Technical Analysis (Part III)
Technical Analysis III
by James A. Maccaro
Another early developer of Dow Theory was Glenn G. Munn, who was a security
analyst for Paine Webber in the 1920's and was a leading writer about the stock
market. He was the editor of the Encyclopedia of Banking and Finance and wrote
Meeting the Bear Market, an account of the 1929 stock market crash originally
published in the following year.
Munn agreed with Dow that price changes fall within three movements, which he
characterized as the primary or cyclical movement, the secondary or intermediate
swing and the tertiary movement of daily price changes.
Munn wrote that stock prices will consistently be in "motion" as investors react to
business changes. He believed that primary movements are caused by economic
fundamentals, while tertiary movements are almost wholly technical, that is, based on
the trading history of the security in question. Secondary movements, he added, are
chiefly technical but also respond to economic fundamentals.
To Munn, every price change has significance because it is a forecast of future value.
However, "this is not to say that price and volume changes . . . can always be
interpreted in a way to permit profitable trades." Like Rhea, and virtually all successful
investors, Munn warned that there are times when it is impossible to determine in
which direction the market will go.
The history of the stock market led Munn to conclude that the primary movement
usually swings from bullish to bearish, or vice-versa, very quickly. Stagnant prices
indicate that the prevailing trend is likely to continue. For instance, when prices plateau
during a bull market, the upswing is likely to subsequently continue. Munn reasoned
that if a bear market is to commence, investor confidence must be so weak as to not
support prices at a stable level for a prolonged period of time. Munn applied this rule to
the overall market, not to individual stocks.
Insider trading was accepted as logical and unavoidable during the era when Munn
wrote about the markets. He noted that “any new development in a company’s affairs,
whether favorable or unfavorable, will begin to register itself in the price of the stock in
advance of the announcement of the news." Furthermore, Munn noted without
disapproval that “those in a position first to know of impending developments will
endeavor to capitalize the information.” Even today, after insider trading has been illegal
for generations, stock prices and volume almost always sharply move before a
significant corporate announcement, suggesting that no legal system can override the
desire for profit.
“Few listed stocks are so friendless as to be without a godfather,” Munn observed. He
defined a corporate “godfather” as an investment bank, individual, group or the
corporation itself, willing to enter the market in reaction to price fluctuations. Munn
noted that “the sponsors have in mind a minimum price at which their stock should sell
under a given set of market conditions, and are prepared to purchase at such a price
should it drop thereto.”
This “sponsorship” gives rise to “support points” at which the interested party or
parties will purchase shares, and “resistance points” at which the sponsor will unwind
the accumulation of shares. Of course, this phenomenon can also be caused by profit-
taking and the use of stop-loss orders, as well as by short-selling and the “covering” of
short sales. Also, many corporations today have stock repurchase plans, under which
they buy their own shares on the open market. This provides some degree of price
support, but more importantly, it increases future earnings per share by reducing the
number of shares outstanding and is also a vote of confidence by management in the
stock.
Munn did not believe that a technician should ignore a company’s fundamentals, that is,
company-specific information about its operations and prospects. He concluded that
“fundamentals and (technical) analysis are incorporated.” Nonetheless, Munn admitted
that “there are many successful traders who derive inspiration almost exclusively from
the revelations of the tape.”
Munn summed-up his stock market credo, and perhaps that of most technical analysts,
when he asserted that such investors, who he called “technicists,” are “not
disappointed if the market fails to conform to the course predetermined as logical. He
takes his signals from the market itself and does not quarrel with it. As a result, he is in
step with the market and has no apologies to make if its behavior is counter to
preconceptions."
While much of the most compelling technical research has focused on the Dow Theory
ideas about price movements, also important is analysis of the volume of trading.
Harold Gartley was a pioneering student of volume. He based his studies of volume on
his experiences on Wall Street during much of the 20th century, particularly the boom
years of the 1920’s and the bust that followed.
Article Continues After Sponsors' Messages
He began his career in 1912 and was active through the 1960’s. In common with
many legendary Wall Street figures, such as Bernard Baruch and Jesse Livermore,
Gartley started his career as a “board boy” for a brokerage house. His job was to write
the latest stock prices on blackboards displayed in the firm’s lobby for customers. He
soon progressed to become a stockbroker and analyst. From 1934 to 1947, Gartley ran
his own research company, which was one of the leading independent securities
analysis firms of the day. He was also one of the founders of the New York Society of
Security Analysts and, in the late 1940’s, began a public relations firm specializing in
the then-new field of investor relations.
