to achieve the previous advance or decline. In Fig. 1-7 the time distance between the low and the high for the move
  19. 19. 24 Pm I: TrInd—D¢lermlnlng Technuues ' "°_P’“¢m3 100 percent. The consolidation prior to the breakout should con :3‘-; !vI; l-ecfillallflaslt onethird to of the time taken to achieve the _ ’ P 5 um‘ c°‘f5°lld3I€ 8310!. Ind move on to a new high. It's possible for the consolidation to constitute more than 100 percent of the P"°‘°dl“8 Pfi“ m°V°m°'“- 1" 7353-. the larger the consolidation. the greater the hustle between buyers and 11 d uh ‘ ‘ and lower boundaries become. Sc en in E mom Mgmficam ‘he "PP" ' ‘%Re1racsnisnt should be about onelhiu to two-Inlvds at the previous 100% 01 me advance my’ “WW1-5 H‘"mVm9P¢€-lGar| di1'oisghs(rnagn|1ud¢), Retrseemenl '5 hr less lllsn one-min! my in twirtnlnis Mme Pfwious mly one-tnlid or more of the time Is taken to tom! the raly "9"" 1-7 lder-nfvms pale and troughs (time). 11ieMai'lt¢tO; cleModd 25 These are only rough guidelines, and in the final analysis it is ajudgment call based on experience, common sense, a bit of intuition. and, perhaps most important of all, a review of other factors such as volume, support, resis- tance principles. and so on. We have mainly been studying these concepts in a rising trend. However, the principles work exactly the mme in a declin- ing trend in that rallies should reuace one-third to lWt>ll’lil'd.1 of the previ- ous dedine. Also. lines or consolidations should take at least one-third of the duration of the previous decline. It is also irnpormnt to categorize which kind of trend is being monitored. Obviously, a reversal derived from a series of rallies and reactions each last- ing, say, 2 to 3 weeks would be an intermediate reversal. This is because the swings would be short tenn in nature. On the other hand, peak-and-trough revernls that develop in inn-aday charts are likely to have significance over a much shorter period. How short would depend on whether the swings were a reflection of hourly or, say, frminute bars. Summary 0 A number of different trends simultaneously influence the price level of any security. - The three most important trends are primary, intermediate, and short term. - The principles of technical analysis apply to intraday trends. but since they are more random in nature, the analysis is generally less reliable than for longer~ter-m trends. I Very long term. or secular, trends influence the magnitude of primary bull and bear trends. . 0 Pealt-and—Irough progression is the most basic trend-identification tech- nique and is a basic building block of technical analysis. 0 As a general rule, in order to qualify as a new legitimate pealt or trough, the price should reuace between one-third and two-thirds of the previ- ous move. ' Lines or consolidations also qualify as peaks and troughs where they form between one-third and two-thirds of the n'me taken to produce the pre- vious advance or decline.
  20. 20. Financial Markets and the Business Cycle Introduction The basic ffif ~ . , . ta concem o is book is the technical approach, but it is also im 1-. nt to understand that pnmary trends of stocks b ds are duemfined by me attitude Ofinvemm I . onf 1, daind commodities business cycle Each market has 3 (end: Owarcl un 0 ng events in the ~ . ' C it d ' pogits dunng the business cycle in a corilsCi>s]te‘iii)ccahr: liiliol: vg)il: §lh; :ita; lilfer(: £-: un erstand' f (_h ' - - ' , er" mg 0 e interrelationship of debt, equity, and commodity markets ‘:1 mm . . . , marku pm“ es 3 useful ewmk f°r ‘dam-‘fY"'1S major reversals in each The Discounting Mechanism of Financial Markets The trend of all financial markets is essentially lejfiplectations of movements in the economy the effect those chan I Eyto have Lh ' « i . _ 3" 3"’ deals, and theo; ’]5Yc}io}l: ;iet: ;)Ifati1dcti: t:set which a Specific finmcm market tal factors. Market Partici ants ‘E 0 mves. “?n toward the“ f““d3m°fl' financial development, mg uk typlsany mucipatc fimlfe °C°"°’“l° and e action by buying or selling the appropfi. determined by investors‘ 26 l-1riaricialMarlte'tsandtheBiisiriessQrcle 27 ate assets, with the result that a market normally reaches a major tuming point well ahead of the actual development. An expanding level of economic activity is usually favorable for stock prices. a weak economy is bullish for bond prices, and a tight economy is favorable for industrial commodity prices. These three markets often move in different directions simultaneously because they are discounting diifer- ent things. An economy is rarely stable; generally, it is either expanding or con- tracting. As a result, financial markets are also in a continual state of flux. A hypothetical economy, as shown in Fig. 2-1, revolves around a point of bal- ance known as eq-iiiiibriurn. Roughly speaking, equilibrium can be thought of as a period of zero growth in which the economy is neither expanding nor contracting. In practice, this state of affairs is rarely, if ever, atmined, since an economy as a whole possesses tremendous momentum in either the expansionary or the conuactionary phase, so that the turnaround rarely occurs at an equilibrium level. In any event, the “economy" consists of a host of individual sectors, many of which are operating in different directions at the same time. Thus, at the beginning of the business cycle, leading economic indicators, such as hous- ing starts, might be rising, while lagging indicators, such as capital spend- ing or employment levels, could be falling. Investors in financial markets are not concemed with periods of extended stability or equilibrium, for such periods do not produce volatile price swings and opportunities to make quick profits. The ever-changing character of the economic cycle creates tremendous opportunities for investors and traders because it means that difierent industries are experiencing different economic conditions simul- taneously. Since housing leads the economy, housing stocks do well at the start of the recovery, when capital-intensive stoclu such as steel are still under pressure. Later in the cycle, the tables are turned and its housing that peaks Economy is growing Equilibrium Economy is contracting Fliiun 2-1 The idealized business cycle.
