Technical Analysis (Part I)
Technical Analysis (Part I)
by James A. Maccaro
"Technical Analysis" is derived in part from research conducted by the author for Technical
Analysis, Inc., which was published in their magazines and website. This material is
copyrighted, 2001 - 2006, by Technical Analysis, Inc., which reserves all rights, and is
used with the permission of the publisher.
There are almost certainly no two names more associated with Wall Street than
Dow and Jones. This leads to a natural question: Who were those guys?
The short answer is that they were ground-breaking 19th century financial
journalists who founded The Wall Street Journal. As if that was not enough, Charles
Dow laid the foundation for technical analysis of the stock market, which was used
by his successors to create Dow Theory, the first in-depth analytic study of stock
price movements.
What distinguishes technical analysis from other ways of thinking about the market is
that it is based solely on the record of a security’s price and the volume of trading as
they vary over time. Someone who is a strict “technician” is indifferent to the
underlying company and overall economic prospects. Indeed, many technicians take
pride in the fact that they have bought and sold stocks in companies when they had
no idea what products or services were provided by the firms.
Technical analysis can be contrasted to the other great school of stock market
analysis, known as “fundamental analysis,” which focuses on the strengths and
weaknesses of the underlying company and is unconcerned about daily price
movements and volume variations.
Charles Dow and Edward Jones were reporters who met in the early 1880's while
working for the Providence (R.I.) Journal. After several years of experience as
financial writers, they joined together in 1882 with a third man, Charles
Bergstresser, to start their own financial information service, which they named
Dow, Jones & Company.
Their first product was a newsletter called The Customer's Afternoon Letter,
which was hand-delivered to clients in and around the Wall Street area. It would
slowly evolve into The Wall Street Journal, which began publication in 1889.
Charles Dow was born in Sterling, Connecticut, on November 6, 1851. He was
described by friends and business associates as a quiet, subdued and unpretentious
man.
Jones was four years younger and was a flamboyant man-about-town who enjoyed
the Gilded Age social world of New York City. Among his friends were high-
society architect Stanford White and members of the incredibly-wealthy Astor
family, as well as leading financiers such as James Keene and Phillip Armour.
The contrast in personal style between the two men caused tension, which was
exacerbated when Bergstresser assumed a more prominent role in the firm.
Bergstresser was nicknamed "Buggy" by Jones and was initially the junior partner at
the firm. He played a subordinate role to Dow and Jones, and was assigned the
more routine chores involved in running the firm, such as arranging delivery of the
newsletter by a small regiment of local boys. But this changed as Dow and Jones
grew apart because of their different lifestyles and because Jones became less
interested in the day-to-day operations of the firm. At the same time, Dow and
Bergstresser became closer, both personally and professionally, as Dow came to
rely on Bergstresser to full the void caused by Jones' diminished activity on behalf of
the firm. This process was accelerated by Bergstresser's marriage to a cousin of
Dow's wife. As a result of their personal and business connections and their
compatible personalities, the two families spent a lot of time together. Jones
apparently began to feel like the odd man out. He left the partnership in January
1899 to become a successful stockbroker.
In March 1902, Dow, Jones & Company was purchased for $130,000 by
Clarence Walker Barron, the owner of financial newspapers published in Boston
and Philadelphia. Only a few months latter, Charles Dow died.
Article is Continued After Sponsors' Messages
Although Barron's Boston newspaper was lucrative, his Philadelphia operation was
not. It, and Barron's lavish lifestyle, consumed most, if not all, of his income; the
money to finance the purchase of Dow, Jones & Company was provided by
Barron's wealthy wife, Jessie Waldron Barron. Their heirs are the controlling-
shareholders of Dow, Jones & Company today.
A feature of The Journal that immediately caught readers' attention was the Dow-
Jones Averages, stock indexes of blue chip companies, which eventually became
accepted measures of the health of the overall market. Although they carried the
names of both men, the indexes were solely the creation of Charles Dow.
The first Dow-Jones index was issued in 1884 and consisted of 11 stocks. Nine of
these stocks were railroad companies, which reflects the fact that railroads
dominated the securities market at that time. On the first trading day of 1897, the
index was divided into two: the Dow-Jones industrial index and the Dow-Jones
railroad index (which subsequently evolved into the transportation index). In January
1929, the Dow-Jones utility index was added.