Gartley presented his ideas about volume in numerous articles and speeches and in a
book published in the 1930’s, entitled Profits in the Stock Market.
Gartley rhetorically asked, “is it volume which causes price changes, or do price
changes cause volume -- the hen or the egg, which came first?” He did not answer this
question because he saw volume not as a trigger of events, but rather as a barometer of
market conditions. He equated volume with “market pressure,” which he concluded
depends on the supply and demand of stocks.
Four primary general rules about volume were advocated by Gartley.
.
First, when an increase in volume is coupled with a significant price change, either
higher or lower, prices are likely to continue in the same direction.
Second, a decrease in volume indicates that prices are likely to change direction.
Third, volume of a speculative issue usually increases as the price moves up, reaching a
peak just prior to the stock reaching its highest price. Conversely, volume will decrease
as the price declines.
Fourth, volume increases during a bull market and decreases during a bear market. Bear
markets, Gartley asserted, “begin in great activity and end in pronounced dullness.”
Gartley made a distinction between volume when a stock’s price is increasing and
volume when it is decreasing. He designated the number of shares traded during price
advances as “demand volume” because he concluded that the volume was driven by
increased demand for the stock. The number of shares traded during price declines is
“supply volume,” because, according to Gartley, it is caused by investors dumping
shares and thereby increasing supply.
Under Gartley’s system, increasing supply volume (i.e., increased trading during
periods of price declines) and decreasing demand volume (i.e., decreased trading during
bullish trends) are bearish indicators. Conversely, increasing demand volume (i.e.,
increased trading during a bull market) and decreasing supply volume (i.e., decreased
trading during periods of price declines) are bullish indicators.
Furthermore, Gartley asserted that if volume sharply increases after a period of rising
prices, and the price advance slows or stops, this suggests that the balance between
supply and demand has shifted and that prices will decrease. Likewise, a decrease in
volume after a bearish trend indicates that prices have stabilized and that the downward
pressure has eased.
According to Gartley, high levels of volume initially characterize bear markets. He cited
the period from November 1929 to April 1930, when volume increased immediately
following the Great Crash of October 1929. Gartley attributed this to the combined
forces of the increased supply of stocks and increased demand. The increased supply
at the beginning of a bear market is triggered by investors covering losses, whom he
called “liquidators,” but they are matched by an increase in demand because of
purchases by optimists hoping to obtain bargains.
Bull market volume, according to Gartley, is initially relatively low because a bull
market usually evolves from the “extreme dullness” that characterized the end of the
preceding bear market. However, as the bull market gains strength, demand volume will
increase until it reaches a “crescendo” that continues during the peak of the bull market
but then falls off as supply volume asserts itself.
Gartley applied his analysis of volume to both the general market and to individual
securities. He also asserted that the ratio of volume for a particular stock to the volume
for the market as a whole is important. He labeled these relationships as “volume ratios”
and stated that increasing volume ratios provide confirmation of other bullish or bearish
indicators relative to that stock. Conversely, a decreasing volume ratio suggests that a
trend is about to change.
Dow Theory, born at the turn of the last century, was a starting point for technical
analysis. Many other systems have been created to predict stock price movements
based upon patterns formed by stock prices and the volume of trading.
Because many of the people who look for market patterns and trends rely on charts of
stock prices and trading volume (as advocated by the proponents of Dow Theory), the
tradition developed of referring to them as "chartists." At first, this term was often
applied in a dismissive way, but many technical analysts soon adopted it as a badge of
honor.
Robert Rhea can be considered to be one of the first high-profile stock chartists
because he taught that daily price changes should be charted and studied. Daily
fluctuations were meaningless to Rhea unless they form a "line" or pattern when linked
together. He noted that "a series of charted daily movements always eventually develops
into a pattern easily recognized as having a forecasting value." He also believed that the
volume of trades should be charted because bull markets end during periods of high
volume of trading and begin with light volume.
Charting was taken to a new level by Richard W. Schabacker, a financial writer in the
1920’s and 30’s, whose work appeared frequently in Forbes. He used Dow Theory as
a starting point to develop ideas about how to anticipate market movements. His most
important contribution to technical analysis was a sophisticated examination of stock
charts.
