Technical Analysis (Part II)
Technical Analysis II
by James A. Maccaro
Shortly after Charles Dow's death, his writings were studied and promoted by
Samuel A. Nelson, a financial writer and publisher who was the first to call Dow’s
ideas about the stock market "Dow Theory."
Nelson, the publisher of a series of books under the imprint of the “Wall Street
Library,” gathered Dow’s editorials into a brief textbook called The ABC of Stock
Speculation, published in 1903.
Nelson elaborated on Dow's ideas by focusing in particular on the psychology of
investing. He felt that it was vital that an investor have confidence in all investment
decisions. Otherwise, he reasoned, the investor would buy and sell at the wrong
times. By analyzing market psychology, as reflected by stock price movements and
the volume of trading, Nelson believed that future prices could be projected.
Nelson warned that investors should not over-trade by putting too much money at
risk. "Sell down to the sleeping point," he advised. If you are nervous about an
investment, reduce the amount of money at risk to a level that you are comfortable
with (that is, a level that allows you to sleep soundly at night), even if this means
liquidating the entire investment.
Investors should know when to walk away from the stock market, Nelson believed.
He warned that when a stock position turns out to be unprofitable, do not "double
up" by trading in the opposite direction. For instance, if you sell short a stock (i.e.,
sell borrowed stock in the expectation that the stock’s price will decline) but it
subsequently increases in value, do not go long (i.e., buy shares at the higher
prevailing price in the hope that it will continue higher). If you lose again after
"doubling up," the result will be "complete demoralization."
Nelson believed in the need to monitor the stock market at all times because of the
importance of market timing. "Run quick or not at all," he asserted. He meant by
this that you should only sell a stock at the beginning of its bearish trend, that is,
when the stock first begins to falter. If you missed this opportunity, hold on to your
investment and ride-out the cycle. Nelson came to this conclusion because he
thought that it is extremely difficult to know when a stock has hit bottom and a new
bullish trend has begun. In this way, Nelson took issue with Dow’s advice to “cut
your loses.”
Although Nelson was a pioneer of technical analysis, he also accepted the value of
what would become known as fundamental analysis, that is, of analyzing the
operations and prospects of a company before buying the stock. "Value has little to
do with temporary fluctuations,” he wrote, “but is the determining factor in the long
run." Therefore, he urged, carefully investigate a business before buying its stock.
Today, this position would be heresy to a pure technician.
Nelson summarized his market philosophy by stating that “. . . what use is it to pile
up imposing paper profits if they are all to be swept away when the tidal wave
strikes? The only way . . . people can avoid being caught in a panic is by the
exercise at all times of great conservatism and considerable skepticism. The
successful speculator must be content at times to ignore probably two out of every
three apparent opportunities to make money, and must know how to sell and take
his profits when the ‘bull’ chorus is loudest."
Nelson died of tuberculosis a few years after Dow's death and did not reach a large
audience. However, he is still a significant figure in the history of stock market
analysis because of the role he played in preserving Dow’s writings and in bringing
recognition to the fact that it reflects a broad understanding of the stock market.
The first person to widely publicize Dow Theory was William Peter Hamilton, an
Englishman born in 1867 who after a career as a reporter in, among other places,
the financial markets of London and the gold and diamond fields of South Africa,
immigrated to the United States in 1899. He immediately went to work for Dow,
Jones and Company, and he became editor of The Wall Street Journal in 1907. In
1921, he also became editor of Barron’s. His book on Dow Theory, The Stock
Market Barometer, published in 1922, was a best seller and went through many
editions.
Hamilton, unlike Dow, made a conscious attempt to devise a stock-picking system.
In articles for The Journal, as well as in his book, Hamilton argued that Dow's ideas
serve as the basis of a scientific indicator of future market activity.
The most important element of Dow's investment philosophy, according to
Hamilton, was his concept of the market being driven by three movements: the
movement of daily price changes; the "short swing," which reflects short term
trends of from two weeks to a month or more; and the "main movement" which
occurs over several years. While Dow wrote that the "main movement" generally
occurs over at least a four-year period, Hamilton believed that the time frame could
be much less.
Hamilton was a strong proponent of the view that the health of the stock market
determined the health of the economy in the near future. However, Hamilton
cautioned that all three Dow-Jones indexes (the industrial, rail and utility indexes)
must be in agreement before drawing firm conclusions about the economy.
