When a stock has a heavy supply of shares for sale with little demand to buy, it will find itself in a full retreat until a point of equilibrium is reached. That price point where demand fi- nally enters the picture with enough power to halt the selling is called “support” and will act as a pivot area on the chart. In a position like this, technicians don’t look for “why” the stock has declined but simply note that it has occurred. The only thing of interest to them is where it might stop and find support. Once we have that recorded on a chart, it will act as a road marker for us in the future. We will be able to see at what price buy- ers were willing to commit funds in the past. As long as that level is not violated on the downside, we can use that price level as an indication of where we might wish to enter a new posi- tion. This reference point is also useful in a study of reward/risk because we can at least determine where our downside risk is found. If support is violated, the stock would be considered a sell. (See Figure 4-1.)
Inversely, heavy demand for a stock when there is a lim- ited supply to be offered will force the price of the stock to rally until a greater force on the sell side appears to halt the advance. After an upward run, the price will reach a point where sellers are enticed to let go of their shares, and that in turn stops the advance. This equilibrium point on the upside is called “resis- tance.” Like its counterpart, resistance points show us a price at which buyers were no longer able to influence the stock price and allowed sellers to take control. (See Figure 4-2.)
We can also have a stock that has reached a neutral area, and a trading range is formed. Until one side or the other takes the upper hand, the existing support and resistances areas will act as boundaries. Many times this pattern is found after a strong move and an overbought or oversold condition needs to
be digested. The longer a neutral pattern is in force, the more significant the move once the stock has broken out of the pat- tern. The point to all of this is that support and resistance lev- els show us the prices that are essential to a stock’s outlook. A penetration of a resistance level or a violation of a support carry with that action the implication of either falling to the next lower support point or starting a new upward leg. How long those lev- els were intact many times will determine how far a move is likely to be.The study of supply and demand is the most basic element in economics and the main reason that technicians be- lieve that charts reflect everything in the marketplace. Let’s take a minute and explain a bit more about that thought. Tech- nicians look at a chart as the end result of the sum total of all investors’ feelings toward a particular financial instrument. Everyone has a chance to buy or sell a stock on any given day in the open market. News stories, TV interviews, government announcements, overall market fears and optimism, plus a hun- dred other facts influence investors’ reactions towards a stock
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or the market. When the buyers and the sellers meet and come to an agreed-upon price is when technicians look for real knowl- edge. We look for answers in price.
Another major concept that must be accepted by any stu- dent of the market is that “stocks trend.” Once again we will have to go back to some basic concepts. Just like Sir Isaac New- ton, many new investors need to be hit in the head with an ap- ple from time to time to have them come around to the idea that a “body in motion will tend to stay in motion until a force greater than the prevailing trend causes a halt to occur.” He was speak- ing about gravity, and I am talking about supply and demand. A price will move in a trend or general direction until there is a shift in the supply/demand equation and the domineering force is alerted and overpowered by the other.
I believe that it would be impossible to go any further if we didn’t touch upon the belief that price patterns repeat them- selves. Again, like most things in technical analysis, we like our basic truths. In the financial arena, no matter which one you
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choose (stocks, bonds, currencies, etc.), we cannot get away from human nature and the awesome power of fear and greed. An in- vestor might dress differently, have different surroundings, background, different beliefs and habits, but we all act the same way when it comes to “our” money. You just can’t deny the truth of that statement.
It is that sameness called the “human condition” that tends to reoccur over and over again in the world markets. It is also the reason that technical analysis works very well on a global basis. The market is always dealing with these two major mo- tivators namely:
1. The human condition, which unfortunately seems to
never change.
2. The power of fear and greed, which tells us we will
lose all our money or miss a great opportunity, are the elements that makes many chart patterns recur again and again. One of the clearest examples of patterns repeating themselves can be found in the Dow Jones Industrial Averages.
Figure 4-3 shows the Dow Jones from the beginning of the Korean War to the present. During that 50⫹-year span we have seen good times and bad, Democrats and Republican adminis- trations, high interest rates and low interest rates, high unem- ployment and low unemployment, earnings rising and earnings dropping like a stone in a lake; you get the idea. In all that time, with all those forces seemingly pulling on stock prices, we still witnessed an important bottom registered roughly every four to four-and-a-half years. Keep in mind that the stock market is the original 900-pound gorilla. No one can tell the markets what or when to do anything. Yet we are faced with the fact the Dow Jones Industrial Averages does seem to have a repeating pat- tern to it.
If we look at the Dow Jones bottom of 1938 as a starting point, we can see the next meaningful low was established in April of 1942. After World War II, the market made a low in 1946 and, because of the shifting from guns to butter economy, the price activities during that cycle were neutral until we came into late 1949 to mid-1950. In June of 1950 North Korea in- vaded South Korea and the market took a hard hit for about
one month when it lost roughly 12 percent but finally bottomed at 1954. In January of 1958, 53 months later we witnessed an- other major low for the Dow at 416.
In 1962 the world was really coming unglued. Early in the year President Kennedy placed price controls on the steel in- dustry in an attempt to head off inflation. This action sent the stock market into a decline. Later that year that decline turned into a nosedive due to the Cuban Missile Crisis and the real possibility of starting World War III. All in all a fairly nervous time. The Dow Jones, however, made another major bottom al- most at the moment that the Russian merchant ship turned around. In 1966 in the middle of the Vietnam War, the Dow bot- tomed in October of that year at 736 and again in 1970. Despite the expansion of the War into Cambodia, the Dow managed a major significant low at 627 almost exactly four years from top
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to bottom. By the time the DJIAs made their lows in 1974 at a price of 563, we had been in a solid two-year selloff that truly did look like the end of capitalism. After a rally from that low point, the next 4-year cycle took place and by late 1978 we had another low.
August of 1982 was the start of the largest bull market in history. It would usher in a new secular bull market that is likely to stand as the best rally period in the record books for many years to come. Our next low was found in October of 1987, which made that a 5-year cycle. All cycles do have the element of variation to them. The market made us pay for that extra time on the upside in October of that year. I think I still have a nervous tick because of that one. The low in 1987 was the first time in 40 years that we had a 5-year cycle, possibly because we had just started a major longer secular bull market, and the first thrust upward was the largest.
Going forward we saw another market low in 1990, 1994, 1998, and again in 2002. The fact that the market repeats it- self is not amazing to me at all. After 40 years in the business, I’ve seen countless chart patterns that keep repeating. I’ve wit- nessed seasonal patterns work year after year. I’ve seen com- modity prices respond to the calendar and the planting sched- ules. So the concept that “patterns trend” and repeat themselves does work. What I can’t figure out is how more people don’t see the same events. I guess it must be that left-brain/right-brain thing. I gave up a long time ago trying to convince anyone about things that are right in front of their noses.
If we take these few basic ideas that history repeats itself and therefore patterns should also, then it is a short jump to the idea that the market is a discounting mechanism and that the market/stocks do move in trends. It seems to flow that study- ing those trends and patterns would be the next logical step. So let’s take a look at our first instrument in our toolbox: charts and their construction.