Schabacker wrote numerous articles and several books that set forth the basics of
technical analysis. In the 1920’s, he started a small publishing company called the
Schabacker Institute to promote his ideas. He also managed money for a handful of
clients.
In September 1929, Schabacker wrote an article for Forbes, in which he predicted an
“impending major reaction.” This, of course, occurred during the following month,
when the stock market suffered through the Great Crash of ’29.
He believed that the direction of the market is greatly influenced by the most actively
traded and best known stocks, which he called the "market leaders." Today, we see
this when announcements from Microsoft, Wal-Mart, Dell Computer, General Electric,
Home Depot, Intel and other market leaders influence, and even almost dictate, the
direction of the overall market.
Schabacker noted that important changes are often anticipated and reflected in a stock's
price prior to the public announcement of the change. He also noted that closing prices
greatly influence the public and can direct how a stock will perform at the opening of
the next trading day. For instance, if a declining stock closes up for the day, this can
encourage further buying at the opening of the next day of trading. Likewise, a decline
in price can put added pressure on prices during the opening the following day.
Schabacker recognized that recurring patterns appeared in charts of stock prices. He
christened the “head and shoulders” and “double top” patterns that all technicians are
familiar with today.
A “head and shoulders” chart shows prices that moderately increase than decline, only
to be followed by a much greater increase and decline with a subsequent moderate
increase and decline, forming the rough outline of a person’s head and shoulders. Dow
Theory explains these movements based on the concepts of resistance and support, i.e.
that the stock will decline after hitting a resistance level, begin an assent after hitting the
support level and if conditions are favorable will break through the resistance level only
to decline on profit taking before the process continues. If the overall trend is bullish,
subsequent highs will generally be greater, and the lows not as low as before, i.e., the
overall trend will be upwards.
A “double top” chart shows prices moving upward and then declining back almost to
the starting point, only for the pattern to repeat itself. Likewise, a “double bottom”
chart’s stock has declined in price, recovered, declined and recovered again. These
stocks are said to be moving within a trading range, with firm resistance and support
levels.
There are many variations of chart patterns and cleaver names for them. Of course,
while it is easy to identify stock chart movements after the fact, predicting the future is
much more thorny.
Schabacker identified five signs that a bull market is ending.
First, trading volume greatly increases.
Second, tremendous advances occur in the prices of individual stocks that are popular
at the moment, while stock prices for some companies suddenly collapse.
Third, interest rates are high.
Fourth, "everyone is talking stocks."
And finally, warnings about an overheated market appear in the press.
Although interest rates were moderate by historically standards in March 2000, at the
peak of the greatest NASDAQ bull market ever seen (as well as bull markets on the
other major exchanges), the other four factors were clearly present.
Schabacker also identified five signs of the end of a bear market (which he called the
“marking down stage”).
First, trading volume is low.
Second, commodity prices have declined.
Third, interest rates have declined.
Fourth, corporate earnings are low.
Fifth, "Stock prices have dropped for so long that there seems no end" and bad news
about the stock market “makes the front page.”
Schabacker noted that "for at least a year or two previous to the close of 1929 the cry
from the housetops was this familiar one that 'we are in a new era.' The law of cycles,
the laws of action and reaction, the basic fundamentals no longer applied because of the
New Era – the golden age of American progress.” Of course, this was also true in the
bull market of the late 1990’s, when we were told by many who should have known
better that we were in a new era because of the Internet and other computer
technologies, as well as other factors, which purportedly made recessions and bear
markets a thing of the past. Schabacker observed 70 years ago that “such statements
are misleading because they are always at least partly true. Every period of business
expansion or business depression is a new era ...” He could have been speaking of our
own time, and not the 1920’s, when he said that “the recent period of prosperity, with
the greatest bull market ever recorded in American history, was based upon many
factors of a new era. But all the powers of science, of invention, of cost-cutting and
labor-saving, of efficient management, co-operation and combination can hardly be
expected to overrule the basic laws of supply and demand, of cyclical movements
based on excess, and the fundamental theory that inflation in any line does not last
forever."
Schabacker’s brother-in-law, Robert Edwards, a horticulturist for the Burpee seed
company, took over the Schabacker Institute upon Schabacker's early death in 1935.