Subsequent commentators focused on the main Dow-Jones industrial index (which
is the index referred to when people speak of "the Dow-Jones") but many also seek
confirmation in one or both of the other indexes.
During the bull market of the 1920’s, Hamilton observed that "if the stock market
was compelled to deflate, as politicians seemed so earnestly to wish, they would
shortly after experience a deflation elsewhere which would be much less to their
liking." He meant by this that the stock market anticipates what will occur in the
general economy.
Hamilton correctly predicted the end of the 1920's bull market in an editorial
published in The Journal on October 25, 1929, only a few days before the crash.
This warning was probably not taken seriously by most readers because Hamilton
was infamous for loudly predicting an imminent bear market in 1926, just prior to
the greatest bull market in U.S. history. In this way, Hamilton (who was widely
known as a financial expert during his day) set an example for Alan Greenspan,
chairman of the U.S. Federal Reserve from 1987 to 2006, who famously warned of
“irrational exuberance” in 1996. He, like Hamilton, was widely derided because his
comments were virtually on the eve of a great market upswing, but was vindicated
in the following decade.
Hamilton stated that a bull market always eventually results in the significant over-
valuation of stocks, while in turn stocks become very undervalued in bear markets.
"Major bull markets and bear markets alike tend to overrun themselves," he wrote.
During a bull market, a temporary secondary movement can easily be mistaken for
the beginning of a new bearish trend. Investors should be patient during such
periods. During a bearish secondary movement, "the change in the broad general
direction of the market is abrupt, while the resumption of the major movement is
appreciably slower."
The stock market represents the sum of all available information about factors that
affect business, Hamilton believed. “The market is a barometer,” he explained.
“There is no movement in it which has not a meaning.” Hamilton also pointed out
that unfortunately “that meaning is sometimes not disclosed until long after the
movement takes place, and is still oftener never known at all.” There’s the rub:
technical analysis has the potential to explain all stock market activity, but the
pertinent technical forces at play are often not understood until after the event.
Hamilton clearly believed that the stock market forecasts the nation's business
climate because its value is based on people’s assumptions about the foreseeable
future. "The big bull market (of the 1920's) was confirmed by six years of prosperity
and if the stock market takes the other direction there will be a contraction in
business latter..."
A corollary to this rule is that the stock market "cannot protect itself against what it
cannot foresee." Therefore, unforeseen events, such as wars and natural disasters,
will cause uncertainty that leads to price declines that will persist as long as the
uncertainty is prevalent. During Hamilton’s lifetime, this phenomenon was perfectly
demonstrated by the reaction of Wall Street to the outbreak of World War I in
Europe. Although this cataclysm lead to a colossal increase of the American
economy because it led to the transfer of a great deal of wealth from Europe to the
United States, the initial reaction of Wall Street was fear bordering on panic. Prices
did not recover until the uncertainty caused by the war was removed. Of course,
recent events in our own time have also proven Hamilton’s assertion about
uncertainty to be correct.
Hamilton died shortly after he was proved to be correct in 1929 by the great
market crash. As a result of his long career, he greatly increased our understanding
of how the stock market works.
Another major Dow Theory pioneer was Robert Rhea. Where he differs from his
predecessors, including Dow, is that he relied on exhaustive statistical data in
interpreting Dow Theory, which he called "both an art and a science."
Rhea was born in 1896 in Nashville, Tennessee, and was seriously injured in World
War I as a result of his service as a pilot with the U.S. Army Air Corps. As a result
of a plane crash, he lost part of a lung, which was already damaged because of
tuberculosis. He returned from the war virtually bedridden and would remain so for
the rest of his life.
To take his mind off his physical problems, Rhea conducted a statistical analysis of
the stock market, using Dow Theory as his framework. He was familiar with Dow
Theory because his father, a Mississippi River boat captain who owned several
ships, had given him a copy of Hamilton’s book when Rhea was still just a teenager.
Rhea self-published his findings in 1932 in books called The Story of the Averages
and Dow Theory. His conclusions were also published in Barron's, which allowed
him to reach a wide audience. In 1938, he began issuing Dow Theory Comments,
one of the earliest modern investment newsletters.
Rhea became well known by the late 1930’s but his period of relative fame was
very brief because, his lungs weakened by his war wounds as well as his earlier
bout with tuberculosis, he died in 1939.
