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Technical Analysis Explained

Page 53

by Martin J Pring


  Technical Factors

  3. Positive divergences between the A/D line and the major averages are much rarer than negative ones at market tops. Indeed, the line often lags at most bear market lows. However, when divergences do develop, they are usually followed by an above-average bull market. That was true of the divergence between the (Bolton) weekly A/D lines at the 1942 and 1982 lows (see Chart 27.2). Such a divergence was also present at the 2009 low.

  4. Net new highs can also diverge with the averages, but seem to work better when smoothed with a moving average Chart 27.12 also shows a positive divergence in the 30-day high/low ratio at the 2009 bear market low.

  5. Other confirming signs would be record volume coming off the low, as in 1978, 1982, and 1984. Also, most bottoms involve a rally and subsequent test of the low. When the second rally surpasses the first, a series of rising peaks and troughs is signaled. This approach was one of the few in the 1929–1932 bear market that had not previously experienced a whipsaw. It is generally a reliable signal, especially when combined with Dow theory buy signals. Another confirming but extremely important signal is the ability of the S&P Composite to rally above its 12-month MA.

  6. In extended bear markets, the final low is usually confirmed by a bottoming in smoothed long-term momentum. In this instance, the Coppock Index, described in Chapter 13 and featured in Chart 13.8, is probably the most reliable, as it appears to work with amazing consistency on a number of different markets. During shallow bear markets not associated with recessions, smoothed long-term momentum can often prove to be agonizingly slow. Long-term ROCs will occasionally prove to be better substitutes when it is possible to observe momentum price pattern breakouts or upside penetrations of down trendlines. If you are able to identify a bullish secular environment, the analytical test for a bear market low does not have to meet such a stringent level, as would be the case in a secular bear trend.

  7. If short-term oscillators are signaling mega overbought or extreme swing conditions, as described in Chapter 13, this is also a sign that psychology has changed for the better.

  Economic Factors

  8. Normally, it is a prerequisite of a bottom for the economic news to be at or close to its worst. Chart 35.2 shows the 9-month trend deviation indicator for the Conference Board Coincident Indicators. The same concept is shown in Chart 35.3, which compares the S&P to a composite economic indicator. Note that the Master Economic Indicator bottoms pretty closely to major stock market lows associated with recessions.

  CHART 35.2 The S& Composite, 1956–1980, and the Coincident Indicator (deviation from trend)

  CHART 35.3 The S& Composite, 1978–2000, and the Coincident Indicator (deviation from trend)

  Chronological and Cyclical Factors

  9. In terms of the financial market chronological sequence, it is normal for a stock market bottom to be preceded by the 3-month commercial paper yield crossing below its 12-month MA. At the actual bottom, the S&P will be below its 12-month MA, but so, too, will the CRB Spot Raw Material Index. If the yield and commodity index are below their average and the S&P is above its, then the S&P crossover confirms that a bottom is in place, and the markets are in the correct sequence for a Stage II, as described in Chapter 2.

  10. Is it possible to observe three discernible intermediate declines during recession-associated bear markets? This is by no means infallible, but often a good sign.

  11. Does the market meet most of the characteristics cited previously in a year in which the 4-year stock market cycle is due to bottom? If so, the odds of a major bottom are greatly increased. If the year ends in the number 4, this is also a positive sign since years ending in a 5 are the most bullish of the decade. Hence, 1954, 1974, 1984, and 1994 were major bottoms (the first bottom developed at the end of 1953), all of which were followed by 5 strong years. With the exception of 1984, all were also 4-year cycle lows.

  Psychological Factors

  12. Sentiment is typically very bearish at a major bottom. This can show up in extreme readings in advisory sentiment, public short ratios, or the put/call ratio reversing from its overbought level.

  13. Sentiment is also reflected in the media, and here cover stories are a great place to build a contrary case. Occasionally, brokers use the buying opportunity derived from the bear market as the basis for an ad campaign. Such ads do not necessarily indicate the wisdom of brokerage houses, although they are certainly courageous for taking a bullish stance. Rather, it is recognition of the fact that the decline in equity prices has caught the attention of the public. Remember, when everyone thinks alike, it is time to expect a market turn.

  14. How does the market respond to bad news? During the decline, it would be normal for it to sell off on bad news, such as an unexpectedly poor earnings report, huge layoffs, a major bankruptcy, and so on. However, if it starts to shrug off such news and actually rises, the psychology has probably changed.

  Summary

  If it were necessary to summarize these characteristics for peaks and troughs into a few vital points, they would probably be as follows:

  1. Crowd psychology has moved to a measurable extreme.

  2. Interest rates have already reversed their trend.

  3. Long-term momentum is at an extreme or has already reversed from one.

  4. The technical position of leading versus lagging groups is consistent with the direction of the turning point in question.

  5. These conditions have been confirmed with the completion of a price pattern and the penetration of a long-term MA, for example, 12-month, 200-day, and so on.

