Technical Analysis Explained Page 5
These countertrends, or reactions against the main trend, are notoriously difficult to forecast in terms of character, magnitude, and duration. Therefore, they should generally be avoided from a trading point of view, as they will almost invariably be subject to confusing whipsaws. By their very nature, they tend to fool the majority and are usually extremely treacherous. It is possible to design successful mechanized systems based on intermediate price movements, but poor or losing signals usually come from secondary market movements that occur against the main trend. Intermediate-term trends that move in the same direction as the primary trend are generally easier to profit from. Those who do not have the patience to invest for the longer term will find that successful analysis of intermediate movements offers superior results, especially as the day- to-day or minor swings are, to a large degree, random in nature and, therefore, even more difficult to capitalize on. This tendency has been most pronounced in recent years when increasingly sharp price movements have resulted from emotional knee-jerk reactions to the release of unexpected economic data.
A secondary reaction does not have to be a decline in a bull market or a bear market rally. It can also take the form of a sideways movement or consolidation, under the same idea as Charles Dow’s line formation (see the discussion in Chapter 3).
Intermediate movements can go either with or against the main trend, which means that there is an intermediate cycle similar to a primary one. An intermediate cycle consists of a primary intermediate price movement and a secondary reaction. It extends from the low of one intermediate trend to the low of the other, as shown in Figure 4.2.
FIGURE 4.2 Intermediate-Term Cycles
In a bull market, the up phase of the cycle should be longer in time and greater in magnitude. The low on the secondary reaction should be higher than its predecessor. In a bear market, the reverse conditions hold true; i.e., declines are longer and greater, while rallies are shorter and sharper, but of less magnitude. Accordingly, technicians are alerted first to the possibility of a reversal in the primary trend when a third intermediate cycle is nearing completion. It is also important to note whether the overall technical structure looks weak (strong in a bear market) as the previous intermediate low (high) is approached and, finally, to note whether that level is decisively broken on the downside (upside).
This does not mean that primary movements can never encompass more or fewer than three primary intermediate price movements, for often they do. Expect three as a normal event, but do not be caught off guard if there are fewer or more.
Causes of Secondary Reactions
Since the primary trend of stock prices is determined by the attitudes of investors to the future flow of profits, which are, in turn, determined to a large degree by the course of the business cycle, it would seem illogical at first to expect longer-term movements to be interrupted by what often prove to be very uncomfortable reactions (or in the case of a bear market, very deceptive rallies).
History shows that secondary reactions occur because of technical distortions, which arise in the market as a result of overoptimism (or overpessimism), and also because new factors emerge that suggest business conditions are not going to be as extreme as was originally anticipated, or even that they are going to materialize in the opposite direction. For example, after the first intermediate-term rally in a bull market for equities, a reaction may develop because investors, who had discounted a strong recovery, now see some chinks appearing that might even forecast an actual decline in business conditions. Such fears eventually prove ungrounded, but are sufficient to cause a countercyclical intermediate reaction. Another possibility might be a fear of rising interest rates, which could choke off the recovery. Since prices had discounted a strong recovery, this change in perception causes investors to pull back and prices to fall accordingly. At the same time, many investors get carried away during the rally phase and leverage themselves up. As prices begin to fall, this causes their equity to shrink and forces them to liquidate, which adds further fuel to the price decline.
A bear market rally for stocks generally takes place because of an improved outlook for business conditions over what was anticipated. A bear market rally for bonds develops under the opposite set of conditions. Corrections in commodity and currency markets all have their roots in a changed, but incorrect, perception of the underlying (primary) economic trend. The catalyst for the rally is the rush by traders and investors to cover their short positions (for a definition and explanation of short selling, see the Glossary). It should be added that the apparent motivating force for the correction need not necessarily be directly linked to the outlook for business or interest rates.
Major Technical Principle At any one time, there are four influences on prices. They are psychological, technical, economic, and monetary in nature.
Any of these influences could be the “excuse” for a countercyclical intermediate price movement. It could be linked to the anticipated resolution or worsening of a political or military problem, for example. Essentially, the change in anticipated conditions, combined with the unwinding of the technical distortions of the previous primary intermediate trend and its associated sharp price movement, are sufficient to confuse the majority. Only when business conditions are correctly expected to change from recovery to recession (or vice versa) is the primary trend of equities likely to reverse. Note the emphasis on the word “likely.” Although equity prices fluctuate around perceived future economic conditions, there have been exceptions. For example, the economy moved out of recession at the end of 2001, yet stocks continued to decline into October 2002. In that case, it would appear that the unwinding of the tech bubble was a stronger influence than was improving economic activity. That sort of decoupling, though, is far more the exception than the rule.