Article is Continued After Sponsor's Message
Although Rhea respected Dow Theory, he warned that "the theory is not an
infallible system for beating the market." He recognized that there is no sure way to
beat the market. "Such a method would, of course, very quickly result in there being
no market." As investors, we justify our gains by the fact that we put our money at
risk and while risk can and should be minimized, it cannot be eliminated.
He was a cautious investor and warned that short selling is rarely profitable over a
long period of time.
The pivotal act that a successful investor must undertake, according to Rhea, is to
determine whether the primary movement of the market is bullish or bearish. Rhea
asserted that bull and bear markets last from less then one year to several years. He
added that unfortunately "there is no known method of forecasting the extent or
duration of a primary movement." Like Hamilton, he did not believe in any ironclad
rules for determining the exact duration of a bull or bear market; he believed that
Dow Theory only provides guidelines.
Rhea concluded that a bull market goes through three stages: a period of reviving
confidence, an advance in stock prices that reflects improving conditions, followed
by rampant speculation. "Truly, the termination of bull markets represents a period
when nothing can justify the prices at which stocks are changing hands except the
hope and expectation of those who are suffering from excessive speculative
temperature."
Likewise, according to Rhea, a bear market also goes through three stages: the
abandonment of hopes (bearish sentiment), followed by a decline in prices that
reflects true business conditions, finally followed by distress selling of securities
regardless of value.
Rhea wrote that a primary trend changes from bullish to bearish when stock prices
fail to reach new highs and decline below the low reached in the previous secondary
reaction. He strongly believed in following the overall trend of particular stocks and
of the overall stock market. "Success in both speculation and investment depends
upon one's ability to swim with the tide rather than against it."
A stock's performance compared to the over-all market is its "relative strength" and
is likely to continue. Nonetheless, Rhea added that "there are, of course, some men
who buy stocks on a declining market to put away as permanent investments. No
criticism is intended of that operation."
Investors should be mindful not to over-estimate their ability to accurately predict
the market. Rhea cautioned that "there are many periods when even the most skillful
trader is in doubt as to what will happen." Therefore, in Rhea’s words, "they profit
most from Dow's Theory who expect least of it."
To continue to Part III, click here
by James A. Maccaro
Shortly after Charles Dow's death, his writings were studied and promoted by
Samuel A. Nelson, a financial writer and publisher who was the first to call Dow’s
ideas about the stock market "Dow Theory."
Nelson, the publisher of a series of books under the imprint of the “Wall Street
Library,” gathered Dow’s editorials into a brief textbook called The ABC of Stock
Speculation, published in 1903.
Nelson elaborated on Dow's ideas by focusing in particular on the psychology of
investing. He felt that it was vital that an investor have confidence in all investment
decisions. Otherwise, he reasoned, the investor would buy and sell at the wrong
times. By analyzing market psychology, as reflected by stock price movements and
the volume of trading, Nelson believed that future prices could be projected.
Nelson warned that investors should not over-trade by putting too much money at
risk. "Sell down to the sleeping point," he advised. If you are nervous about an
investment, reduce the amount of money at risk to a level that you are comfortable
with (that is, a level that allows you to sleep soundly at night), even if this means
liquidating the entire investment.
Investors should know when to walk away from the stock market, Nelson believed.
He warned that when a stock position turns out to be unprofitable, do not "double
up" by trading in the opposite direction. For instance, if you sell short a stock (i.e.,
sell borrowed stock in the expectation that the stock’s price will decline) but it
subsequently increases in value, do not go long (i.e., buy shares at the higher
prevailing price in the hope that it will continue higher). If you lose again after
"doubling up," the result will be "complete demoralization."
Nelson believed in the need to monitor the stock market at all times because of the
importance of market timing. "Run quick or not at all," he asserted. He meant by
this that you should only sell a stock at the beginning of its bearish trend, that is,
when the stock first begins to falter. If you missed this opportunity, hold on to your
investment and ride-out the cycle. Nelson came to this conclusion because he
thought that it is extremely difficult to know when a stock has hit bottom and a new
bullish trend has begun. In this way, Nelson took issue with Dow’s advice to “cut
your loses.”
Although Nelson was a pioneer of technical analysis, he also accepted the value of
what would become known as fundamental analysis, that is, of analyzing the
operations and prospects of a company before buying the stock. "Value has little to
do with temporary fluctuations,” he wrote, “but is the determining factor in the long
run." Therefore, he urged, carefully investigate a business before buying its stock.