  EPILOGUE

  The suggestion was made at the outset that the keys to success in financial markets are knowledge and action. The knowledge part of the equation has been discussed as comprehensively as possible, but the final word has been reserved for investor action, since the way in which knowledge is used is just as important as understanding the process itself.

  Indicated in the following are some common errors that all of us commit more often than we would like to admit. The most obvious of these can be avoided by applying the accompanying principles.

  1. Perspective. The interpretation of any indicator should not be based on short-term trading patterns; the longer-term implications should always be considered.

  2. Objectivity. A conclusion should not be drawn on the basis of one or two reliable or favorite indicators. The possibility that these indicators could give misleading signals demonstrates the need to form a balanced view derived from all available information. Objectivity also implies removing as much emotion from the trading and investing process as possible. If incorrect decisions are being made, they will almost always come from a position of mental imbalance. Every effort should therefore be made to reduce the emotional content of any decision on both the buy and sell sides.

  3. Humility. One of the hardest lessons in life is learning to admit a mistake. The knowledge of all market participants in the aggregate is, and always will be, greater than that of any one individual or group of individuals. This knowledge is expressed in the action of the market itself, as reflected by the various indicators. Anyone who fights the tape or the verdict of the market will swiftly suffer the consequences. Under such circumstances, it is as well to become humble and let the market give its own verdict. A review of the indicators will frequently suggest the future direction of prices. Occasionally, the analysis proves to be wrong, and the market fails to act as anticipated. If this unexpected action changes the basis on which the original conclusion was drawn, it is wise to admit the mistake and alter the conclusion.

  4. Tenacity. If the circumstances outlined previously develop, but it is considered that the technical position has not changed, the original opinion should not be changed either.

  5. Independent thought. If a review of the indicators suggests a position that is not attuned to the majority view, that conclusion is probably well founded. On the other hand, a conclusion should never be drawn simply because it is opposed to
the majority view. In other words contrariness for its own sake is not valid. Since the majority conclusion is usually based on false assumptions, it is prudent to examine such assumptions to determine their accuracy.

  6. Simplicity. Most things done well are also done simply. Because the market operates on common sense, the best approaches to it are basically very simple. If an analyst must resort to complex computer programming and model building, the chances are that he or she has not mastered the basic techniques and therefore requires an analytical crutch.

  7. Discretion. There is a persistent temptation to call every possible market turn, along with the duration of every move a security is likely to make. This deluded belief in one’s power to pull off the impossible inevitably results in failure, a loss of confidence, and damage to one’s reputation. For this reason, analysis should concentrate on identifying major turning points rather than predicting the duration of a move—there is no known formula on which consistent and accurate forecasts of this type can be based.

  APPENDIX

  THE ELLIOTT WAVE

  Introduction

  The Elliott wave principle was established by R. N. Elliott and was first published in a series of articles in Financial World in 1939. The basis of the Elliott wave theory developed from the observation that rhythmic regularity has been the law of creation since the beginning of time. Elliott noted that all cycles in nature, whether of the tide, the heavenly bodies, the planets, day and night, or even life and death, had the capability for repeating themselves indefinitely. Those cyclical movements were characterized by two forces: one building up and the other tearing down.

  The principal part of the theory is concerned with form or wave patterns, but other aspects include ratio and time. In this case, pattern does not refer to the types of formation covered in earlier chapters, but to a waveform. Ratio refers to the concept of price retracements and time to the period separating important peaks and troughs.

  Chapter 15 described several techniques based on the Fibonacci number sequence. This same sequence forms the basis for retracement and time development in Elliott theory.

  The Fibonacci Sequence

  This concept of natural law also embraces an extraordinary numerical series discovered by a thirteenth-century mathematician named Fibonacci. The series that carries his name is derived by taking the number 2 and adding to it the previous number in the series. Thus, 2 + 1 = 3, then 3 + 2 = 5, 5 + 3 = 8, 8 + 5 = 13, 13 + 8 = 21, 21 + 13 = 34, and so on. The series becomes 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, and so on. It has a number of fascinating properties, among which are the following:

  1. The sum of any two consecutive numbers forms the number following them. Thus, 3 + 5 = 8 and 5 + 8 = 13, and so on.

  2. The ratio of any number to its next higher is 61.8 to 100, and the ratio of any number to its next lower is 161.8 to 100.

  3. The ratio 1.68 multiplied by the ratio 0.618 equals 1.

  The connection between Elliott’s observation of repeating cycles of nature and the Fibonacci summation series is that the Fibonacci numbers and proportions are found in many manifestations of nature. For example, a sunflower has 89 curves, of which 55 wind in one direction and 34 in the opposite direction. In music, an octave comprises 13 keys on a piano, with 5 black notes and 8 white. Trees always branch from the base in Fibonacci series, and so on.

  The Wave Principle

  Combining his observation of natural cycles with his knowledge of the Fibonacci series, Elliott noted that the market moves forward in a series of five waves and then declines in a series of three waves. He concluded that a single cycle comprised eight waves, as shown in Figure A.1 (3, 5, and 8 are, of course, Fibonacci numbers).

