Technical Analysis Explained Page 3

  The Discounting Mechanism of Financial Markets

  The primary trend of all financial markets is essentially determined by investors’ expectations of movements in the economy, the effect those changes are likely to have on the price of the asset in which a specific financial market deals, and the psychological attitude of investors to these fundamental factors. Market participants typically anticipate future economic and financial developments and take action by buying or selling the appropriate assets, with the result that a market normally reaches a major turning point well ahead of the actual development.

  Expectations of an expanding level of economic activity are usually favorable for stock prices. Anticipation of a weak economy is bullish for bond prices, and prospects for capacity constraints offer a favorable tailwind for industrial commodity prices. These three markets often move in different directions simultaneously because they are discounting different things.

  An economy is rarely stable; generally, it is either expanding or contracting. As a result, financial markets are in a continual state of flux. A hypothetical economy, as shown in Figure 2.1, revolves around a point of balance known as equilibrium. Roughly speaking, equilibrium can be thought of as a period of zero growth in which business activity is neither expanding nor contracting. In practice, this state of affairs is rarely, if ever, attained, since an economy as a whole possesses tremendous momentum in either the expansionary or the contractionary phase, so that the turnaround rarely occurs at an equilibrium level. In any event, the “economy” consists of a host of individual sectors, many of which are operating in different directions at the same time. Thus, at the beginning of the business cycle, leading economic indicators, such as housing starts, might be rising, while lagging indicators, such as capital spending, could be falling.

  FIGURE 2.1 The Idealized Business Cycle

  Major Technical Principle The business cycle is nothing less than a set series of chronological events that are continually repeating.

  Market participants in financial markets are not concerned with periods of extended stability or equilibrium, for such environments do not produce volatile price swings and opportunities to make quick profits. The ever-changing character of the economic cycle creates tremendous opportunities for investors and traders because it means that different industries are experiencing different economic conditions simultaneously. Since housing leads the economy, housing stocks do well at the start of the recovery, when capital-intensive stocks such as steels tend to underperform. Later in the cycle, the tables are turned and housing peaks first, usually in an absolute sense, but occasionally as measured by its relative performance to a market average such as the S&P Composite. Different equity sectors discounting their specific area of the economy give rise to the sector rotation process, which is discussed at length in Chapter 22.

  Since the financial markets lead the economy, it follows that the greatest profits can be made just before the point of maximum economic distortion, or disequilibrium. Once investors realize that an economy is changing direction and returning toward the equilibrium level, they discount this development by buying or selling the appropriate asset. Obviously, the more dislocated and volatile an economy becomes, the greater is the potential, not only for a return toward the equilibrium level, but also for a strong swing well beyond it to the other extreme. Under such conditions, the possibilities for making money in financial markets are greater because they, too, will normally become subject to wider price fluctuations. Two of the wildest post–World War II economic swings (1973–1974 and 2007–2008) certainly provided traders and investors with a roller coaster ride, with great profit possibilities were they able to identify the two respective bear market lows.

  Market Movements and the Business Cycle

  The major movements of interest rates, equities, and commodity prices are related to changes in the level of business activity. Please note that the term “commodity prices” refers to industrial prices that are sensitive to business conditions, as opposed to weather-driven commodities such as grains. Figure 2.2 represents a business cycle, which typically has a life of between 3 and 5 years between troughs. The horizontal line reflects a level of zero growth, above which are periods of expansion and below which are periods of contraction. After the peak is experienced, the economy continues to grow, but at a declining rate, until the line crosses below the equilibrium level and contraction in economic activity takes place. The arrows in Figure 2.2 show the idealized peaks and troughs of the financial markets as they relate to the business cycle.

  FIGURE 2.2 The Idealized Business Cycle and Financial Market Turning Points (B = Bonds; S = Stocks; C = Commodities)

  Periods of expansion generally last longer than periods of contraction because it takes longer to build something up than to tear it down. For this reason, bull markets for equities generally last longer than bear markets do. The same could be said for interest rates and commodities, but in all cases, the magnitude and duration of primary trends depend on the direction of the secular trend, as discussed in Chapters 1 and 23.

  Figure 2.3 shows the hypothetical trajectories of bond prices, commodities, and equities during the course of a typical business cycle. Referring back to Figure 2.2, we can see that the bond market is the first financial market to begin a bull phase. This usually occurs after the growth rate in the economy has slowed down considerably from its peak rate, and quite often is delayed until the initial stages of the recession. Generally speaking, the sharper the economic contraction, the greater the potential for a rise in bond prices will be (i.e., a fall in interest rates). Alternatively, the stronger the period of expansion, the smaller the amount of economic and financial slack, and the greater the potential for a decline in bond prices (and a rise in interest rates).