Dow would also occasionally write editorials about his market philosophy and
ideas. These pieces were based on his conviction that “the market is not like a
balloon plunging hither and thither in the wind. As a whole, it represents a serious,
well considered effort on the part of far-sighted and well-informed men to adjust
prices to such values as exist or which are expected to exist in the not too remote
future." It was from these editorials that technical analysis began, but it was not until
after Dow's death in 1902 that they were published in book form and began to be
referred to as Dow Theory.
It is clear that Dow did not intend that his occasional writings should be considered
as the basis of a formal investment system. Nor did he ever describe his ideas as
"Dow Theory." Nonetheless, his writings, which have been extensively amplified
and elaborated since his death by a legion of Wall Street commentators, were the
basis for the first and still best known technical stock-picking system. For this
reason, Dow is deservedly known as the founder of technical analysis.
Dow concluded that the stock market has three movements that constantly and
simultaneously occur, none of which are independent of the others. The first is the
movement of share prices from day to day. The second is the "short swing," which
was also referred to by Dow as the "medium swing"; this is the movement of stocks
over a period of from ten days to three months. Subsequent commentators have
called it the intermediate trend. Finally, there is the "main movement," which occurs
according to Dow over at least four years. This is also known as the major trend.
Several commentators have compared market movements to the movements of the
oceans: the major trend is the tide, which rises or falls with unstoppable power; an
intermediate trend is a wave, which is potentially powerful but of limited duration;
and the daily moves are ripples, which are not inherently significant but can build
into a wave.
Dow asserted that investors should ignore the day-to-day movement of stock prices
and instead concentrate on the "short swing." An investor's aim, according to Dow,
should be to determine what a stock is going to sell for in three months. To do so,
he said that investors must keep track of the daily price and volume of trading of the
stocks that they are following and should chart this information.
A stock whose "short swing" is bullish was defined by Dow as a company whose
share price reaches new highs that exceed highs reached over prior periods, while a
bearish stock is one whose lows exceed previous lows.
Dow saw that many stocks tend to trade within a range of prices. He noticed that
when they reached a certain high point, they tended to decline on profit-taking (that
is, the desire of some investors to transfer their paper profits into cash) and then
they continued to drift lower. The top of the range is the “resistance” level because
the stock price appears to resist moving above it, while the bottom of the range is its
“support.”
If a stock breaks above its resistance level, Dow asserted, it is likely to begin a
new bullish phase and to form a new resistance level, while if it falls through its
support level, it is likely to enter a bearish period.
In addition to the daily, short (or medium) and main movements of a stock, Dow
said that a stock also has a "primary movement" and a “secondary movement.” He
believed that the primary movement of a stock represented its long term potential
but is generally followed by a secondary movement in the opposite direction of
between 30 and 40 percent. Hence, according to this principle, if a stock advances
in price by $10, it is likely to then fall by $3 or $4 as investors engage in profit-
taking or demand slackens because of concerns about the likelihood of future loss.
Also, Dow believed that the size of the secondary movement is related to that of the
primary movement. Consequently, if a stock price changes dramatically, there is
likely to be a significant movement in the opposite direction.
A corollary to this idea is the observation made by many that a stock price that has
crashed is likely to momentarily increase even if the decline is justified. This is
sometimes referred to as the "dead cat bounce" because of the tendency for even a
lousy investment to "bounce” like a dead cat if it drops from a high enough height.
Likewise, if a stock moves sharply higher, pressure will build for the price to drop in
the short term as a result of profit taking.
Dow further asserted that stocks trade in patterns that occur over roughly ten-year
cycles. This is because "the business community has a tendency to go from one
extreme to the other." In other words, prices will increase during a bull market, this
increase will accelerate as people jump on the bandwagon, prices will then reach an
unsustainable level as enthusiasm runs wild, an inevitable decline will set in, which
likewise will accelerate as pessimism spreads until prices bottom-out, only to
eventually repeat the process, which Dow believed generally took a total of ten
years.
In sum, Dow held that stocks become overvalued at the peak of a bull market
because of over-confidence and then enter a bear market phase which takes about
five or six years. At this point, confidence in the market is regained but eventually
turns into unjustified optimism, which causes the cycle to begin again. This pattern
was frequently described by early Dow theorists as the "panic cycle."