In the 1940's, Edwards began a collaboration with John Magee, an engineer who was
trained at the Massachusetts Institute of Technology. They set forth the basics of
modern technical analysis in numerous writings. Their book, Technical Analysis of
Stock Trends, was frequently described by experts in the 1950’s and 1960’s as "the
bible of technical analysis."
Magee was somewhat eccentric and was infamous for the fact that he worked out of a
small room with all of the windows covered to avoid any distractions. Magee explained
that, "when I come into this office I leave the rest of the world outside to concentrate
entirely on my charts. This room is exactly the same in a blizzard as on a moonlit June
evening. In here I can't possibly do myself and my clients the disservice of saying 'buy'
simply because the sun is out or 'sell' because it is raining."
Magee expressed the essence of technical analysis when he stated that, "prices move in
trends, and trends tend to continue until something happens to change the supply-
demand balance." He considered himself to be a "pure technician" because he relied
solely upon "trends, repetitive motions, (and) extrapolations." He declared that all that a
technical analyst needed to know was a stock’s symbol and its price and volume charts.
Edwards and Magee, like all pure technicians, explicitly declared that the best way to
interpret the stock market is through the study of charts of prices and volume. The
volume of trading "follows the trend," they asserted. It tends to increase during bull
markets and decrease during bear markets. A significant increase in volume may signal
the beginning (the "breakout") or the end (the "climax") of a trend. To identify and
understand these trends, they added, “charts are the most satisfactory tools thus far
devised.” They can show when a stock is “gathering strength,” that is, moving upward
in price on increasing volume, or “playing out,” that is, moving down on heavy volume.
Edwards and Magee warned against getting caught-up in an overheated bull market.
They noted that “more money had been lost by buying perfectly good stocks in the
later and most exciting phases of a bull market and then selling them, perhaps from
necessity, in the discouraging conditions prevailing in a bear market than from all other
causes combined!” Of course, it is a lot easier in retrospect to recognize when this
phenomenon has occurred, which it does with distressing regularity, then to realize it is
occurring at the time.
The most famous example of money piling into an over-extended market, with
inevitable harsh consequences, is the run-up to the Great Crash of ’29, but it also
occurred in the 1960’s, particularly among electronics companies, during the stock
market boom of the “Go-Go” market, as well as in the early 1970’s among the so-
called “Nifty Fifty” blue chip stocks, and in the early 1980’s among computer
companies and, of course, in the recent “dot.com” and telecom bubbles of the late
1990’s. Furthermore, even excellent companies can have overpriced stock prices.
A modern tool for guarding against an “overheated” market is the price to earnings
ratio, widely known as the P/E ratio.
The ratio of a stock’s price to its earnings per share is a basic analytical tool applied
both to individual stocks and to overall markets. It tells you how much you must pay
for every dollar of earnings per share. Another way of looking at the P/E ratio is that it
tells you how many years have to pass before the company’s total annual earnings per
share equal the price that was paid for the stock assuming that earnings do not grow.
The Leuthold Group, a money management group, has analyzed the P/E ratio of the
S&P 500 going back to 1950 and has calculated that the average ratio is 17.8 and that
the ratio peaked at 35.1 in July 1999.
The inverse of the P/E ratio tells you the earnings yield. For example, a stock that has
earnings per share of $2.50 and sells for $50 per share has an E/P ratio of five percent ,
meaning that its earnings per share are five percent of the share price. The P/E ratio
would be 20. The E/P ratio allows you to compare a stock’s earnings to the yields of
other investments.
After years of study, Edwards and Magee concluded that "it is easy, in a detailed study
of the many and fascinating phenomena which stock charts exhibit, to lose sight of the
fact that they are only the rather imperfect instruments by which we hope to gauge the
relative strength of supply and demand, which in turn exclusively determines what
way, how fast and how far a stock will go." They warned against taking “a purely
mechanical approach” and advised investors to “stick closely to first principles.”
“Major bull and bear markets,” they wrote, “have recurred in fairly regular pattern
throughout all recorded economic history and there is no reason to suppose that they
will not continue to recur for as long as our present system exists.” They key to
success, therefore, is to be cautious during bull markets and, in turn, to not lose faith
when prices are low.