  21. 21. lllIIIIIlEEWE'§3 28 Put ll Ttvnr‘l-Determining Techniques first. This situation gives rise to are group rotation procex, which is dis- cussed at length in Qiapter 19. Since the finandal markets lead the economy, it follows that the greatest profits can be made just before the point ofrnaxlrnum econouiic distortion, or disequilibrium Once investors realize that In economy is changing direc- tion and returning toward the equilibrium level, they discount this devel- opment by buying or selling the appropriate asset. Obviously, the more dislocated and volatile an economy becomes, the greater is the potential for a retum toward the equilibrium level, and also for a strong swing well beyond it to the other extreme. The risks are also greater if you are too early. Under such conditions, the possibilities for making money in financial mar- kets are greater because they too will normally become subject to wider price fluctuations. Market Movements and the Business Cycle The major movements of interest rates, equities, and commodity prices are related to changes in the level of business activity. Please note that the term commodity prices refers to industrial prices that are sensitive to business con- ditions, as opposed to weather-driven commodities such as the grains. Figure 2-2 represents a business cycle, which ranges from 3 to 5 years between troughs. The horizontal line reflects a level of zero growth, above which are periods of expansion, and below which are periods of contrac- tion. After the peak is experienced, the economy continues to grow, but at a declining rate, until the line crosses below the equilibrium level and con- traction in economic activity takes place. The arrows in Fig. 2-2 show the idealized peaks and troughs of the financial markets as they relate to the business cycle. Periods of expansion generally last longer than periods of contnction, because it takes longer to build something up than to tear it down. For this reason, bull markets for equities generally last longer than bear markets. The same could be said for interest rates and commodities, but in this case the magnitude and duration of a primary trend depend on the direction of the secular trend, as discussed in Chapter I. Figure 2-3 shows how the three markets of short-tenu interest rates, com- modities, and equities also relate to the typical business cycle. In the exam- ple, interest rates have been plotted inversely to correspond with bond prices. A bull market for bonds is marked by a rising line and a bar mar- ket by a descending one. FrrianclalMarlt&ai'idt| 'ieBtu'nusCVC1¢ 29 Equiibvium o_p 4.——ui T B T 5 tag. “ 2-2 The 'idealimd' busines cycle and finaricial market tuming point: (B - B°"d5= S - Stocks; C - Comrnoditial I-'igure2-3 ldaalizzdsinectirvesforthreemarltets. Referring back to Fig. 2-2, we can see that the bond market is the arts}: financial market to begin a bull phase. This usually occurs after the gro d rate in the economy has slowed down considerably from 1t5_P°3k ‘me “"1 quite often is delayed until the initial stages of the recession. General 3)! ’ speaking, the sharper the economic contraction, the greater the potent: for a rise in bond prices (that is, a fall in interest rates). Altematively. the stronger the period of expansion, the smaller the amount 0f. eC0n°: “C fnd financial slack, and the greater the potenual for a decline in bon prices (and a rise in interest rates).