In his excellent book Profits in the Stock Market (Lambert Gann Publishing, 1935), H. M. Gartley pointed out that in the 40 years ending in 1935, two-thirds of all bull market corrections in the U.S. stock market developed in two waves of liquidation separated by a minor rally that retraced between one-third and two-thirds of the first decline. Observation of such corrections since 1935 also bears out the finding that most intermediate corrections consist of two, rather than one or three, phases of liquidation. Unfortunately, intermediate corrections within a bear market cannot be so easily categorized since some are one-move affairs or consist of a rally out of a small base, while still others unfold as a very volatile sideways movement. Even though Gartley’s observations were concerned with the equities, this form of correction applies to all financial markets.
Relationship Between Primary Intermediate Moves and Subsequent Reactions
In Profits in the Stock Market, Gartley published a series of diagrams using the classification of intermediate trends established by Robert Rhea. Gartley’s conclusion was that the smaller in magnitude the primary intermediate-term movement was, the larger the retracement tended to be, and vice versa. He noted that this was just as valid for bull market reactions as for bear market rallies. Observations of the period since 1933 for virtually all markets appear to support this hypothesis. For example, the rally off the 1962 stock market low was only 18 percent, compared to the mean average of 30 percent between 1933 and 1982. This represented part of a double bottom formation and, therefore, the first primary intermediate rally. This relatively small advance was followed by a somewhat larger 71 percent retracement. However, the ensuing rally from late 1962 until mid-1963 was 32 percent and was followed by a small 25 percent retracement of the gain. Interested readers may wish to be satisfied that what goes up does not necessarily come down, and vice versa.
The 1976–1980 gold bull market was very powerful, but the intermediate corrections were quite brief. On the other hand, the rallies between 1982 and 1990 were far less strong, but were followed by corrections of much greater magnitude proportionally.
Using Intermediate Cycles to Identify Primary Reversals
Number of Intermediate Cycles
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br /> A primary movement may normally be expected to encompass two and a half intermediate cycles (see Figure 4.3). Unfortunately, not all primary movements correspond to the norm; an occasional primary movement may consist of one, two, three, or even four intermediate cycles. Furthermore, these intermediate cycles may be of very unequal length or magnitude, making their classification and identification possible only after the event. Even so, intermediate-cycle analysis can still be used as a basis for identifying the maturity of the primary trend in most cases.
FIGURE 4.3 Intermediate Trends and Volume
Whenever prices are well advanced in a primary intermediate trend following the complication of two intermediate cycles, technicians should be alerted to the fact that a reversal of the primary trend itself may be about to take place. Again, if only one intermediate cycle has been completed, the chances of prices reaching higher levels (lower levels in a bear market) are quite high.
Characteristics of the Final Intermediate Cycle in a Primary Trend
In addition to actually counting the number of intermediate cycles, it is possible to compare the characteristics of a particular cycle with those of a typical pivotal or reversal cycle of a primary trend. These characteristics are discussed in the following sections.
Reversal from Bull to Bear Market Since volume leads price, the failure of volume to increase above the levels of the previous intermediate-cycle up phase is a bearish sign. Alternatively, if over a period of 3 to 4 weeks, volume expands on the intermediate rally close to the previous peak in volume but fails to move prices significantly, it represents churning and should also be treated bearishly. Coincidence of either of these characteristics with a downward crossover of a 40-week moving average (see Chapter 11) or a divergence in an intermediate-term momentum index (see Chapter 13) would be an additional reason for caution.
There are essentially two broad characteristics that suggest that the downward phase of an intermediate cycle could be the first downleg of a bear market. The first is a substantial increase in volume during the price decline. The second is a cancellation or retracement of 80 percent or more of the up phase of that same intermediate cycle. The greater the retracement, the greater the probability that the basic trend has reversed, especially because a retracement in excess of l00 percent means that any series of rising troughs has been broken, thereby placing the probabilities in favor of a change in the primary trend. Other signs would include the observation of a mega oversold or an extreme swing (see Chapter 13 on momentum for a full explanation of these terms).
Reversal from Bear to Bull Market The first intermediate up phase of a bull market is usually accompanied by a substantial expansion in volume that is significantly greater than those of previous intermediate up phases. In other words, the first upleg in a bull market attracts noticeably more volume than any of the intermediate rallies in the previous bear market. Another sign of a basic reversal occurs when prices retrace at least 80 percent of the previous decline. Again, the greater the proportion of retracement, the greater the odds of a reversal in the basic trend. If the retracement is greater than 100 percent, the odds clearly indicate that a reversal in the downward trend has taken place because the series of declining peaks will have broken down.
Since volume normally expands substantially as the intermediate down phase during a bear market reaches a low, a shrinkage in volume during an intermediate decline could well be a warning that the bear market has run its course. This is especially true if the price does not reach a new low during this intermediate decline, since the series of declining intermediate cyclical lows, which is a characteristic of a bear market, may no longer be intact. An example of this is shown in Chart 8.12 where the overall peak in volume was seen in the June 1962 decline rather than the August–October sell-off.
A final sign might include a mega overbought condition or an extreme swing; again please refer to Chapter 13 for an explanation of these concepts.