To return to Part I, click here
To go to Fundamental Analysis, click here
by James A. Maccaro
Another early developer of Dow Theory was Glenn G. Munn, who was a security
analyst for Paine Webber in the 1920's and was a leading writer about the stock
market. He was the editor of the Encyclopedia of Banking and Finance and wrote
Meeting the Bear Market, an account of the 1929 stock market crash originally
published in the following year.
Munn agreed with Dow that price changes fall within three movements, which he
characterized as the primary or cyclical movement, the secondary or intermediate
swing and the tertiary movement of daily price changes.
Munn wrote that stock prices will consistently be in "motion" as investors react to
business changes. He believed that primary movements are caused by economic
fundamentals, while tertiary movements are almost wholly technical, that is, based on
the trading history of the security in question. Secondary movements, he added, are
chiefly technical but also respond to economic fundamentals.
To Munn, every price change has significance because it is a forecast of future value.
However, "this is not to say that price and volume changes . . . can always be
interpreted in a way to permit profitable trades." Like Rhea, and virtually all successful
investors, Munn warned that there are times when it is impossible to determine in
which direction the market will go.
The history of the stock market led Munn to conclude that the primary movement
usually swings from bullish to bearish, or vice-versa, very quickly. Stagnant prices
indicate that the prevailing trend is likely to continue. For instance, when prices plateau
during a bull market, the upswing is likely to subsequently continue. Munn reasoned
that if a bear market is to commence, investor confidence must be so weak as to not
support prices at a stable level for a prolonged period of time. Munn applied this rule to
the overall market, not to individual stocks.
Insider trading was accepted as logical and unavoidable during the era when Munn
wrote about the markets. He noted that “any new development in a company’s affairs,
whether favorable or unfavorable, will begin to register itself in the price of the stock in
advance of the announcement of the news." Furthermore, Munn noted without
disapproval that “those in a position first to know of impending developments will
endeavor to capitalize the information.” Even today, after insider trading has been illegal
for generations, stock prices and volume almost always sharply move before a
significant corporate announcement, suggesting that no legal system can override the
desire for profit.
“Few listed stocks are so friendless as to be without a godfather,” Munn observed. He
defined a corporate “godfather” as an investment bank, individual, group or the
corporation itself, willing to enter the market in reaction to price fluctuations. Munn
noted that “the sponsors have in mind a minimum price at which their stock should sell
under a given set of market conditions, and are prepared to purchase at such a price
should it drop thereto.”
This “sponsorship” gives rise to “support points” at which the interested party or
parties will purchase shares, and “resistance points” at which the sponsor will unwind
the accumulation of shares. Of course, this phenomenon can also be caused by profit-
taking and the use of stop-loss orders, as well as by short-selling and the “covering” of
short sales. Also, many corporations today have stock repurchase plans, under which
they buy their own shares on the open market. This provides some degree of price
support, but more importantly, it increases future earnings per share by reducing the
number of shares outstanding and is also a vote of confidence by management in the
stock.
Munn did not believe that a technician should ignore a company’s fundamentals, that is,
company-specific information about its operations and prospects. He concluded that
“fundamentals and (technical) analysis are incorporated.” Nonetheless, Munn admitted
that “there are many successful traders who derive inspiration almost exclusively from
the revelations of the tape.”
Munn summed-up his stock market credo, and perhaps that of most technical analysts,
when he asserted that such investors, who he called “technicists,” are “not
disappointed if the market fails to conform to the course predetermined as logical. He
takes his signals from the market itself and does not quarrel with it. As a result, he is in
step with the market and has no apologies to make if its behavior is counter to
preconceptions."
While much of the most compelling technical research has focused on the Dow Theory
ideas about price movements, also important is analysis of the volume of trading.
Harold Gartley was a pioneering student of volume. He based his studies of volume on
his experiences on Wall Street during much of the 20th century, particularly the boom
years of the 1920’s and the bust that followed.
Article Continues After Sponsors' Messages
He began his career in 1912 and was active through the 1960’s. In common with
many legendary Wall Street figures, such as Bernard Baruch and Jesse Livermore,
Gartley started his career as a “board boy” for a brokerage house. His job was to write
the latest stock prices on blackboards displayed in the firm’s lobby for customers. He
soon progressed to become a stockbroker and analyst. From 1934 to 1947, Gartley ran
his own research company, which was one of the leading independent securities
analysis firms of the day. He was also one of the founders of the New York Society of
Security Analysts and, in the late 1940’s, began a public relations firm specializing in
the then-new field of investor relations.