  22. 22. 30 Put I: Trend-Determ| n.1ngTechnlques Following the bear market low in bond prlca. economic activity begins to contract more sharply. At this point, parficipants in the equity market are able to ‘look through‘ the valley in corporate profits, which are now declin- ing sharply because of the recession, and begin accumulating stocks. Generally speaking, the longer the lead between the low in bonds and that of stocks, the greater the potential for the stock market to rally. This is because the lag implies a particularly weak recession in which extreme cor- pomte belt tightening is able to drop break-even levels to a very low level. During the recovery, increases in revenue are therefore able to quickly move to the bottom line. Afier the recovery has been under way for some time, capacity starts to tighten, tesourcebased companies feel some pricing power retum, and commodity prices bottom. Occasionally after a commodity boom of unusual magnitude, industrial commodity prices reach their actual bottom during the recession due to severe margin liquidation on behalf of speculators. However, this bottom is often subsequently tested; a sustainable rally only begins after the recovery has been under way for a few months. At this point, all three financial markets are in a rising trend. Gradually, the economic and financial slack, which developed as a result of the receuion, is substantially absorbed, putting upward pressure on the price ofcredit, that is, interest rates. Since rising interest rates mean falling bond prices. the bond market peaks out and begins its bear phase. Because some excul plant and labor capacity still eadsts, rising business activity ruults in improved productivity and a continued positive outlook The stock mar- ket discounts uends in corporate profits, so it remains in an uptrend until investors sense that the economy is becoming overheated and the potential for an improvement in profits is very low. At this point, there is less reason to hold equities, and they in tum enter into a bear phase. Later, the rise in interest rates takes its toll on the economy and commodity prices begin to slip. Once this juncture has been reached, all three financial markets begin to fall. They will continue to decline until the credit markets bottom out. This final stage, which develops around the same time as the beginning of the recession, is usually associated with a free fall in prices in at least one of the financial markets. Ifa panic is to develop, this is one of the most likely points for it to take place. Introducing the Six Stages Since there are three financial markets and each has two tuming points, it follows that there are conceptually six tuming points in a typical cycle. I call nmmuuultasuaeuatuagswae 31 these the six stays and they can be used as reference points for detennin- ing the current phase of the business cycle. The six stages are indicated In Fig. 2-4. , , When identifying a stage. it is important to look at the long—term techn; cal position of all three markets so that theycan act as a crosscheck on eac other. The stages are also useful in that specific groups do well at particu- lar times. For example, liquidity-driven or early-cycle leaders tend to out- perform the market in Stages l and 2 when bond pnces are nsmg and interest rates falling. On the other hand, eamings-driven or late~cycle lead- ers perform well in Stages 4 and 5 when commodity pnces are I"_a“)'| “$- These aspects are covered more fully in Chapter l9 on group rotation- Longer Cycles Some expansions encompass much longer periods, and they usually include at least one slowdown in the growth rate followed by a second round of eco- nomic expansion. This has the efiect of splitting the overall expansion "110 two or three parts, each of which results in a complete cycle ln the. fi'nan- cial markets. I call this a double Lycle An example of this phenomenon IS illus— ttated in Fig. 2-5. Idealized Business Cycle for the Six Stages 01 he Business CW9
  23. 23. 32 Put l: Trend-Determining Techniques Equilibrium figure 2-5 Hnanclal market peaks and troughs In a double cycle. A double cycle developed in the 19805 and another in the 19905. In the mid—1980s, for example, commodity and industrial parts of the countrywere very badly affected. but the east and west coasts continued their expansions unabated. The strong areas more than otfset the weaker ones and so the country as a whole avoided a recession. It is certainly true that the six—stage concept works well in many cycles, but it must be noted that there are excep~ tions. I believe, therefore, that it is best used as a conceptual framework rather than an ironclad discipline. For example, some of the worst excep- tions in over 200 years of recorded history occurred in the 19905 when the U. S. equity market was experiencing an unprecedented equity rally, which fatally distorted the normal chronological sequence. The Role of Technical Analysis Technical analysis comes into play by helping to determine when the var- ious markets have turned in a primary-sense way. This is achieved by apply- ing the various techniques outlined in subsequent chapters, moving average crossovers, changes in the direction of long—term momentum, and so forth. Each market can then be used as a cross-check against the other two. For example, if the weight of the technical evidence suggests that bonds have bottomed but commodity prices remain in a bear market, the next thing to do would be to look for technical signs pointing to a stock mar- ket bottom. Financial Markets and the Buslnms Cycle 33 Market Experience, 1966-2001 Chan 2-1 shows how peaks and troughs developed for the vanous markets between 1966 and 1977. Please note that inversely plotted short-term inter- est rates have been substituted for bond pnces. This is because there is‘; much closer link between equity prices and short-tenn rates that; :1 . longer-term rates, due in part to the fact that corporations do more 0 I Cl! ” bon-owing in the money markets than the bond markets. hlso, market par; ticipants buy stocks on margin, the cost of which is determined by the leg: of short-ter1n rates. Short-term rates are also more volatile than those at 9 end of the yield spectrum. d The peaks and troughs in Chart 2-1 tumed out very much as expected- Although the chronological sequence was more or less perfect. lht 163 5 and lags in each cycle varied considerably, because of the different Chara: teristics in each cycle. In 1966, for instance, bonds and stocks bottome more or less simultaneously, whereas the lag for the commodity market bot» tom was well over a year. _ Chart 2-2 shows the same markets, but this time we are looking at the 1980s. The two small, upward-pointing arrows in 1982 and 1990 reflect reg: sions. The series of three bottoms that developed between 1984 and 1 reflects the mid-1980s growth recession. Generally speaking, the ; l'I| ’°3]°‘ logical sequence works satisfactorily until we get to the late 1980s w ere e Char! 2-1 Three financial rnarlozts, 1966-1977. (From Inlernmrket Review. ) 9:3 .