  FIGURE 2.3 Idealized Sine Curves for the Three Financial Markets

  Following the bear market low in bond prices, economic activity begins to contract more sharply. At this point, participants in the equity market are able to “look through” the trend of deterioration in corporate profits, which are now declining sharply because of the recession, and to begin accumulating stocks. Generally speaking, the longer the lead between the low in bonds and that of stocks, the greater the potential for the stock market to rally. This is because the lag implies a particularly deep recession in which extreme corporate belt tightening is able to drop breakeven levels to a very low level. During the recovery, increases in revenue are therefore able to quickly move to the bottom line.

  After the recovery has been under way for some time, capacity starts to tighten, resource-based companies feel some pricing power return, and commodity prices bottom. Occasionally, after a commodity boom of unusual magnitude, industrial commodity prices bottom out during the recession as a result of severe margin liquidation due to excessive speculation during the previous boom. However, this low is often subsequently tested, with a sustainable rally only beginning after the recovery has been under way for a few months. At this point, all three financial markets are in a rising trend.

  Gradually, the economic and financial slack that developed as a result of the recession is substantially absorbed, putting upward pressure on the price of credit, i.e., interest rates. Since rising interest rates mean falling bond prices, the bond market peaks out and begins its bear phase. Because some excess plant and labor capacity still exists, rising business activity results in improved productivity and a continued positive outlook. The stock market discounts trends in corporate profits, so it remains in an uptrend until investors sense that the economy is becoming overheated and the potential for an improvement in profits is very low. At this point, there is less reason to hold equities, and they, in turn, enter into a bear phase. Later on, the rise in interest rates takes its toll on the economy, and commodity prices begin to slip.

  Once this juncture has been reached, all three financial markets begin to fall. They will continue to decline until the credit markets bottom. This final stage, which devel
ops around the same time as the beginning of the recession, is usually associated with a free-fall in prices in at least one of the financial markets. If a panic is to develop, this is one of the most likely points for it to take place.

  The Six Stages

  Since there are three financial markets and each has two turning points, it follows that there are conceptually six turning points in a typical cycle. I call these the six stages, and they can be used as reference points for determining the current phase of the cycle. The six stages are indicated in Figure 2.4.

  FIGURE 2.4 The Six Stages of the Typical Business Cycle

  When identifying a stage, it is important to look at the long-term technical position of all three markets so they can act as a cross-check on each other. The stages are also useful, in that specific industry groups outperform the market at particular times and vice versa. For example, defensive and liquidity-driven early-cycle leaders tend to do well in Stages I and II. On the other hand, earnings-driven or late-cycle leaders perform well in Stages IV and V when commodity prices are rallying. These aspects are covered more fully in Chapter 22 on sector rotation.

  Longer Cycles

  Some expansions encompass much longer periods, and they usually include at least one slowdown in the growth rate followed by a second round of economic expansion. This has the effect of splitting the overall expansion into two or three parts, each of which results in a complete cycle in the financial markets. I call this a double cycle. An example of this phenomenon is illustrated in Figure 2.5. A double cycle developed in the 1980s and another in the 1990s. In the mid-1980s, for example, commodity and industrial parts of the country were very badly affected as a result of the unwinding of the commodity boom that ended in 1980, but the east and west coasts continued their expansions unabated. The strong areas more than offset the weaker ones, and so the country as a whole avoided a recession.

  FIGURE 2.5 Financial Market Peaks and Troughs in a Double Cycle

  The Role of Technical Analysis

  Technical analysis comes into play by helping to determine when the various markets have turned in a primary way. This is achieved by applying the various techniques outlined in subsequent chapters, moving average crossovers, changes in the direction of long-term momentum, and so forth. Each market can then be used as a cross-check against the other two. For example, if the weight of the technical evidence suggests that bonds have bottomed but that commodity prices remain in a bear market, then the next thing to do would be to look for technical signs pointing to a stock market bottom and so forth.

  This analysis has also formed the basis of the Dow Jones Pring U.S. Business Cycle Index (symbol DJPRING) as shown in Chart 2.1. The index uses models to identify the six stages and then allocates assets and equity sectors based on their historical performance in each stage since the mid-1950s. It is far from perfect, but does show consistent long-term results. This methodology is also used in the Pring Turner Business Cycle ETF (Symbol DBIZ). The exchange-traded fund (ETF) does not seek to replicate the index, but rather to beat it on a risk-adjusted basis.

  CHART 2.1 The Dow Jones Pring Business Cycle Index Performance versus Three Asset Classes

  Market Experience, 1966–2001

  Chart 2.1 shows how peaks and troughs developed for the various markets between 1966 and 1977.