Gartley presented his ideas about volume in numerous articles and speeches and in a
book published in the 1930’s, entitled Profits in the Stock Market.
Gartley rhetorically asked, “is it volume which causes price changes, or do price
changes cause volume -- the hen or the egg, which came first?” He did not answer this
question because he saw volume not as a trigger of events, but rather as a barometer of
market conditions. He equated volume with “market pressure,” which he concluded
depends on the supply and demand of stocks.
Four primary general rules about volume were advocated by Gartley.
.
First, when an increase in volume is coupled with a significant price change, either
higher or lower, prices are likely to continue in the same direction.
Second, a decrease in volume indicates that prices are likely to change direction.
Third, volume of a speculative issue usually increases as the price moves up, reaching a
peak just prior to the stock reaching its highest price. Conversely, volume will decrease
as the price declines.
Fourth, volume increases during a bull market and decreases during a bear market. Bear
markets, Gartley asserted, “begin in great activity and end in pronounced dullness.”
Gartley made a distinction between volume when a stock’s price is increasing and
volume when it is decreasing. He designated the number of shares traded during price
advances as “demand volume” because he concluded that the volume was driven by
increased demand for the stock. The number of shares traded during price declines is
“supply volume,” because, according to Gartley, it is caused by investors dumping
shares and thereby increasing supply.
Under Gartley’s system, increasing supply volume (i.e., increased trading during
periods of price declines) and decreasing demand volume (i.e., decreased trading during
bullish trends) are bearish indicators. Conversely, increasing demand volume (i.e.,
increased trading during a bull market) and decreasing supply volume (i.e., decreased
trading during periods of price declines) are bullish indicators.
Furthermore, Gartley asserted that if volume sharply increases after a period of rising
prices, and the price advance slows or stops, this suggests that the balance between
supply and demand has shifted and that prices will decrease. Likewise, a decrease in
volume after a bearish trend indicates that prices have stabilized and that the downward
pressure has eased.
According to Gartley, high levels of volume initially characterize bear markets. He cited
the period from November 1929 to April 1930, when volume increased immediately
following the Great Crash of October 1929. Gartley attributed this to the combined
forces of the increased supply of stocks and increased demand. The increased supply
at the beginning of a bear market is triggered by investors covering losses, whom he
called “liquidators,” but they are matched by an increase in demand because of
purchases by optimists hoping to obtain bargains.
Bull market volume, according to Gartley, is initially relatively low because a bull
market usually evolves from the “extreme dullness” that characterized the end of the
preceding bear market. However, as the bull market gains strength, demand volume will
increase until it reaches a “crescendo” that continues during the peak of the bull market
but then falls off as supply volume asserts itself.
Gartley applied his analysis of volume to both the general market and to individual
securities. He also asserted that the ratio of volume for a particular stock to the volume
for the market as a whole is important. He labeled these relationships as “volume ratios”
and stated that increasing volume ratios provide confirmation of other bullish or bearish
indicators relative to that stock. Conversely, a decreasing volume ratio suggests that a
trend is about to change.
Dow Theory, born at the turn of the last century, was a starting point for technical
analysis. Many other systems have been created to predict stock price movements
based upon patterns formed by stock prices and the volume of trading.
Because many of the people who look for market patterns and trends rely on charts of
stock prices and trading volume (as advocated by the proponents of Dow Theory), the
tradition developed of referring to them as "chartists." At first, this term was often
applied in a dismissive way, but many technical analysts soon adopted it as a badge of
honor.
Robert Rhea can be considered to be one of the first high-profile stock chartists
because he taught that daily price changes should be charted and studied. Daily
fluctuations were meaningless to Rhea unless they form a "line" or pattern when linked
together. He noted that "a series of charted daily movements always eventually develops
into a pattern easily recognized as having a forecasting value." He also believed that the
volume of trades should be charted because bull markets end during periods of high
volume of trading and begin with light volume.