  24. 24. 34 Pm li Trend-Deteriiiinlng Techniques Chart 1-Z Three financial inarirm, 1980-1992. (From Inlu-market Review. ) Money Market Prices 1989 bottom in rates is juxtaposed with the stock market peak. Unfortunately, these out-of-sequence events are a fact of life. Fortunately, in the 20 years I have studied these relationships. they represent the excep- tion rather than the mle. Chart 2-5 shows the closing years of the twentieth century. This is the most difficult period I have encountered because of the record performance by the stock market and the strong deilationary forces associated with the tech- nological revolution. This had the eflect of reducing the normal tyclirzl fluc- tuation in the equity market. Since the stock market boom was unprecedented, it is unlikely that the normal chronological sequences have been more than temporarily interrupted. Summary rates, equities, and commodities. All are influenced by the same economic and financial forces, but each responds diifcrently. 0 These markets undergo a chronological sequence, which repeats in most cycles. FinandalMax'ltetsaridtheBi. i§1iess(. n: le 35 Ginrt 2-3 Three ilriandal mm 1989-2001. (From lriterrnarket Review. ) I Some cycles experience a slowdown in the growth rate and not all: acttéfig recession. Even so, the chronological sequence between the ma! 9“ 5 to 0 rate. ‘ 0 ; 'll’i: el: l:ds angll-ags vary from cycle to cycle and have little forecasting zalua 0 The chronological sequence of peaks and troughs in the E1’10-ll-S nan- cial markets can be used as a framework for identifying the P05m°“ 0‘ 3 specific market within its bull or bear market cycle.
  25. 25. Dow Theory . Dow theory is the oldest and by far the most plriblrcized method of iden- flfymg n_i3L_m trends in the stock market. An extensive account will not be “e“e‘5“ Y. h°"e- 35 thtff are many excellent books on the subject. A brief explanation, however, is in order because the basic principles of the Dow theory are used in other branches of technical analysis. The goal of the theory is to determine changes in the primary or major $: ‘;: =;: ;f: l;; mul<let Once a trend has been established, it is assumed tionof a trend and :5: “fpmved-‘ Dow theory I? confirmed with the dim" sum“ in 1897 as no oremstrng value as to its ultimate duration or size. Indusu_iaiSAvem v :1 mVCSt0I' who purchased the stocks in the Dowjones th _ . 8° ( __lIA) following each Dow theory buy signal, 1iqu', dmed 5 position on sell signals, and reinvested the money on the next buy gig. éigevebhad his or her piiginal investment of $44 in 1897 grow to . _ 31 . ‘ yjanuary 1990. If, instead, the investor had held onto the Ens"! 344 investment throughout that period, the invesu-mm would mu age grown, but only to about 82500. In reality, the substantial profit earned by ollowrng the Dow theory would have been trimmed by transaction cost; d . . . . . : r°: ‘P"3-l 83105 ‘axes. Eyen ifla wide margin for error were allowed, and f can certainly arise in the interpretation of the theory, the invesu-nem per ormance using this approach would still have been far superior to the l _ . . "=5‘_’D'; °‘-'* 5'-‘Y‘= “d hold sir-negya The theory will still have done well in the Pen between 1990 and 2001. However, the spectacular bull market f th 19905 would not have made the comparison between the theory and th: b C . . . . . “Y and hold approach particularly rnsprnng for Dow flqeog-ism‘ ‘This as u». m . . “med in 1 at e averages were amiable in 1897. Actually, Dow theory was lint pub 86 37 (,1: . _ ’ it should be recognized that the theory does not always keep page; with events; it occasionally leaves the investor in doubt and is by no means infal- Dow'l‘h¢ary A’; lible, since small losses are sometimes inc ed. These points emphasize <_ ) , . that, while mechanical devices can be useful forforecasting the stock mar- ket, there is no substitute for obtaining additional supportive analysis on which to base sound, balanced judgment Remember, in our weight-of-the- evidence approach Dow theory is one piece of evidence. The Dow theory evolved from the work of Charles H. Dow, who published a series of The Wall Street journal editorials between 1900 and 1902 con- cerning market action. Dow used the behavior of the stock market as a barometer of business conditions rather than as a basis for forecasting stock prices themselves. His successor, William Peter Hamilton, developed Dow's principles and organized them into something approaching the theory as we know it today. These principles were outlined rather loosely in Hamilton's book The Stock Market Barometer, published in 1922. It. was not until Ruben Rhea published Dow Theory in 1932 that a more complete and formalized account of the principles finally became available. The theory assumes that the majority of stocks follow the underlying trend of the market most of the time. In order to measure "the market, " Dow con- structed two indexes, which are now called the Dow jam: Imiustrial Average and the Dawjmm Trampanation Averages. The lndustrials were originally con- structed from 12 (but now include 30) blue-chip stoclu and the Dowjzmes Rail Average, comprising 12 railroad stocks. Since the Rail Average g intended as a proxy for transportation stocks, the evolution of aviation and other forms of transportation has necessitated modifying the old Rail Average in order to incorporate additions to this industry. Consequently, the name of this index has been changed to Tmnspovtatian Average. lnteryjiefing the Theory In order to interpret the theory correctly, it is necessary to have a record of the daily closing’ prices of the two averages and the total of daily transac- tions on the New York Stock Exchange (NYSE). The six basic tenets of the theory are as follows. ‘Ir is im rtanl lo use closin ricel. since intrada fluctuations are more sub‘ect to _ yo :4 P y manipulation. a‘; -V‘