Dow believed that “at the extreme of stock market optimism, you should go short,
while at the nadir of pessimism, you should become fully invested in equities.” This is
an example of classic contrarian investing, that is, of buying when most others are
selling, and selling when market sentiment says that stocks can only go higher. Dow
wrote that “the best profits in the stock market are made by people who get long or
short at the extremes and stay for months or years before they take their profit."
Of course, recognizing when a stock has reached its low or high is easier said than
done. For this reason, Dow’s warning to an investor was to “cut your losses and let
you profits run,” which is perhaps the most famous maximum of Wall Street. To do
this, he advised that you should protect your investments by placing stop-loss
orders at a price a few dollars less than you paid. A stop-loss order directs your
broker to sell a stock if the price declines to a preset level. This limits your losses,
while letting your profitable investments "run." Unfortunately, it also guarantees that
you will lose money after a price drop even if the stock eventually recovers and
continues its upward march.
Dow’s many years of experience as a financial journalist lead him to conclude that
“the surface appearance of the market is apt to be deceptive." However, he was
confident that an intelligent investor who looked below the surface would make
superior profits.
Edward Jones clearly harbored no bitterness about the breakup of his partnership
with Charles Dow. When Dow died on December 4, 1902, his old partner wrote
the following tribute, published in the newspaper that they founded:
May I offer a brief tribute to the memory
of your senior partner with whom I worked
as an editor 28 years ago in Providence,
R.I., and whose partner I was in Dow, Jones
& Co. until three years ago. He was always
a ceaseless searcher for facts and the best
way to tell and distribute them. He was a tower
of strength in early struggles to force reluctant
railroad managers to furnish reports which tell
something to protect the speculating public
from swindlers in and out of Wall Street and
to praise where praise was due. His honesty
was rugged, his industry was prodigious, his
integrity unsullied and his home life ideal.
Financial journalism loses one of its most
honest exponents, his family mourns a devoted,
loving son, husband and father, and Wall Street
parts with a most conscientious, forceful and
able critic. I do not think that his place can be filled.
To continue to Part II, click here
To continue to Part III, click here
by James A. Maccaro
"Technical Analysis" is derived in part from research conducted by the author for Technical
Analysis, Inc., which was published in their magazines and website. This material is
copyrighted, 2001 - 2006, by Technical Analysis, Inc., which reserves all rights, and is
used with the permission of the publisher.
There are almost certainly no two names more associated with Wall Street than
Dow and Jones. This leads to a natural question: Who were those guys?
The short answer is that they were ground-breaking 19th century financial
journalists who founded The Wall Street Journal. As if that was not enough, Charles
Dow laid the foundation for technical analysis of the stock market, which was used
by his successors to create Dow Theory, the first in-depth analytic study of stock
price movements.
What distinguishes technical analysis from other ways of thinking about the market is
that it is based solely on the record of a security’s price and the volume of trading as
they vary over time. Someone who is a strict “technician” is indifferent to the
underlying company and overall economic prospects. Indeed, many technicians take
pride in the fact that they have bought and sold stocks in companies when they had
no idea what products or services were provided by the firms.
Technical analysis can be contrasted to the other great school of stock market
analysis, known as “fundamental analysis,” which focuses on the strengths and
weaknesses of the underlying company and is unconcerned about daily price
movements and volume variations.
Charles Dow and Edward Jones were reporters who met in the early 1880's while
working for the Providence (R.I.) Journal. After several years of experience as
financial writers, they joined together in 1882 with a third man, Charles
Bergstresser, to start their own financial information service, which they named
Dow, Jones & Company.
Their first product was a newsletter called The Customer's Afternoon Letter,
which was hand-delivered to clients in and around the Wall Street area. It would
slowly evolve into The Wall Street Journal, which began publication in 1889.
Charles Dow was born in Sterling, Connecticut, on November 6, 1851. He was
described by friends and business associates as a quiet, subdued and unpretentious
man.
Jones was four years younger and was a flamboyant man-about-town who enjoyed
the Gilded Age social world of New York City. Among his friends were high-
society architect Stanford White and members of the incredibly-wealthy Astor
family, as well as leading financiers such as James Keene and Phillip Armour.
