- 1998: Volume 7, No. 6 Technical Analysis 101: Bridge Over Troubled Waters

Watching stocks succumb to relentless selling pressure in July and August, it seems appropriate to review the sequence of events leading up to the crash of 1929. Picking up J.R. Levien's Anatomy of a Crash, I scanned the pages searching for evidence that might suggest a repeat performance. Nothing significant surfaced until I reached the end of the book. Using point and figure analysis, Victor deVilliers reconstructed the technical action of the market leading up to and following the crash. I was astonished to find that a simple point and figure chart and single trendline were sufficient in sidestepping that unprecedented decline. In revisiting this time period, I was reminded of two things: the extreme value of technical analysis and the merits of simplicity.

Somewhere along the way, the KISS (Keep It Simple Stupid) approach has fallen into obscurity. We have come to believe that to compete successfully in today's markets, we need some turbo-charged version of the latest analytical software. Maybe it's all those competing ads touting triple digit returns in a day. But looking at the bare facts, the price of a given security at any point in time is nothing more than a function of supply and demand. If there are more sellers than buyers, the price drops. If there are more buyers than sellers, the price rises. Nothing complicated there. So if market dynamics really are this straightforward, why do we persist in cluttering our analysis with so many indicators? Why not limit our analysis to those indicators that assess supply and demand?

In an attempt to help fledgling technicians sort through the maze of existing indicators, I interviewed 16 prominent stock market technicians to determine which indicators have proven the most reliable for them over the years. The result was Technically Speaking, a collection of useful tips and strategies for technical analysts. Drawing from selected indicators discussed in the book, I'll demonstrate that a handful of simple indicators proved sufficient in forecasting the market top in mid-July.

The ongoing battle between buyers and sellers resolves itself in one of three ways: stocks move sideways, they move up, or they move down. In technical jargon, they "trend." One of the cardinal rules of technical analysis is, "the trend is your friend." To keep technicians in step with the existing trend, we have at our disposal moving averages of multiple durations and trendlines. A nine month trendline drawn off the October 1997 low, which had acted as support on three previous pullbacks, was violated on July 31. While the longer-term trendline remained intact, this particular trendline break suggested some intermediate-term weakness. Also, on July 24, the Dow fell below its 50-day moving average line. Investor's Intelligence tracks the number of NYSE stocks above their 200-day moving average line. Most technicians use 200 days when analyzing longer-term conditions. During the week the DJIA made a new high, only 50 percent of NYSE stocks were above their 200-day moving average line compared to the 68 percent recorded during the April 6 high. The new high achieved by the DJIA on July 17 masked the fact that half the listed stocks were losing steam. When an average sets new highs and the majority of stocks don't participate, you have an extremely vulnerable market.

Market breadth showed signs of deterioration leading up to the high set on July 17. Breadth takes into account six variables: the number of stocks advancing, the number of stocks declining, the volume of advancing stocks, the volume of declining stocks, the number of stocks reaching new 52-week price highs, and the number of stocks reaching new 52-week lows. In order for a market to be deemed "healthy," a technician expects to see more stocks making new 52-week highs when the market averages set new highs. However, this wasn't the case on July 17 when the Dow closed at a record high of 9337.97. On that day, there were fewer new daily highs than there had been on July 14 and 16, two previous highs. Further, from July 6 to July 13, the number of new lows expanded while the number of new highs dropped. The same picture was unfolding on a weekly basis. For the week ending July 17, fewer stocks made the new high list than the week before and a greater number of stocks recorded new lows, all within a week where the DJIA set three record highs. This negative divergence was just one sign that the market might be in for some rough sailing.

Negative divergences were also appearing at this time in the advance/decline numbers. As the DJIA set a record high on July 17, the cumulative advance/decline line lagged its old April 3 high by about 8000 issues. Various calculations using the number and volume of advancing stocks and the number and volume of declining stocks all indicated the same thing: that stocks were being distributed, not accumulated. In Technically Speaking, Peter Eliades introduced what he called a "churning pattern," designed to detect periods of low market volatility. The indicator is derived daily by dividing the number of advancing issues on the NYSE by the number of declining issues on the NYSE. If the ratio remains between .65 and 2.20 for 21 consecutive days, that's a warning sign. You next have to consider what occurs during the next three trading days. If the average of the ratios on those next three days stays below .75, then you have a full-fledged sell signal. Such a sell signal was given on July 20.

From surveys to put/call ratios, sentiment measures provide valuable insight into the mindset of market participants. Based on the theory that the majority opinion is usually wrong at major turning points, sentiment should be viewed from a contrarian perspective and within the context of existing market conditions. One of the most widely followed gauges of sentiment is Investor's Intelligence's weekly survey of newsletter writers. During the week of July 17, Investor's Intelligence reported that 52 percent of newsletter writers were bullish and 24 percent bearish. This bullish bias indicated the majority believed the market was going higher. Interestingly, the bullish percent remained above 50 percent over the course of the next three weeks despite a 750 point market drop. Such a persistently bullish attitude into a declining market is a bad omen.

The final clue was issued by a technical indicator that's been around for more than 100 years—the Dow Theory. The Dow Theory holds that a major trend in the stock market must be confirmed by similar movements in the DJIA and DJTA. If movement in one average fails to confirm the other, the market will return to its previous trading range. When the DJIA set a new high on July 17, the DJTA fell short of its previous high, signaling a divergence. On cue, both averages subsequently began an extensive decline.

Although there was much more evidence, you can see that astute observation and a few key indicators provided advance warning of the impending decline. Noted technical analyst and author, John Murphy, is one veteran analyst who endorses a more simplified analytical approach. Speaking at seminars around the world, Murphy witnessed aspiring technicians using state-of-the-art trading systems without first knowing how to construct a simple trendline. Seeing a trend in this direction inspired his latest "return to basics" book, The Visual Investor. Maybe it's time to follow Murphy's lead. Choose a few indicators which have a consistent track record. Watch for significant patterns developing. Monitor sentiment, look for divergences in breadth, and use trendlines and moving averages to stay with the trend and you will discover that less is indeed more.

Chris Wilkinson is an active private trader and author of Technically Speaking. The book is available through the publisher, Traders Press at 800-927-8222.