  26. 26. 38 Part 1: Trad-Deterrnlnirig Tedtnlqus l. The Averages Discount Everything Changes in the daily closing pricu reflect the aggregate judgment and emo tions of all stock market participants, both cuirent and potential. It is there- fore assumed that this process discounts everything known and predictable that can afiect the demand/ supply relationship of stocks. Although acts of God are obviously unpredictable, their occurrence is quickly appraised and their implications are discounted. 2. The Market Has Three Movements There are simultaneously three movements in the stock market. Primary Movement The most important is the primary or major trend, more generally known as a bull (rising) or bear (falling) market. Such move- ments last from less than 1 year to several years. A primary bum math! is a long decline interrupted by important rallies. It begins as the hopes on which the stocks were fiist purchased are abandoned. The second phase evolves as the level; of business activity and profits decline. The bear market reaches a ciféiéi when stocks are liquidated regardless of their underlying value (because of the depressing state of the news or because of forced liquidation caused. for example, by margin calls). This represents the third stage of the bear market. A primary bull mantel is a broad upward movement, normally averaging at least 18 months, which is interrupted by secondary reactions. The bull mar- ket begins when the averages have discounted the worst possible news, and confidence about the future begins to revive. The second stage of the bull market is the response of equities to known improvements in business con- ditions. while the third and final phase evolves from overconfidence and speculation when stoclu are advanced on projections that usually prove to be unfounded. Secondary Rcadlons A secondary or intennediale reaction is defined as “an important decline in a bull market or advance in a bear market. usually last- ing from three weeks to as many months, during which interval, the move- ment generally retnces from 38 to 66 percent of the primary price change 3 Dow Theow 9 since the termination of the last precediflfi 5°‘3°“d3"Y ’°3°‘i°‘_‘-“.3 (MY ax view is that a secondary or intermediate move should last a numltnum 3 in weeks. ) This relationship is shown in Fig. 3-1(9) £0’ 3 ‘'““‘S "'3' °' 3“ Fig. 3-] (b) for a declining one. . _ Occasionally, a secondary reaction can retrace the whole] oéttilisgcgfigz primary movement, but normally the move falls in the one- a _ _ area, often at the 50 percent mark. As discussed in greater detail later in the chapter, the correct differentiation between the first leg of a new ‘gn- mary trend and a secondary movement within the exist1nE “end Pm“ 55 Dow theorists with their most difi-lcult problem. . tw to as Minor Movement: The minor mauementlasts from a week or oil? long as 6 weeks. It is important only in that it forms part of the pnmarjyjzr . - _ ‘ 1 . is secondary moves; it has no forecasung value for longer t: l:n"l‘| 'al: ':5 ‘l’>l| :ted to is specially important since short-term movements can P mm: extent, unlike the secondary or pnmary trends- 300 150 200 150 ID! ) 50 JFMAMJJASDNDOJFMAM-l-JASOND (at W Flnun: 3-1 secondary retracememx ‘Rhea, Robert. Dow hm NewYork: Barron's. 1932.
  27. 27. §%‘%T'§§'E§‘%%f'%'§§ 40 Part I: T Tazhniqu-s 3.L| n¢slndicmeMovemait Rhea defined a line as "a price movement 2 to 3 weeks or longer, during which period, the price variation of both averages moves within a range of approximately 5 percent (of tliei. r mean average). Such a movement ind} mtes either accumulation [uodt moving into rtrmig and knowledgeable hands and tlinqinz bullish] or distribution [stock moving into weak hands and tlierqim bea1i. tIt]. " An advance above the limits of the line incliates accumulation and pre~ diets higher prices, and vice versa. When a line occurs in the middle of a primary advance, it is really forininga horizontral secondary movement and should be treated as such. ,1; L413?’ My own view is that the fonnatioii of a legitimaie line should probably take longer than 2 to 5 weeks with, say, a minimum of 4. After all. a line is really a substitute for an intermediate price trend and 2 to 3 weeks is the time for a short-term or minor price movement 4. Prloe/ Volume Rdationshlps Provide Background The nonnal relauonship is for volume to expand on rallies and contract on declines. If volume becomes dull on a price advance and atpands on a decline, a waming is given that the prevailing trend may soon be reversed This principle should be used as background information only, since the conclusive evidence of trend reversals can be given only by the price of the respective averages. 