  Please note that inversely plotted short-term interest rates have been substituted for bond prices. There is a much closer link between equity prices and short-term rates than with longer-term ones. That is because corporations do more of their borrowing in the money markets than in the bond markets. Short-term rates are also more volatile than those at the end of the yield spectrum. The peaks and troughs turned out very much as expected. While the chronological sequence was more or less perfect, the leads and lags in each cycle varied considerably because of the different characteristics in each cycle.

  In 1966, for instance, bonds and stocks bottomed more or less simultaneously, whereas the lag for the commodity market bottom was well over a year.

  Chart 2.2 shows the same markets, but this time we are looking at the 1980s. The two small upward-pointing arrows in 1982 and 1990 reflect recessions. Such environments represent good buying opportunities for bonds, but terrible ones for owning commodities. The series of three bottoms that developed between 1984 and 1986 reflect the mid-1980s growth recession.

  CHART 2.2 Three Financial Markets, 1966–1977

  Generally speaking, the chronological sequence works satisfactorily until we get to the late 1980s, where the 1989 bottom in rates is juxtaposed with the stock market peak. Unfortunately, these out-of-sequence events are a fact of life. In my experience studying the 200 years of out-of-sequence relationships, I find they represent the exception rather than the rule.

  Chart 2.3 shows the closing years of the twentieth century. This is the most difficult period I have encountered because of the record performance by the stock market and the strong deflationary forces associated with the technological revolution. This had the effect of reducing the normal cyclical fluctuation in the equity market. In the fourth edition of this book, I said, “Since the stock market boom was unprecedented, it is unlikely that the normal chronological sequences have been more than temporarily interrupted.”

  CHART 2.3 Three Financial Markets, 1980–1992

  Chart 2.4 proves that conclusion to be mostly correct, except for the late 2001 low in commodities that preceded equities.

  CHART 2.4 Three Financial Markets, 1989–2001

  One could still argue, though, that the equity market lagged because it was still in the process of unwinding the tech bubble. Remember it continued to decline even after the 2001 recession ended. Note the double cycle that developed between 2010 and 2012 in Chart 2.5.

  CHART 2.5 Three Financial Markets, 1999–2013

  Summary

  1. A typical business cycle embraces three individual cycles for interest rates, equities, and commodities. All are influenced by the same economic and financial forces, but each responds differently.

  2. These markets undergo a chronological sequence that repeats in most cycles.

  3. Some cycles experience a slowdown in the growth rate and not an actual recession. Even so, the chronological sequence between markets still appears to operate.

  4. The leads and lags vary from cycle to cycle and have little forecasting value.

  5. The chronological sequence of peaks and troughs in the various financial markets can be used as a framework for identifying the position of a specific market within its bull or bear cycle.

  3 DOW THEORY

  Introduction

  The Dow theory is the oldest, and by far the most publicized, method of identifying major trends in the stock market. An extensive account will not be necessary here, as there are many excellent books on the subject. A brief explanation, however, is in order because the basic principles of the Dow theory are used in other branches of technical analysis.

  The goal of the theory is to determine changes in the primary, or major, movement of the market. Once a trend has been established, it is assumed to exist until a reversal is proved. Dow theory is concerned with the direction of a trend and has no forecasting value as to the trend’s ultimate duration or size.

  It should be recognized that the theory does not always keep pace with events; it occasionally leaves the investor in doubt, and it is by no means infallible, since losses, as with any other technical approach, are occasionally incurred. These points emphasize that while mechanical devices can be useful for forecasting the stock market, there is no substitute for obtaining additional supportive analysis on which to base sound, balanced judgment. Remember there are no certainties in technical analysis because we are always dealing in probabilities.

  The Dow theory evolved from the work of Charles H. Dow, which was published in a series of Wall Street Journal editorials between 1900 and 1902. Dow used the behavior of the stock market as a barometer of business conditions rather than as a basis
for forecasting stock prices themselves. His successor, William Peter Hamilton, further developed Dow’s principles and organized them into something approaching the theory as we know it today. These principles were outlined rather loosely in Hamilton’s book The Stock Market Barometer, published in 1922. It was not until Robert Rhea published Dow Theory, in 1932, that a more complete and formalized account of the principles finally became available.

  The theory assumes that the majority of stocks follow the underlying trend of the market most of the time. In order to measure “the market,” Dow constructed two indexes, which are now called the Dow Jones Industrial Average, which was originally a combination of 12 (but now includes 30) blue-chip stocks, and the Dow Jones Rail Average, comprising 12 railroad stocks. Since the Rail Average was intended as a proxy for transportation stocks, the evolution of aviation and other forms of transportation has necessitated modifying the old Rail Average in order to incorporate additions to this industry. Consequently, the name of this index has been changed to Transportation Average.

  Interpreting the Theory