The contrast in personal style between the two men caused tension, which was
exacerbated when Bergstresser assumed a more prominent role in the firm.
Bergstresser was nicknamed "Buggy" by Jones and was initially the junior partner at
the firm. He played a subordinate role to Dow and Jones, and was assigned the
more routine chores involved in running the firm, such as arranging delivery of the
newsletter by a small regiment of local boys. But this changed as Dow and Jones
grew apart because of their different lifestyles and because Jones became less
interested in the day-to-day operations of the firm. At the same time, Dow and
Bergstresser became closer, both personally and professionally, as Dow came to
rely on Bergstresser to full the void caused by Jones' diminished activity on behalf of
the firm. This process was accelerated by Bergstresser's marriage to a cousin of
Dow's wife. As a result of their personal and business connections and their
compatible personalities, the two families spent a lot of time together. Jones
apparently began to feel like the odd man out. He left the partnership in January
1899 to become a successful stockbroker.
In March 1902, Dow, Jones & Company was purchased for $130,000 by
Clarence Walker Barron, the owner of financial newspapers published in Boston
and Philadelphia. Only a few months latter, Charles Dow died.
Article is Continued After Sponsors' Messages
Although Barron's Boston newspaper was lucrative, his Philadelphia operation was
not. It, and Barron's lavish lifestyle, consumed most, if not all, of his income; the
money to finance the purchase of Dow, Jones & Company was provided by
Barron's wealthy wife, Jessie Waldron Barron. Their heirs are the controlling-
shareholders of Dow, Jones & Company today.
A feature of The Journal that immediately caught readers' attention was the Dow-
Jones Averages, stock indexes of blue chip companies, which eventually became
accepted measures of the health of the overall market. Although they carried the
names of both men, the indexes were solely the creation of Charles Dow.
The first Dow-Jones index was issued in 1884 and consisted of 11 stocks. Nine of
these stocks were railroad companies, which reflects the fact that railroads
dominated the securities market at that time. On the first trading day of 1897, the
index was divided into two: the Dow-Jones industrial index and the Dow-Jones
railroad index (which subsequently evolved into the transportation index). In January
1929, the Dow-Jones utility index was added.
Dow would also occasionally write editorials about his market philosophy and
ideas. These pieces were based on his conviction that “the market is not like a
balloon plunging hither and thither in the wind. As a whole, it represents a serious,
well considered effort on the part of far-sighted and well-informed men to adjust
prices to such values as exist or which are expected to exist in the not too remote
future." It was from these editorials that technical analysis began, but it was not until
after Dow's death in 1902 that they were published in book form and began to be
referred to as Dow Theory.
It is clear that Dow did not intend that his occasional writings should be considered
as the basis of a formal investment system. Nor did he ever describe his ideas as
"Dow Theory." Nonetheless, his writings, which have been extensively amplified
and elaborated since his death by a legion of Wall Street commentators, were the
basis for the first and still best known technical stock-picking system. For this
reason, Dow is deservedly known as the founder of technical analysis.
Dow concluded that the stock market has three movements that constantly and
simultaneously occur, none of which are independent of the others. The first is the
movement of share prices from day to day. The second is the "short swing," which
was also referred to by Dow as the "medium swing"; this is the movement of stocks
over a period of from ten days to three months. Subsequent commentators have
called it the intermediate trend. Finally, there is the "main movement," which occurs
according to Dow over at least four years. This is also known as the major trend.
Several commentators have compared market movements to the movements of the
oceans: the major trend is the tide, which rises or falls with unstoppable power; an
intermediate trend is a wave, which is potentially powerful but of limited duration;
and the daily moves are ripples, which are not inherently significant but can build
into a wave.
Dow asserted that investors should ignore the day-to-day movement of stock prices
and instead concentrate on the "short swing." An investor's aim, according to Dow,
should be to determine what a stock is going to sell for in three months. To do so,
he said that investors must keep track of the daily price and volume of trading of the
stocks that they are following and should chart this information.
A stock whose "short swing" is bullish was defined by Dow as a company whose
share price reaches new highs that exceed highs reached over prior periods, while a
bearish stock is one whose lows exceed previous lows.