Charting was taken to a new level by Richard W. Schabacker, a financial writer in the
1920’s and 30’s, whose work appeared frequently in Forbes. He used Dow Theory as
a starting point to develop ideas about how to anticipate market movements. His most
important contribution to technical analysis was a sophisticated examination of stock
charts.
Schabacker wrote numerous articles and several books that set forth the basics of
technical analysis. In the 1920’s, he started a small publishing company called the
Schabacker Institute to promote his ideas. He also managed money for a handful of
clients.
In September 1929, Schabacker wrote an article for Forbes, in which he predicted an
“impending major reaction.” This, of course, occurred during the following month,
when the stock market suffered through the Great Crash of ’29.
He believed that the direction of the market is greatly influenced by the most actively
traded and best known stocks, which he called the "market leaders." Today, we see
this when announcements from Microsoft, Wal-Mart, Dell Computer, General Electric,
Home Depot, Intel and other market leaders influence, and even almost dictate, the
direction of the overall market.
Schabacker noted that important changes are often anticipated and reflected in a stock's
price prior to the public announcement of the change. He also noted that closing prices
greatly influence the public and can direct how a stock will perform at the opening of
the next trading day. For instance, if a declining stock closes up for the day, this can
encourage further buying at the opening of the next day of trading. Likewise, a decline
in price can put added pressure on prices during the opening the following day.
Schabacker recognized that recurring patterns appeared in charts of stock prices. He
christened the “head and shoulders” and “double top” patterns that all technicians are
familiar with today.
A “head and shoulders” chart shows prices that moderately increase than decline, only
to be followed by a much greater increase and decline with a subsequent moderate
increase and decline, forming the rough outline of a person’s head and shoulders. Dow
Theory explains these movements based on the concepts of resistance and support, i.e.
that the stock will decline after hitting a resistance level, begin an assent after hitting the
support level and if conditions are favorable will break through the resistance level only
to decline on profit taking before the process continues. If the overall trend is bullish,
subsequent highs will generally be greater, and the lows not as low as before, i.e., the
overall trend will be upwards.
A “double top” chart shows prices moving upward and then declining back almost to
the starting point, only for the pattern to repeat itself. Likewise, a “double bottom”
chart’s stock has declined in price, recovered, declined and recovered again. These
stocks are said to be moving within a trading range, with firm resistance and support
levels.
There are many variations of chart patterns and cleaver names for them. Of course,
while it is easy to identify stock chart movements after the fact, predicting the future is
much more thorny.
Schabacker identified five signs that a bull market is ending.
First, trading volume greatly increases.
Second, tremendous advances occur in the prices of individual stocks that are popular
at the moment, while stock prices for some companies suddenly collapse.
Third, interest rates are high.
Fourth, "everyone is talking stocks."
And finally, warnings about an overheated market appear in the press.
Although interest rates were moderate by historically standards in March 2000, at the
peak of the greatest NASDAQ bull market ever seen (as well as bull markets on the
other major exchanges), the other four factors were clearly present.
Schabacker also identified five signs of the end of a bear market (which he called the
“marking down stage”).
First, trading volume is low.
Second, commodity prices have declined.
Third, interest rates have declined.
Fourth, corporate earnings are low.
Fifth, "Stock prices have dropped for so long that there seems no end" and bad news
about the stock market “makes the front page.”
Schabacker noted that "for at least a year or two previous to the close of 1929 the cry
from the housetops was this familiar one that 'we are in a new era.' The law of cycles,
the laws of action and reaction, the basic fundamentals no longer applied because of the
New Era – the golden age of American progress.” Of course, this was also true in the
bull market of the late 1990’s, when we were told by many who should have known
better that we were in a new era because of the Internet and other computer
technologies, as well as other factors, which purportedly made recessions and bear
markets a thing of the past. Schabacker observed 70 years ago that “such statements
are misleading because they are always at least partly true. Every period of business
expansion or business depression is a new era ...” He could have been speaking of our
own time, and not the 1920’s, when he said that “the recent period of prosperity, with
the greatest bull market ever recorded in American history, was based upon many
factors of a new era. But all the powers of science, of invention, of cost-cutting and
labor-saving, of efficient management, co-operation and combination can hardly be
expected to overrule the basic laws of supply and demand, of cyclical movements
based on excess, and the fundamental theory that inflation in any line does not last
forever."