5.PrloeAct! onDetermlnesthe'l'rerid Bullish indications are given when successive rallies penetrate peaks while t. lie trough of an intervening decline is above the preceding trough. Conversely, bearish indimtions come from a series of declining peaks and troughs. Figures 3-2(a)—(d) show a theoretiml bull trend interrupted by a sec- ondary reaction. In Fig. 3~2(a), the index makes a series of three peaks and troughs, each higher than its respective predecessor. The index rallies fol- lowing the third decline. but is unable to surpass its third peak. The next r / ‘lbid. F. .. 4 1 Dow 1‘heoIv zoo “° no X zoo I50 _ _l 150 “,0 we so ‘° °. vrmAii. i.iAs0N° . i'riiAu. i.IAsauD (B) 250 zoo I90 I00 ° ano °. iriiAii. i.iAsunii JFIIIM-‘~"5 (c) (dl Figure 3-2 Primary trend reversals. decline takes the average below its low point, conlinninE; _b€:1Ye‘: u'l']l‘: l_: a‘; ’_ it does so, at point x In Fig. 3-2(b). following the third P6 din mious we ltet. a bear market is indimted as the average falls below . 9 P of I bun ondary trough. In this instance, the preceding secondary 15 l1:1;( ) Man market, not the first trough in a bear market, as showlt ll‘! 578-3.? b“ "0 be :1 Dow theorists do not consider penetration at point X in Fig. (C lcomcw sufficient indication of a bear market. They prefer to take a. mor “hm re. afiyg Position by waiting for a rally and a subsequent penetration 0 P vious trough marked as point Yin Fig. 3-‘2(b)« _ . dd_u_°ml can‘ In such cases, it is wise to approach the mterPr¢'= '=°" W" ' ‘d d d lion. Ifa bearish indication is given from the volume pattems an 2.1]? ! dl’ identifiable speculative stage for the bull market has al| ’¢3d_)’ : ";i‘; "1n'lfihe’ it is probably safe to assume that the beansli indication is k I [fie henc- absence of such charactensdcs, it is wiser to give the bull In" C
  28. 28. 42 Fun I: Tiuid-Determining Techniques Q~'f’— / )5‘—‘xx5 fit of the doubt and adopt a more conservative position. Remember, tech- nical analysis is the art of identifying trend reversals based on the weight of the evidence. Dow theory is one piece of evidence, so if four or live other indicators are pointing to a trend reversal, it is usually a good idea to treat the halfsignal at point X as an indimtion that the trend has reversed. Figures 3-2(c) and (:1) represent similar instances at the bottom of a bear market The examples in Figs, $301) and (b) show how the primary reversal would appear if the average had formed a line at its peak or trough. The importance of being able to distinguish between a valid secondary correc- tion and the first leg of a new primary trend is now evident This is perhaps the most difiicult part of the theory to interpret, and unquestionably the most critical. It is essential to establish that the secondary reaction has retraced at least one-third of the preceding primary movement, as measured from the ter- mination of the preceding secondary. The secondary should also extend for at least 3 to 4 weeks. Vital clues can also be obtained from volume characteristics and from an assessment of the maturity of the prevailing primary trend. The odds of a major reversal are much greater if the market has undergone its third phase, characterized by speculation and false hopes during a primary upswing or a bout of persistent liquidation and widespread pessimism during a major decline. A change in the primary trend can occur without a clearly identi- fiable third phase, but generally such reversals prove to be relatively short- 2.'1O 250 so 50 0 . JFMAMJJASOND JFMAMJJASOMD (8) (ll) Flfitlres 3-3 ljriabeinglornwdatapeakortroitgh. Dow ‘lheary 43 lived. On the other hand, the largest primary swings usually develop Whfll the characteristics of a third phase are especially marked during the pre- ceding primary movement. Hence, the excessive bgtiué of speculation in 1919, 1929, 1968, and 2000 in the NASDAQ were followed by particularly sharp setbacks. Intermediate-term movements are discussed more exten- sively in Chapter 4. 6. The Averages Must Confirm One of the most important principles of Dow theory is that the movement of the Industrial Average and the Tiansportation Average should always be considered together (that is, the two averages must confirm each other). The need for confinning action by both averages would seem funda- mentally logical, because if the market is truly a barometer of future busi- ness conditions, investors should be bidding up the prices of companies that produce goods and of companies that transport them in. an expanding economy. It is not possible to have a healthy economy in which goods are being manufactured but not sold (that is, shipped to ma. rkcI)« This principle of confirmation is shown in Figs. 3—4(a) and (II). In Fig. 3-4(a), the Industrial Average is the first to signal a beargtrend (point A), but the actual bear market is not indicated until the Transportation Average confirms at point E. Figure 34(b) shows the begin- ning of a new bull market. Following a sharp decline, the Industnals make a new low. A rally then develops, but the next reaction holds above the pre- lndunrlnll ’ Yranspodatlvn Figure 3-4 Dow Theory inquires both averages to confirm.