  FIGURE A.1 Typical Cycle

  The upper part of the cycle consists of five waves. Waves 1, 3, and 5 are protrend moves and are called impulse waves. Waves 2 and 4, on the other hand, are called corrective waves because they correct waves 1 and 3. The declining part of the cycle consists of three waves, known as a, b, and c.

  The longest cycle in the Elliott concept is called the grand supercycle. In turn, each grand supercycle can be subdivided into eight supercycle waves, each of which is then divided into eight cycle waves. The process continues to embrace primary, intermediate, minute, minuette, and subminuette waves. The various details are highly intricate, but the general picture is represented in Figures A.1 and A.2.

  FIGURE A.2 Complete Cycle with Subwaves

  Figure A.2 shows a complete cycle with its subwaves. The determinant of whether a wave divides into five or three is the direction of the next largest wave. Corrections are always three-wave affairs.

  Figures A.3 and A.4 show Elliott in historical perspective. Figure A.3 illustrates the first five waves of the grand supercycle, which Elliott deemed to have begun in 1800. Some Elliott wave theoreticians believe that the grand supercycle peaked at the end of the twentieth century.

  FIGURE A.3 The Grand Supercycle

  FIGURE A.4 Supercycle

  As the wave principle is one of form, there is no way to determine when the three corrective waves are likely to appear. However, the frequent recurrences of Fibonacci numbers representing time spans between peaks and troughs are probably beyond coincidence. These time spans are shown in Table A.1.

  TABLE A.1 Time Spans Between Stock Market Peaks and Troughs

  More recently, 8 years occurred between the 1966 and 1974 bottoms, the 1968 and 1976 tops, and the 1990 and 1998 bottoms. Also, there were 5 years between the 1968 and 1973 tops, for example. By the same token, there are many peaks and troughs that are not separated by numbers in this sequence.

  It can readily be seen that the real problem with Elliott is interpretation. Indeed, every wave theorist (including Elliott himself) has at some time or another become entangled with the question of where one wave finished and another started. As far as the Fibonacci time spans are concerned, although these periods recur frequently, it is extremely difficult to use this principle as a basis for forecasting; there are no indications whether time spans based on these numbers will produce tops to tops or bottoms to tops, or something else, and the permutations are infinite.

  We have hardly scratched the surface, and in some respects the old maxim “A little knowledge is a dangerous thing” applies probably more to Elliott than to any other market theorist. Its subjectivity in itself can be dangerous because the market is very subject to emotional influences. Consequently, the weight given to Elliott interpretations should probably be downplayed. Those wishing to pursue this theory in greater detail are referred to the classic text on the subject, by Frost and Prechter, called Elliott Wave Principle (Gainsville, GA, New Classics Library, 1978), since the theory has been described in this Appendix only in its barest outline.

  GLOSSARY

  Advance/Decline (A/D) line An A/D line is constructed from a cumulative plurality of a set of data over a specified period (usually daily or weekly). The result is plotted as a continuous line. The A/D line and market averages usually move in the same direction. Failure of the A/D line to confirm a new high in the market average is a sign of weakness, whereas failure of the A/D line to confirm a new low by the market averages is a sign of technical strength.

  Advisory services Privately circulated publications that comment upon the future course of financial markets, and for which a subscription is usually required.

  Bear trap A signal that suggests that the rising trend of a security has reversed, but which soon proves to be false.

  Breadth (in the market) The term breadth relates to the number of issues participating in a move. A rally is considered suspect if the number of advancing issues is diminishing as the rally develops. Conversely, a decline that is associated with fewer stocks falling is considered to be a bullish sign.

  Bull trap A signal that suggests that the declining trend of a security has reversed, but which soon proves to be false.

  Customer free balances The total amount of unused money on deposit in broke
rage accounts. These are “free” funds representing cash that may be employed in the purchase of securities.

  Cyclical investing The process of buying and selling stocks based on a longer-term or primary market move. The cycle approximates to the 4-year business cycle, to which such primary movements in stock prices are normally related.

  Divergence A nonconfirmation that is not cleared up. Negative divergences occur at market peaks, while positive divergences develop at market bottoms. The significance of a divergence is a direct function of its size—that is, over time and the number of divergences in a given situation.

  Insider Any person who directly or indirectly owns more than 10 percent of any class of stock listed on a national exchange or who is an officer or director of the company in question.

  Margin Occurs when an investor pays part of the purchase price of a security and borrows the balance, usually from a broker; the margin is the difference between the market value of the stock and the loan that is made against it. In the futures markets, margin is a good-faith deposit for a contract for future delivery.

  Margin call The demand upon a customer to put up money or securities with a broker. The call is made if a customer’s equity in a margin account declines below a minimum standard set by the exchange or brokerage firm. This happens when there is a drop in price of the securities being held as collateral.

  Members Members of a stock exchange who are empowered to buy and sell securities on the floor of the exchange either for a client or for their own account.

 

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