Technical Analysis And Market Psychology

This article examines the relevance of technical analysis to today’s financial markets. Its genesis springs from two branches, Dow theory and the Elliott wave principal.

Originally, Dow theory sprang from an attempt to discern the state of the economy through the construction of representative stock indices for railroads and industrials. Elliott came into existence in the 1930s, but only really became widely followed in the late 1980s.

Both Dow and Elliott were intended to help investors make profits by reading equity stock indices, though their use has spread to other financial assets. The validity of this wider use is questioned.

And finally, Elliott wave theory has some disturbing implications for current equity markets. But how valid is Elliott or is it little more than a financial ouija board? And what has technical analysis to say about cryptocurrencies?

Introduction

There are two basic branches of technical analysis, that is to say, the art of financial prediction based on chart patterns and various derived indicators. Today, chartists have their own favourite indicators, the enormous variety of which only really became possible with computers. But the origin of technical analysis can be traced back to the Dow theory by Charles Dow —the founder of the Dow-Jones financial news service, inventor of the Dow stock market averages and before 1902 editor of the Wall Street Journal.

Dow was primarily interested not in using his findings for stock market speculation, but more as a barometer to gauge general business trends. Before they were quantified by Dow’s stock averages, businessmen, speculators, and even the British economist Arthur Pigou were aware of the interesting phenomenon that stocks tended to rise and fall together, and that the few that bucked this underlying trend were unlikely to do so for very long.

So far as we can tell, they missed the reason for this cyclical behaviour, which had its foundation in the cycle of bank credit expansion and contraction. At the time we are discussing, money was meant to be sound, being anchored to gold standards, and the fact that banks created credit out of thin air was poorly understood. Figure 1 shows the notable crises of the nineteenth century, and their regularity of ten or eleven years on average is striking.

Later research would have answered Dow’s curiosity. We now know that the root cause of business trends was —and still is —money; occasionally through new gold discoveries, but regularly through the expansion and contraction of bank credit which plagues us to this day.

Not only does banking behaviour create economic cycles, but it also drives stock markets, and it was Charles Dow who gave us the tools to judge the effects.

Basic Dow theory

Instead of pursuing business cycles, Dow gave birth to a new art form, which can be best described as based on the recognition of investor psychology. However, it remains wholly subjective within its framework. If it was to be otherwise, all investors would make money consistently by trading substitutes for the averages and no one would have to engage in production of the goods we would wish to consume with our new-found wealth. Logic tells us that this can never be the case and experience also confirm that despite Dow theory and the whole field of what is now called technical analysis of stock trends, the majority of traders still lose money and investors still tend to buy high and sell low.

In 1897 Dow commenced his investigation by taking the average of 20 railroad stocks, being the dominant corporate enterprises at the time, to compute what we know today as the Dow Jones Transportation Average. He also calculated an industrial average comprised of twelve stocks, which was later expanded to 20 in 1916 and then 30 in October 1928. This latter average is now the bell-weather Dow Jones Industrial Average.

Dow’s germ of an idea was further developed by his successor at the Wall Street Journal, William Hamilton, into Dow theory as we now know it. As listed in Edwards & Magee’s Technical Analysis of Stock Trends, which is taken by most Dow theorists as the definitive work on the subject, there are some basic tenets that apply:

1. The averages discount everything, except “acts of God”, because they reflect the combined activities of thousands (now millions) of investors, many of which are skilled and well-informed.

2. The market follows three discernible trends: major trends that last for a year or more resulting in appreciation or depreciation of 20% or more, interrupted by secondary trends in contrary direction, and minor trends in either direction or day to day fluctuations which are unimportant.

3. In a bull market, primary uptrends are usually comprised of three phases. The first is an accumulation phase following a bear market, where far-sighted investors are willing to pick up shares offered by discouraged and distressed sellers. At this early stage, financial reports are still bad, and the general public is getting out of stocks. The second phase usually accompanies the early stages of economic and business recovery and offers the skilled trader the best environment for profitable investment. The third phase sees the general public return to the market, encouraged by a combination of bullish news and a desire to not miss out on sure-fire opportunities.

4. Edwards & Magee described a bear market also consisting of three phases. Initially, in a distribution phase far-sighted investors sense things have gone too far and sell their stocks to the public, who still tend to be eager buyers, not realising that valuations have over-discounted evolving prospects. This is followed by a panic phase, as buyers begin to thin out and sellers become more aggressive. And lastly, there is a third phase, when the business news deteriorates rapidly, and inexperienced investors who held out through the panic phase lose all hope and finally accept their losses.

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Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not reflect those of Goldmoney, unless expressly stated. The article is for general information ...

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