  29. 29. 44 Put 1: T radunqm vious low. When prices push above the preceding rally a bull si al ' ‘ by the lndustrials at point A. In the meantime, the Transportagtlrin rig makes a series of two succeeding laws. The qucsfion mm "-555 is; which 3V€fl8= 15 Correctly representing the prevailing uend? Since it is always assumed that a trend is in existence until a reversal is proved the eondu. sion should be drawn at this point that the Transportatzion Average is indi_ cating the correct outcome. It is only when this average exceeds the peak of the preceding secondary at point B that a new bull market is confirmed by both averages, resulting in a Duow theory buy signal. The movement of one average unsupported by me 0 er often lead to a false and misleading conclusion, which is well urikllfllfid In Fig. 3-5 by the following example from 1930, e 1929—1932.bear market began in September 1929 and was confirmed by both averages in late October. Injune 1930, both averages made a new 1:: then rallied and reacted in August Following this correction, the . ustnals surpassed LhCll'-pI'EVl0|lS peak. Many observers believed that this "81"-led 33¢ end of a particularly sharp bear market and that it was only a matter of time before the Rails would follow suit. As it tumed out, the action :1‘ the lndustrials was totally misleading; the bear market still had another year! to run. - 300 200 I50 I00 JFMAIJJASOND I930 Hum 3-5 1930 example. DowTh2ovy 45 Additional Considerations Dow theory does not specify a time period beyond which a confirmation of one average by the other becomes invalid. Generally, the closer the confir- mation, the stronger the following move is likely to be. For example, con- firmation of the 1929-1932 bear market was given by the Rail Average just 1 day after the Industrial Average. The sharp 1962 break was continued on the same day. _—/ ,—‘_-‘-A One of the major criticisms of Dow theory is that many of its signals have proved to be late, often 20 to 25 percent after a peak or trough in the aver- ages has occurred. One rule of thumb that has enabled Dow theorists to 1 ,2 anticipate probable reversals at an earlier date is to observe the dividend yield on the lndustrials. When the yield on the Industrial Average has fallen to 3 percent or below, it has historically been a reliable indicator at market tops. Similarly, a yield of 6 percent has been a reliable indicator at market bottoms. Dow theorists would not necessarily use these levels as actual buy ing or selling points, but would probably consider altering the percentage of their equity exposure if a significant nonconfirmation developed between the Industrial Average and the Transponation Average when the yield on the Dow reached there extremes. This strategy would help to improve the investment retum of the Dow theory, but would not always result in a supe- rior performance. At the 1976 peak, for example, the yield on the Dow never reached the magic 3 percent level, and prices fell '20 percent before a mechanical signal was confirmed by both averages. ln addition, the 5 percent top would have missed the mark by about 5 years in the late 1990:. Over the years, many criticisms have been leveled at the theory on the basis that from time to time (as in periods of war) the Rails have been over- regulated or that the new Transponation Average no longer reflects investors‘ expectations about the future movement of goods. The theory has stood the tat of time, however, as Table 3-] indicates. indeed, criticism is perfectly healthy, for if the theory gained widespread acceptance and its sig- nals were purely mechanistic instead of requiring experienced judgment, they would be instantly discounted, which would render the Dow theory use- less for profitable investment. Charts 3-1 to 3-4 show {low theory signals between l953 and 2001. These should not be taken ¥'gospel since they represent my own interpretation that many c_ould legitimately disagree with. They were also made with the benefit of hindsight However. I tried to make them as conservative as . K 9.
  30. 30. . Table 3-1 DowTheoryAnalysls ohms-1 oawtr-em9s!9ruls.1953-195$ __f _ : ___ H _. __A__ Bwsi9nak' Sclioaalf M, _ Percentage Percentage -50 . Date of Price of gain front sell Due or Price of gain from Signal Dow signal when short Signal Dom buy signal m"'—m 100 ' Jul. 1397 44 Dec. 1099 63 43 I Oct 1900 59 6 jun. 1903 59 0 , 1111. 1904 51 14 Apr. 1906 92 so Apr. 1908 70 24 May 1910 as 21 550 on 1910 as 4 Jan. 1915 05 3 ' Apr. 1915 65 24 Aug. 1917 B6 32 May 1913 32 5 , Feb. 1920 99 22 Feb. 1922 04 re jun. 1923 91 3 Dec. 1923 94 (los) s on. 1929 506 220 we May 1935 54 75 Sep. 1937 164 95 jun. 1993 127 23 Mar. 1939 135 '1 ]ul. 1039 143 5 May 1940 133 (Ian) 7 Feb. 1943 126 3 Aug. 1946 191 52 Apr. 1943 134 4 Nov. 1948 17: (loss) 6 on 1950 229 (lossJ52 Apr. 19521 230 22 Jan. 1954 239 (last) 3 on. W56 468 63 so _ 5 66 67 69 Apr. 1950 450 4 Mar. 1960 512 36 5;, 5. as 55 57 59 59 so 51 52 an 54 6 Nov. 1960 602 2 Apr. 1962 631 13 1 Nov. 1962 625 9 May 1966 900 43 Jan. 1967 923 9 jun. 1969 900 9 Dec. 1970 1125 9 A 1. 19721 921 12 _1963.199o. _]an. 1975 680 26 021. 1977 801 is Ch-na-2 Dowtheoryslgna-15 Apr.1978 790 5 11.1. 1991 960 23 Aug. 1982 840 13 Feb. 1994 use 41 jun. 1985 1261 (lost) 6 Oct. 1939 2510 104 Dec. 1990 2610 (log) 1 Aug 1993 3490 225 Average ofall cycles 10% Average all cycles 46% 47 ' 46 Put 1: Tr: -rd-Detzrrrrlnirg Technlqirss DouThearv ‘When considering the mum. note 111.1 thue signals are the result of my interpretation, in some ass with the benefit of hindsight Some Dow theorists would disagree with my inter- pretation, but none would dispute t. he fact that. in general, the theory works. ? uunsultultfl raunvrnrsnnunnnuurll