Dow saw that many stocks tend to trade within a range of prices. He noticed that
when they reached a certain high point, they tended to decline on profit-taking (that
is, the desire of some investors to transfer their paper profits into cash) and then
they continued to drift lower. The top of the range is the “resistance” level because
the stock price appears to resist moving above it, while the bottom of the range is its
“support.”
If a stock breaks above its resistance level, Dow asserted, it is likely to begin a
new bullish phase and to form a new resistance level, while if it falls through its
support level, it is likely to enter a bearish period.
In addition to the daily, short (or medium) and main movements of a stock, Dow
said that a stock also has a "primary movement" and a “secondary movement.” He
believed that the primary movement of a stock represented its long term potential
but is generally followed by a secondary movement in the opposite direction of
between 30 and 40 percent. Hence, according to this principle, if a stock advances
in price by $10, it is likely to then fall by $3 or $4 as investors engage in profit-
taking or demand slackens because of concerns about the likelihood of future loss.
Also, Dow believed that the size of the secondary movement is related to that of the
primary movement. Consequently, if a stock price changes dramatically, there is
likely to be a significant movement in the opposite direction.
A corollary to this idea is the observation made by many that a stock price that has
crashed is likely to momentarily increase even if the decline is justified. This is
sometimes referred to as the "dead cat bounce" because of the tendency for even a
lousy investment to "bounce” like a dead cat if it drops from a high enough height.
Likewise, if a stock moves sharply higher, pressure will build for the price to drop in
the short term as a result of profit taking.
Dow further asserted that stocks trade in patterns that occur over roughly ten-year
cycles. This is because "the business community has a tendency to go from one
extreme to the other." In other words, prices will increase during a bull market, this
increase will accelerate as people jump on the bandwagon, prices will then reach an
unsustainable level as enthusiasm runs wild, an inevitable decline will set in, which
likewise will accelerate as pessimism spreads until prices bottom-out, only to
eventually repeat the process, which Dow believed generally took a total of ten
years.
In sum, Dow held that stocks become overvalued at the peak of a bull market
because of over-confidence and then enter a bear market phase which takes about
five or six years. At this point, confidence in the market is regained but eventually
turns into unjustified optimism, which causes the cycle to begin again. This pattern
was frequently described by early Dow theorists as the "panic cycle."
Dow believed that “at the extreme of stock market optimism, you should go short,
while at the nadir of pessimism, you should become fully invested in equities.” This is
an example of classic contrarian investing, that is, of buying when most others are
selling, and selling when market sentiment says that stocks can only go higher. Dow
wrote that “the best profits in the stock market are made by people who get long or
short at the extremes and stay for months or years before they take their profit."
Of course, recognizing when a stock has reached its low or high is easier said than
done. For this reason, Dow’s warning to an investor was to “cut your losses and let
you profits run,” which is perhaps the most famous maximum of Wall Street. To do
this, he advised that you should protect your investments by placing stop-loss
orders at a price a few dollars less than you paid. A stop-loss order directs your
broker to sell a stock if the price declines to a preset level. This limits your losses,
while letting your profitable investments "run." Unfortunately, it also guarantees that
you will lose money after a price drop even if the stock eventually recovers and
continues its upward march.
Dow’s many years of experience as a financial journalist lead him to conclude that
“the surface appearance of the market is apt to be deceptive." However, he was
confident that an intelligent investor who looked below the surface would make
superior profits.
Edward Jones clearly harbored no bitterness about the breakup of his partnership
with Charles Dow. When Dow died on December 4, 1902, his old partner wrote
the following tribute, published in the newspaper that they founded:
May I offer a brief tribute to the memory
of your senior partner with whom I worked
as an editor 28 years ago in Providence,
R.I., and whose partner I was in Dow, Jones
& Co. until three years ago. He was always
a ceaseless searcher for facts and the best
way to tell and distribute them. He was a tower
of strength in early struggles to force reluctant
railroad managers to furnish reports which tell
something to protect the speculating public
from swindlers in and out of Wall Street and
to praise where praise was due. His honesty
was rugged, his industry was prodigious, his
integrity unsullied and his home life ideal.
Financial journalism loses one of its most
honest exponents, his family mourns a devoted,
loving son, husband and father, and Wall Street
parts with a most conscientious, forceful and
able critic. I do not think that his place can be filled.
To continue to Part II, click here
To continue to Part III, click here
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