|Charles Henry Dow, the creator of Dow theory, and his early followers were investment trailblazers who searched financial data for the mechanisms that direct the movement of stock prices, and in the process created the discipline of technical analysis. Dow theory, first developed in the early 1900s, was a starting point for technical analysis. Since then, many more systems have been created to predict stock price movements based upon price patterns and trading volume. |
Because many of those who look for market patterns and trends rely on charts of stock prices and trading volume, the tradition developed of referring to them as "chartists." At first, this term was often applied in a dismissive way, but technical analysts soon after adopted it as a badge of honor. Richard Schabacker, Robert Edwards, and John Magee were among these early technicians.
Richard W. Schabacker was a financial writer in the 1920s and 1930s whose work appeared frequently in Forbes magazine. He used Dow theory as a starting point to develop ideas about how to anticipate market movements. Schabacker wrote numerous articles and several books that set forth the basics of technical analysis. In the 1920s he started a small publishing company called the Schabacker Institute to promote his ideas. He also managed money for a handful of clients.
Schabacker was a market observer of his times; in September 1929, he wrote an article for Forbes in which he predicted an "impending major reaction" in the stock market — which, of course, occurred the following month in the Great Crash of 1929. He was also one of the earliest to recognize that recurring patterns appear in charts of stock prices. It was he who christened the "head and shoulders" and "double top" patterns that all technicians are familiar with today. He wrote about his belief that the direction of the market is greatly influenced by the most actively traded and best-known stocks, which he referred to as "market leaders." We see this today when companies that are considered market leaders influence, and sometimes seem to dictate, the direction of the overall market.
He noted that fundamental changes are often anticipated and reflected in a stock's price prior to the public announcement of the change. He also observed 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 open of the following day.
A major principle of classic Dow theory is that both individual stocks and the market as a whole tend to develop "resistance points" and "support levels" between which they fluctuate for periods ranging from a few days to a year or more. Schabacker's observations supported this view. As he wrote, "A support level is a comparatively narrow price range, anywhere from one to 10 points, below which the market, or the individual stock, does not appear disposed to move. A resistance level is a similar range above a stock price which limits its advance."
Schabacker identified five signs that a bull market was reaching its end.
A bull market is ending when:
Although nominal interest rates were moderate by historical standards in March 2000, the peak of the greatest Nasdaq bull market yet seen, 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").
A bear market is ending when:
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 1990s. Many who should have known better told us we were in a new era because of the Internet and other computer technologies, as well as other factors, which all claimed to make 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 1920s when he said: "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, cooperation, 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."
EDWARDS AND MAGEE
Schabacker's brother-in-law, Robert Edwards, a horticulturist for the Burpee seed company, took over the Schabacker Institute upon Schabacker's premature death in 1935. In the 1940s, 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. Experts in the 1950s and 1960s frequently described their book, Technical Analysis of Stock Trends, as "the bible of technical analysis," a reference that is echoed even to this day.
Magee, who was somewhat eccentric in his work habits, was famous for working out of a small room with all of the windows covered to avoid any distractions. When asked about it, he explained: "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."
He 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."
Edwards and Magee 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, explaining that volume 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 opined, "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.
Magee and Edwards also warned against getting caught up in an overheated bull market. They noted that "more money has 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 easier in retrospect to recognize when this phenomenon has occurred, which it does with distressing regularity. The most famous example of money piling into an overextended market, with the inevitable consequences, is the runup to the Great Crash of 1929, but it also occurred in the 1960s among electronics companies, in the early 1970s among the so-called "Nifty 50" blue-chip stocks, in the early 1980s among computer companies and, of course, in the recent dotcom and telecom bubbles of the late 1990s.
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 concluded, "have recurred in fairly regular patterns 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." The key to success, therefore, is to be cautious during bull markets and, in turn, not to lose faith when prices are low.
James Maccaro is an attorney and freelance writer. He has written articles for Newsday, Ideas on Liberty, The Massachusetts Law Review, and other periodicals.
SUGGESTED READINGEdwards, Robert D., and John Magee . Technical Analysis Of Stock Trends, 8th ed., W.H.C. Bassetti, ed. Saint Lucie Press.
Schabaker, Richard W., and Donald R. Mack . Technical Analysis And Stock Market Profits: A Course In Forecasting, Financial Times Prentice Hall, reprint edition.
Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.
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