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Back to the Basics: The Fundamentals of Technical Analysis

by Richard Evans

Back To The Basics: The Fundamentals Of Technical Analysis Splash image

To start the new year, I was asked to go back to the basics, so in this month’s column I’ll describe the broad purposes of technical analysis and review the fundamentals of the most important indicator.

Technical analysis is the study of the action of the stock market, and generally it was created when Charles H. Dow, editor of The Wall Street Journal and co-founder of Dow Jones & Co., devised the first stock market averages to reflect the state of the stock market. Dow described the workings of the market through a series of editorials in The Wall Street Journal. These theories were further developed by William Peter Hamilton in his Barron’s editorials and book (“The Stock Market Barometer,” 1926), Robert Rhea (“The Dow Theory,” 1932), and H.M. Gartley (“Profits in the Stock Market,” 1935). In the latter book can be found many of the topics that are important today.

There have been countless other books written on technical analysis and many “niches” have developed over the years—oscillators have become very popular, and momentum, relative strength, stochastics, and moving averages have all found their moments of fame.

But for the individual investor, the key question remains, “What’s the big picture?” While it may be entertaining to follow the day-by-day to week-by-week action of the market, knowing whether the market is a bull market or a bear market remains the most important decision. Despite the wide variety of technical indicators available to provide different insights into the market, the overall trend is still the bottom line.

Trends: The Basics

The exact nature of the trend is determined in large part by support and resistance levels. Support and resistance levels, which are identifiable by price and volume of trading, help define the zigzag nature of trends: Declines tend to stop at support and advances tend to stop at resistance. Support and resistance levels have two other important characteristics. First, they tend to repeat. In addition, they also tend to trade places: After a stock has declined below a support level, it tends to become a resistance level on any rebound rally, and a resistance level, after a stock has moved higher, becomes a support level on any subsequent decline.

Trendlines are used as a tool to help identify trends. Up trendlines are drawn connecting the lows; down trendlines are drawn connecting the highs. Support and resistance influence how and where trendlines are drawn: the lows used in up trendlines represent support levels, while the highs used in down trendlines represent resistance. When prices cross these trendlines, a change in trend may be signaled.

Of course, the most important element of trend analysis is knowing when a change has occurred.

Reviewing the Principles: An Example

For a review of trend analysis principles, let’s consider that last major bearish change of trend in March 1994 and the formation preceding that change of trend (see Figure 1).

First, notice the “trends within trends.” The entire formation is a major trend: Within the major trend is a series of intermediate advances, followed by intermediate declines; within each intermediate advance and decline is a series of minor trend advances and declines.

Note the trendline drawn in, reflecting rising support levels. Trendlines do not develop out of thin air, but rather develop at support levels—levels which are often determined by previous levels of trading concentration. Drawing in a parallel top trendline, connecting the highs or resistance, would form a channel. So, starting with a trendline at the November 1993 low, we can extend the trendline to touch on nearly all the important lows or support levels (and highs or resistant levels) over the next 12 months, a very well-defined trend.

As a general rule, the longer the trend is in force and the easier the trend is to identify, the more significant the eventual change of trend. Most investors, unfortunately, seem to be mesmerized by the market’s lesser, or shorter-term trends.

In 1993, the overall pattern was one of repeating intermediate corrections, followed by moves to higher ground, where both the intermediate advances and declines formed within a major trend channel. After the Dow moved above 3800, the market shot up in almost parabolic fashion, up and away from the trendline. When a market is moving up and away out of a channel, it usually represents the speculative binge, and a market due for a correction, for at least the time being.

Support levels are determined by volume, and during the first week of January, as the market surged to 3850, volume was the heaviest of the year (volume is indicated by the vertical bars along the bottom of the figure). Thus, on the initial sharp one-day drop from the February highs, the high volume at 3850 dictated support, and the Dow did temporarily reverse its drop at that point. Classification-wise, the decline was minor.