Today, this position would be heresy to a pure technician.
Nelson summarized his market philosophy by stating that “. . . what use is it to pile
up imposing paper profits if they are all to be swept away when the tidal wave
strikes? The only way . . . people can avoid being caught in a panic is by the
exercise at all times of great conservatism and considerable skepticism. The
successful speculator must be content at times to ignore probably two out of every
three apparent opportunities to make money, and must know how to sell and take
his profits when the ‘bull’ chorus is loudest."
Nelson died of tuberculosis a few years after Dow's death and did not reach a large
audience. However, he is still a significant figure in the history of stock market
analysis because of the role he played in preserving Dow’s writings and in bringing
recognition to the fact that it reflects a broad understanding of the stock market.
The first person to widely publicize Dow Theory was William Peter Hamilton, an
Englishman born in 1867 who after a career as a reporter in, among other places,
the financial markets of London and the gold and diamond fields of South Africa,
immigrated to the United States in 1899. He immediately went to work for Dow,
Jones and Company, and he became editor of The Wall Street Journal in 1907. In
1921, he also became editor of Barron’s. His book on Dow Theory, The Stock
Market Barometer, published in 1922, was a best seller and went through many
editions.
Hamilton, unlike Dow, made a conscious attempt to devise a stock-picking system.
In articles for The Journal, as well as in his book, Hamilton argued that Dow's ideas
serve as the basis of a scientific indicator of future market activity.
The most important element of Dow's investment philosophy, according to
Hamilton, was his concept of the market being driven by three movements: the
movement of daily price changes; the "short swing," which reflects short term
trends of from two weeks to a month or more; and the "main movement" which
occurs over several years. While Dow wrote that the "main movement" generally
occurs over at least a four-year period, Hamilton believed that the time frame could
be much less.
Hamilton was a strong proponent of the view that the health of the stock market
determined the health of the economy in the near future. However, Hamilton
cautioned that all three Dow-Jones indexes (the industrial, rail and utility indexes)
must be in agreement before drawing firm conclusions about the economy.
Subsequent commentators focused on the main Dow-Jones industrial index (which
is the index referred to when people speak of "the Dow-Jones") but many also seek
confirmation in one or both of the other indexes.
During the bull market of the 1920’s, Hamilton observed that "if the stock market
was compelled to deflate, as politicians seemed so earnestly to wish, they would
shortly after experience a deflation elsewhere which would be much less to their
liking." He meant by this that the stock market anticipates what will occur in the
general economy.
Hamilton correctly predicted the end of the 1920's bull market in an editorial
published in The Journal on October 25, 1929, only a few days before the crash.
This warning was probably not taken seriously by most readers because Hamilton
was infamous for loudly predicting an imminent bear market in 1926, just prior to
the greatest bull market in U.S. history. In this way, Hamilton (who was widely
known as a financial expert during his day) set an example for Alan Greenspan,
chairman of the U.S. Federal Reserve from 1987 to 2006, who famously warned of
“irrational exuberance” in 1996. He, like Hamilton, was widely derided because his
comments were virtually on the eve of a great market upswing, but was vindicated
in the following decade.
Hamilton stated that a bull market always eventually results in the significant over-
valuation of stocks, while in turn stocks become very undervalued in bear markets.
"Major bull markets and bear markets alike tend to overrun themselves," he wrote.
During a bull market, a temporary secondary movement can easily be mistaken for
the beginning of a new bearish trend. Investors should be patient during such
periods. During a bearish secondary movement, "the change in the broad general
direction of the market is abrupt, while the resumption of the major movement is
appreciably slower."
The stock market represents the sum of all available information about factors that
affect business, Hamilton believed. “The market is a barometer,” he explained.
“There is no movement in it which has not a meaning.” Hamilton also pointed out
that unfortunately “that meaning is sometimes not disclosed until long after the
movement takes place, and is still oftener never known at all.” There’s the rub:
technical analysis has the potential to explain all stock market activity, but the
pertinent technical forces at play are often not understood until after the event.
Hamilton clearly believed that the stock market forecasts the nation's business
climate because its value is based on people’s assumptions about the foreseeable
future. "The big bull market (of the 1920's) was confirmed by six years of prosperity
and if the stock market takes the other direction there will be a contraction in
business latter..."