Intermediate Trends in the U.S. Stock Market, 1897–1982
Amplitude and Duration of Primary Intermediate Upmoves
Between 1897 and 1933, Robert Rhea, the author of Dow Theory, classified 53 intermediate-trend advances within a primary bull market, which ranged in magnitude from 7 to 117 percent, as shown in Table 4.1.
TABLE 4.1 Primary Intermediate Upmoves 1897–1933
I have classified 35 intermediate-term moves between 1933 and 1982, and the median averaged 22 percent from low to high. The results are shown in Table 4.2.
TABLE 4.2 Primary Intermediate Upmoves 1933–1982
The median average primary intermediate advance since 1897 appears to be around 20 to 22 percent. The median primary intermediate upmove in the 1933–1982 period does not differ from that of the earlier period classified by Rhea. However, the median duration appears to have increased considerably, from 13 weeks in the 1897–1933 period to 24 weeks in the 1933–1982 period.
Amplitude and Duration of Primary Intermediate Downmoves
Using Rhea’s classification, 39 cases of a primary intermediate decline developed between 1900 and 1932, as summarized in Table 4.3.
TABLE 4.3 Primary Intermediate Downmoves 1900–1932
My research shows that between 1932 and 1982 there were 35 primary intermediate declines, with a median of 16 percent (the decline was measured as a percentage from the high). The results are summarized in Table 4.4.
TABLE 4.4 Primary Intermediate Downmoves 1932–1982
The results in the 1932–1982 period did not differ appreciably from those in the 1897–1933 period. Rhea’s median average swing was 18 percent, as compared to the more recent 16 percent, whereas, the median duration in the earlier period was 13 weeks, as compared to 14 weeks in the 1932–1982 period.
Amplitude, Duration, and Retracement of Bull Market Intermediate Corrections
Bull Market Secondary Reactions Between 1898 and 1933, Rhea classified 43 cases of bull market secondaries. In terms of retracement of the previous primary intermediate upmove, they ranged from 12.4 to 180 percent, with a median of 56 percent. This compared with a range in the 1933–1982 period from 25 to 148 percent, with a median of 51 percent. The duration of the median in the earlier period was 5 weeks, as compared to 8 weeks between 1933 and 1982. The median percentage loss from the previous primary intermediate peak was 12 percent (the mean average was 13 percent) between 1933 and 1982.
Bear Market Rallies Rhea estimated that the median bear market rally retraced 52 percent of the previous decline, which is comparable to my own median estimate of 61 percent in the 1932–1982 period. The two ranges were 30 and 116 percent and 26 and 99 percent, respectively. Median durations were 6 weeks in 1898–1933 and 7 weeks in 1932–1982. Rallies off the low averaged 12 and 10 percent for mean and median, respectively, for the 1933–1982 period.
Since 1982 Charts 4.1 and 4.2 show the S&P Composite between the end of 1982 and the opening of the twenty-first century.
CHART 4.1 S&P Composite 1982–1991 and an Intermediate KST
CHART 4.2 S&P Composite 1991–2001 and an Intermediate KST
The thick vertical lines approximate intermediate rally peaks and the thin ones intermediate troughs. The lower panel contains an intermediate oscillator, the intermediate Know Sure Thing (KST) (see Chapter 15 for an explanation), which roughly reflects the turning points. This period encompassed the secular bull market that began in 1982 and ended at the turn of the century, as well as the subsequent secular bear. The classification of intermediate trends was particularly difficult compared to previous periods. I tried as much as possible to make the intermediate trends fit the swings in the oscillator. Because oscillators have a tendency to lead in bull markets, the actual peaks in the intermediate rallies usually lag those in the KST. The two charts show that the classification of these trends is far from a precise task, and confirms earlier research between 1897 and 1982, that the range of intermediate trends varies tremendously. In the period covered by Chart 4.1, for instance, the first intermediate
rally in the bull market lasted well over a year, from August 1982 to October 1983. Even if I had taken the July 1983 top as a reference point, the rally would still have lasted for almost a year. Moreover, the whole year of 1995 was consumed by one complete intermediate advance.
Chart 4.3 fills in the balance of the picture until 2012. Note the particularly lengthy 2008 and 2009 trends, first on the downside and later on the upside.
CHART 4.3 S&P Composite 2001–2012 and an Intermediate KST
Summary
1. The typical primary trend can be divided into two and a half primary intermediate cycles, each consisting of an upmove and a downmove. In a bull market, each successive up wave should reach a new cyclical high, and in a bear market, each successive down wave of the intermediate cycle should reach a new low. Breaking the pattern of rising lows and falling peaks is an important, but not unequivocal, warning of a reversal in the primary trend. For more conclusive proof, technicians should derive a similar conclusion from a consensus of indicators.
2. A secondary movement or reaction is that part of an intermediate cycle that runs counter to the main trend—a downward reaction in a bull market or a rally in a bear market. Secondary intermediate movements typically last from 3 weeks to 3 months and retrace between one-third and two-thirds of the previous primary intermediate price movement. Secondary price movements may also take the form of a line or horizontal trading pattern.