After a rally attempt back to the highs, the market again declined, this time with a little more sense of urgency. This time the market found intraday support at a prior support level—3750—established the first week of the year, and closed at 3800. At 3800, of course, the market also came in line with the uptrending trendline once again, and the decline could now be classified as a full-fledged intermediate correction.

The market rallied into mid-March, recovering 54% of the prior drop. In terms of support/resistance, the support that had been evident at 3850-3900 in mid-February was now acting as resistance, as buyers at 3850-3900 were anxious to sell out once they saw the market drop to 3800. After the failing rally of 13 days, the Dow declined below 3800, breaking support and the uptrend, and panic followed.

The 3800 mark also represented the 2/3 speed resistance line, popularized by Edson Gould. Speed resistance lines reflect Dow Theory’s 1/3–2/3 trend correction parameters, and are used to define price support levels. For instance, in an uptrend, prices will usually stay above the 2/3 speed resistance line during corrections; if prices do penetrate this support line, prices will tend to fall to the 1/3 speed resistance line, which becomes the new support level. [Speed resistance lines are available in many technical analysis computer programs].

In this instance, breaking the 2/3 speed resistance line is bearish and indicates further decline until the 1/3 speed resistance line is met. As it was, the 2/3 speed resistance line proved resistance for the market rallies throughout 1994 until the market tested the 1/3 speed resistance line in December 1994.

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Similar failed rallies such as the one in March have appeared often, preceding significant market drops. In September 1987 a similar rebound rally lasted 10 days. The spectacular 1929 collapse was preceded by a rally that lasted only six days.

But each rally was preceded by a sharp decline, a five-week 14.7% decline in 1929, a four-week 8.4% decline in 1987, followed by rallies that retraced 65% and 49% of the prior decline respectively, and then another sharp drop through support.

Generally, the sharper the prior drop, the weaker the market underpinnings, and thus the greater the ensuing panic following a failed rally. So, while the drop into March was a bona fide correction, it was less of a drop compared to those preceding the 1987 and 1929 panics.

For trendline followers of W.D. Gann, the 1994 break also came from a trendline that was not too steep, on the order of a 26¼-degree trendline. A trendline break through a steeper trendline—for example 45 degrees—would have greater significance, that is if support is broken.

The 1995 Market

Now let’s take a look at the 1995 market, which has been historic in any number of ways (Figure 2). In trendline analysis, the advance through July was a perfect trendline along a 45-degree angle. While the market has set historic records, the advance still reflects standard trendline development, the market as of early December has not violated any support levels. During August, the 45-degree trendline was broken, but the market settled in at the 4550 support level and the 2/3 speed resistance line, and then moved back up. Note on the upmove that the 45-degree line became a resistance level.

During the next correction the market twice bounced off support at 4650, and in the process, corrected to the 2/3 speed resistance line. Support held, and in November, the Dow moved higher.

As of early December, the market is up, but has run up against the 45-degree line again. While the correct assumption would be for a continuation of the bull market, what would be required in order to effect a change of trend? An important support level would need to be penetrated during a declining zigzag pattern and probably a trendline as well.

Volume and price patterns suggest important support at 4850-4900. The 2/3 speed resistance line will provide a guideline as well. Should the market correct and support there be tested, and hold, then all would be well. If support would fail, on the other hand, it would suggest a steep correction to the 1/3 line.

Conclusion

The world of technical analysis is full of various and sundry nuances. However, basic trend analysis remains of utmost importance, and to most investors, the major trend is key.

A few minutes each week tracking the trend of the market would pay large dividends to the individual investor.


Discussion

Vernon Roberts from FL posted 8 months ago:

Well writen article.


Nenad Toplak from Croatia posted 5 months ago:

Somebody should turn attention to Mr. Evans to produce an updated edition of his book: Finding Winners Among Depressed and Low Priced Stocks. This book deserves more attention.

Also, a good summary of the book would be welcome and useful. Or, maybe series of articles by AAII staff?!


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