Schabacker’s brother-in-law, Robert Edwards, a horticulturist for the Burpee seed
company, took over the Schabacker Institute upon Schabacker's early death in 1935.
In the 1940's, Edwards began a collaboration with John Magee, an engineer who was
trained at the Massachusetts Institute of Technology. They set forth the basics of
modern technical analysis in numerous writings. Their book, Technical Analysis of
Stock Trends, was frequently described by experts in the 1950’s and 1960’s as "the
bible of technical analysis."
Magee was somewhat eccentric and was infamous for the fact that he worked out of a
small room with all of the windows covered to avoid any distractions. Magee explained
that, "when I come into this office I leave the rest of the world outside to concentrate
entirely on my charts. This room is exactly the same in a blizzard as on a moonlit June
evening. In here I can't possibly do myself and my clients the disservice of saying 'buy'
simply because the sun is out or 'sell' because it is raining."
Magee expressed the essence of technical analysis when he stated that, "prices move in
trends, and trends tend to continue until something happens to change the supply-
demand balance." He considered himself to be a "pure technician" because he relied
solely upon "trends, repetitive motions, (and) extrapolations." He declared that all that a
technical analyst needed to know was a stock’s symbol and its price and volume charts.
Edwards and Magee, like all pure technicians, explicitly declared that the best way to
interpret the stock market is through the study of charts of prices and volume. The
volume of trading "follows the trend," they asserted. It tends to increase during bull
markets and decrease during bear markets. A significant increase in volume may signal
the beginning (the "breakout") or the end (the "climax") of a trend. To identify and
understand these trends, they added, “charts are the most satisfactory tools thus far
devised.” They can show when a stock is “gathering strength,” that is, moving upward
in price on increasing volume, or “playing out,” that is, moving down on heavy volume.
Edwards and Magee warned against getting caught-up in an overheated bull market.
They noted that “more money had been lost by buying perfectly good stocks in the
later and most exciting phases of a bull market and then selling them, perhaps from
necessity, in the discouraging conditions prevailing in a bear market than from all other
causes combined!” Of course, it is a lot easier in retrospect to recognize when this
phenomenon has occurred, which it does with distressing regularity, then to realize it is
occurring at the time.
The most famous example of money piling into an over-extended market, with
inevitable harsh consequences, is the run-up to the Great Crash of ’29, but it also
occurred in the 1960’s, particularly among electronics companies, during the stock
market boom of the “Go-Go” market, as well as in the early 1970’s among the so-
called “Nifty Fifty” blue chip stocks, and in the early 1980’s among computer
companies and, of course, in the recent “dot.com” and telecom bubbles of the late
1990’s. Furthermore, even excellent companies can have overpriced stock prices.
A modern tool for guarding against an “overheated” market is the price to earnings
ratio, widely known as the P/E ratio.
The ratio of a stock’s price to its earnings per share is a basic analytical tool applied
both to individual stocks and to overall markets. It tells you how much you must pay
for every dollar of earnings per share. Another way of looking at the P/E ratio is that it
tells you how many years have to pass before the company’s total annual earnings per
share equal the price that was paid for the stock assuming that earnings do not grow.
The Leuthold Group, a money management group, has analyzed the P/E ratio of the
S&P 500 going back to 1950 and has calculated that the average ratio is 17.8 and that
the ratio peaked at 35.1 in July 1999.
The inverse of the P/E ratio tells you the earnings yield. For example, a stock that has
earnings per share of $2.50 and sells for $50 per share has an E/P ratio of five percent ,
meaning that its earnings per share are five percent of the share price. The P/E ratio
would be 20. The E/P ratio allows you to compare a stock’s earnings to the yields of
other investments.
After years of study, Edwards and Magee concluded that "it is easy, in a detailed study
of the many and fascinating phenomena which stock charts exhibit, to lose sight of the
fact that they are only the rather imperfect instruments by which we hope to gauge the
relative strength of supply and demand, which in turn exclusively determines what
way, how fast and how far a stock will go." They warned against taking “a purely
mechanical approach” and advised investors to “stick closely to first principles.”
“Major bull and bear markets,” they wrote, “have recurred in fairly regular pattern
throughout all recorded economic history and there is no reason to suppose that they
will not continue to recur for as long as our present system exists.” They key to
success, therefore, is to be cautious during bull markets and, in turn, to not lose faith
when prices are low.
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