A corollary to this rule is that the stock market "cannot protect itself against what it
cannot foresee." Therefore, unforeseen events, such as wars and natural disasters,
will cause uncertainty that leads to price declines that will persist as long as the
uncertainty is prevalent. During Hamilton’s lifetime, this phenomenon was perfectly
demonstrated by the reaction of Wall Street to the outbreak of World War I in
Europe. Although this cataclysm lead to a colossal increase of the American
economy because it led to the transfer of a great deal of wealth from Europe to the
United States, the initial reaction of Wall Street was fear bordering on panic. Prices
did not recover until the uncertainty caused by the war was removed. Of course,
recent events in our own time have also proven Hamilton’s assertion about
uncertainty to be correct.
Hamilton died shortly after he was proved to be correct in 1929 by the great
market crash. As a result of his long career, he greatly increased our understanding
of how the stock market works.
Another major Dow Theory pioneer was Robert Rhea. Where he differs from his
predecessors, including Dow, is that he relied on exhaustive statistical data in
interpreting Dow Theory, which he called "both an art and a science."
Rhea was born in 1896 in Nashville, Tennessee, and was seriously injured in World
War I as a result of his service as a pilot with the U.S. Army Air Corps. As a result
of a plane crash, he lost part of a lung, which was already damaged because of
tuberculosis. He returned from the war virtually bedridden and would remain so for
the rest of his life.
To take his mind off his physical problems, Rhea conducted a statistical analysis of
the stock market, using Dow Theory as his framework. He was familiar with Dow
Theory because his father, a Mississippi River boat captain who owned several
ships, had given him a copy of Hamilton’s book when Rhea was still just a teenager.
Rhea self-published his findings in 1932 in books called The Story of the Averages
and Dow Theory. His conclusions were also published in Barron's, which allowed
him to reach a wide audience. In 1938, he began issuing Dow Theory Comments,
one of the earliest modern investment newsletters.
Rhea became well known by the late 1930’s but his period of relative fame was
very brief because, his lungs weakened by his war wounds as well as his earlier
bout with tuberculosis, he died in 1939.
Article is Continued After Sponsor's Message
Although Rhea respected Dow Theory, he warned that "the theory is not an
infallible system for beating the market." He recognized that there is no sure way to
beat the market. "Such a method would, of course, very quickly result in there being
no market." As investors, we justify our gains by the fact that we put our money at
risk and while risk can and should be minimized, it cannot be eliminated.
He was a cautious investor and warned that short selling is rarely profitable over a
long period of time.
The pivotal act that a successful investor must undertake, according to Rhea, is to
determine whether the primary movement of the market is bullish or bearish. Rhea
asserted that bull and bear markets last from less then one year to several years. He
added that unfortunately "there is no known method of forecasting the extent or
duration of a primary movement." Like Hamilton, he did not believe in any ironclad
rules for determining the exact duration of a bull or bear market; he believed that
Dow Theory only provides guidelines.
Rhea concluded that a bull market goes through three stages: a period of reviving
confidence, an advance in stock prices that reflects improving conditions, followed
by rampant speculation. "Truly, the termination of bull markets represents a period
when nothing can justify the prices at which stocks are changing hands except the
hope and expectation of those who are suffering from excessive speculative
temperature."
Likewise, according to Rhea, a bear market also goes through three stages: the
abandonment of hopes (bearish sentiment), followed by a decline in prices that
reflects true business conditions, finally followed by distress selling of securities
regardless of value.
Rhea wrote that a primary trend changes from bullish to bearish when stock prices
fail to reach new highs and decline below the low reached in the previous secondary
reaction. He strongly believed in following the overall trend of particular stocks and
of the overall stock market. "Success in both speculation and investment depends
upon one's ability to swim with the tide rather than against it."
A stock's performance compared to the over-all market is its "relative strength" and
is likely to continue. Nonetheless, Rhea added that "there are, of course, some men
who buy stocks on a declining market to put away as permanent investments. No
criticism is intended of that operation."
Investors should be mindful not to over-estimate their ability to accurately predict
the market. Rhea cautioned that "there are many periods when even the most skillful
trader is in doubt as to what will happen." Therefore, in Rhea’s words, "they profit
most from Dow's Theory who expect least of it."
To continue to Part III, click here