  31. 31. 48 49 . Put 1: Tr¢nt'l~DeI2rmini'ng Techniques DuwTheory Chart 3-4 Dow theory signals, 1997-2001. The 1990 hull signal remained ln farce until August l998wher1bofl'tse1iesmaclenew| owsfollowlnganinIerrmdiat¢ rally. The sellsignal iorll’elndustI'la| s(nttl’v2dmxedvertical line)isabltocnurm. ersial because this average actually rnadearnargimslrt¢whlghas! thaddomn1989. Ht1wew. r.iith2pt1oeactionolthe spring/ sirmneroi 1998 lstreated asa line formadorn. thesignal is valid. The NYSEA/ D llne dsouusedb¢lowlts200dayrmwngmmageuumdmismm. Afmrfiiis. &umwasmpabd inwl1idibotl1seriestmt: edrmtas¢rl6olr‘sirglm 'tepv. al¢andtroughs. "l'h. enzwal1- umeh| ghmthehdnsniaksetmJarmary200DM>ddhavebeenabd1signal, bu1th¢Transporls §§§§§ §§§§§ possible. Charts 33 and 3-4 f tu bod, . , at the end of Chaplcr 1 hav:3n0:¢been The half-signals descnbed Then: is no question that interpretation of the theory can at times be Summary Very su ecti , All Q1 . '_ - weight if thVeteevjdencecr:1l(J: it: ”reason to treat the signals as one witness in the - Dow theory is concemed with determining the direction of the Primaf)’ ' trend of the market, not the ultimate duration or size of the trend. Once confirmed by both averages, the new trend is assumed to be in existence until an offsetting confirmation by both averages takes place. ' Major bull and bear markets each have three distinct phases. Both the % idenfification of these phases and the appearance of any divergence in the normal volume/ price relationship otfer useful indications that a reversal in the major trend is about to take place. Such supplementary evidence is particularly useful when the action of the price averages them- selves is inconclusive. llliillliliflnfifiifiu 3
  32. 32. I I I I I I I I- 50 Typical Parameters for Intermediate , Trends Some Basic Observations Tl? ‘ ‘"9 PWWOUS Chapters discussed the main or primary u-end (mm is, the pnce movement that corresponds to changes in economic activity over mg : ::: :,°: :.: :;: ::. :°. ::= :' ““‘“2§“ mm at helpful to have some undeicstghldén "gammy ? f the pnmaly “end, it is also we imcmedme mud for m ms 0 tbs typical Character and duration of and also in assemn wh “:5 P“_Pp0se of improving success rates in trading, 8 CH 6 pnmary movement may have run its courw Asucccssful analysis of int d‘ d5 f me following advantages: erme iatie tren or any market or stock ofiers tlhanges in intermediate trends aid in the idcnttfim in the primary trend. ' lnlter-mediate-term trading involves fewer uansactions than trading of ; minor ric « . . . Imennlidiaticr-l:0ve: lnents and therefore results in lower commission costs. ren reversal points occur several times a year and can, if 1 ' . . , , ca; i‘: Ee"Y interpreted, enable a relatively high and quick return on ' tion oftuming points Typhil Pamreias for intzmiaia. -in Trends 5 1 Intermediate Cycles Defined A primary trend typically consists of five intermediate trends, three of which form part of the prevailing trend, while the remaining two run counter to that trend. In a bull market, the intermediate countertrends are represented by price declines; in a bear market, they form rallies that sep- arate the three intermediate downwaves, as shown in Fig. 4-1. It is apparent from the previous discussion that there are essentially two types of intermediate price movements. The first, which goes in the direc- tion of the primary trend, maybe called a primary intennediaupricemovement. The second is an important price movement that lasts from 4 weeks to 3 months, occasionally longer. It normally recraces between onethird and two- thirds of the preceding primary intermediate trend. This price movement, which runs counter to the main fiend, is called a secondary mmmnznt or reac- tion. Since a primary intermediate price movement operates in the same direction as the primary or main market trend, it almost always lasts longer than its secondary counterpart. Its price mag-nitride is nonnally_ much greater as well. 45/ These countertrends or reactions against the main trend are notoriously difiicult to forecast in terms of character, magnitude, and duration. Therefore, they should generally be avoided from a trading point of view, as they will almost invariably be subject to confusing whipsaws. By their very nature, they tend to fool the majority and are usually extremely ~’ , treacherous. ltis possible to design successful mechanized systems based on I ) vmm, mrvrmuiote wen mm-mvr suco-nary [reaction Secunoory mm-on 3 Primary fltveMnnd) tam mum Pr-mori mm lflull Marin) ______ ___t / “Silt: 4-! intermediate tycla in is primary trend.

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