READING MARKET PATTERNS
In this Section, we want to evaluate and apply one of the most valuable tools in interpreting the Stock Market the reading of Market Patterns.
As the Wall Street adage declares, The market is always telling a story. To those who know what to look for, and to interpret correctly what they find, the story being told by the market is of paramount importance. Practically every successful trader has developed, almost to the point of instinct, a knowledge of how to discern the story the market is telling at any given time. They often speak of this as having the feel of the market, and it is a talent which comes only through long practice.
Up to this point in the Course, we have considered two main groups of tools to be use in studying the market. The first group comprises the economic, political, financial, and general business background of the market at any given time. It also includes a consideration of earning, assets, dividends, etc., on individual stocks.
This type information is generally described, professionally, as the fundamentals. Stock market analysts who stress these fundamentals are usually referred to as fundamentalists.
One the other hand, there is the body of evidence constantly being given by the market which has little or nothing to do with fundamentals, but is concerned entirely with the markets manner of performance. This is Called technical information and considers such evidence as volume of trading, breadth of the market, number of stocks making new highs versus those making new lows, advances versus declines, the relative volume on rallies as against that on declines, action of key groups, and so on. These factors have been covered in recent Sections, and market analysts who stress the use of these tools are professionally referred to as technicians.
Of course, in actual practice, every successful trader or investor is a combination of the two, because to stress one group of information to the exclusion of the other is obviously courting disaster. Thus, the fundamentals background of the market may at a given time be excellent, but its technical performance may be very distressing. Patently, something is wrong, and the alert trader will take notice and act accordingly. By the same token, the fundamental background at another time may be very discouraging, but the markets technical action may be surprisingly good. Again, the smart market operator will want to know why.
Usually, such disparities between fundamentals and technical action foreshadow important turning points. Always, they mean that either the courses of business, or of the market, must change.
Now, in addition to these two types of information, or tools, so to speak, there is another means of analyzing the markets action. That is the method referred to at the beginning of this Section, namely, through a study of market patterns.
But in order to visualize these market patterns, it is necessary to reduce them to graphic form, which is why we suggested early in this Course that you begin keeping your own charts on the Dow Jones Industrial and Transportation Averages, bonds, and certain individual stocks.
Charts are nothing more than pictures of price action. And, as the age-old proverb puts it, "One picture is worth a thousand words. However, stock market charts are really special kind of picture, and it is no exaggeration to say that they are, in a sense, x rays of the stock market, for they reveal in black and white the mass psychology of the investors who make up the market. There is no other way of detecting what is in the minds of these thousand of buyers and sellers than by keeping simple but careful charts on the result of their combined operations as they are disclosed each day in the markets action.
Thus, when considerable numbers of investors are starting to distribute (unload) stocks, their selling will show up in a chart pattern. Conversely, when they are starting to accumulate (buy) stocks, this will also be disclosed on the chart.
Also, there are occasionally critical weak spots, and unusually strong areas in the market which a chart will likewise reveal.
The proper function of charts is often misunderstood by amateurs and persons not familiar with their value. To the casual observer, stock market charts are zig-zag lines and not much else. To others, people using charts are sometimes thought of as mysterious or peculiar. Of course, it is true that some chart devotees are fanatics on the subject, while others use charts that may be highly artistic, but of little practical importance. But, even though many people misuse charts, this still doesnt detract from the great value charts can have when properly utilized.
We value charts, but we dont overrate them. Nor do we suggest that you prepare many charts. Rather, we prefer to use just a few, to get the utmost use out of them. And we use charts in conjunction with the other analytical tools.
Any time that you spend in reading and maintaining charts will be richly repaid. In fact, the few simple ones which we recommend are so easy that another person can keep them up for you after a few easy instructions. Such record-keeping needs only a few minutes a day.
Early in this Course, we suggested that you faithfully and diligently keep a daily record of highs, lows, closing prices, and trading volume of the Dow Jones Industrial and Transportation Averages, as well as certain individual stocks.
To the list of individual stocks earlier suggested, you should add two or three additional stocks in which you are most interested. Such practice will begin to reveal very interesting and valuable trends to you and will guide your future operations in these securities.
At this point we might mention that there are a number of different theories, methods, and systems of charting stocks and Averages.
We have investigated and studied practically all of the known methods; but, after careful deliberation, we have returned to what is probably the most practical. This is the method we started at beginning of this Course, namely, the so-called vertical line system, which plots the daily high, low and close of the Average, or of an individual stock, by a single straight
line and records as well daily volume activity.
The illustration on the following page shows (Chart 1) a vertical line chart for a well-know industrial issue.
The chart shows daily highs and lows, which are joined to make a vertical line for each days trading.
The diagonal lines marked by various letters are trend lines marking significant directional moves. For example, the line A-C-E shows declining tops, while B-D simultaneously shows declining bottoms.
Likewise, the line D-F-G-H indicates ascending bottoms, and the line D-K shows a longer range, broader series of ascending bottoms.
Another type of chart used by some technicians is the so-called point and figure variety, an example of which is shown on the following page. In this method, price are recorded in actual figures, ignoring fractions. Thus, in the sample here, the charting is started at A, when the price was 27. Each advance above 27 is written down as an X, in a vertical, rising column, until the rise in price ceases. In this case, the advance stopped at B, or a price of 31. Thereafter, the trend was downward, so a new column of Xs is started to the right, beginning with 30 and extending down to 18, at which point the downtrend in price is checked (C). The next succeeding move is again upward, so still another column is made (at D) at the price of 19, which carries up to 26. Thereafter, another decline sets in, from 25 down to 18 again.
And so on
By reading through the chart, you will note that the stock subsequently made new highs at 39, 43, 64, 75 and 77.
The figure chart 2 does, it is true, suggest a trend in motion but not nearly as sensitively or as well as in the vertical line system.
Its main defect, aside from its relative complexity, is the minimizing of the time factor. Thus, unless the stock actually shows a change of at least one point, there is no new entry on the chart. However, in the vertical line method, each and every daily price is recorded, regardless of whether or not a change takes place. Because a stocks remaining at one price, without showing a material change, can be highly significant, we feel that this factor should be displayed. It might mean the formation of a new floor or ceiling which, as we shall see later in this Section, can be a distinct market signal.
Thus the reasons why we prefer the vertical line type of chart over the point and figure and other systems are that it:
1. Is simple, easy to prepare and easily understood
2. Shows the time factor (which is vitally important in investing) whereas the point and
figure method fails to do so;
3. Is more sensitive and even shows fractional changes, which are ignored in the point
and figure type;
4. Records new highs and lows as soon as they occur;
5. Is most useful for discerning resistance points, turning points, and areas of
accumulation and distribution, whereas the point and figure system often shows signals
too late to be effectively capitalized upon;
6. Shows volume activity.
We now consider some of the important market patterns revealed by vertical line charts which signal coming trends.
One of the more indicative market patterns is the formation of ascending top and bottoms. This means not only a rising market, but a market in which each daily high of the stock or market averages is succeeded by a still higher figure, and each low point succeeded by a still higher low point.
Thus, in the chart shown below, the points marked A-B-C-D-E-F-G mark a series of successively higher lows while H-I-J-K-L-M-N show a simultaneous series of successive new highs.
Such a market formation is generally of bullish implications, particularly if it is accompanied by volume and other bullish indications.
The exact reverse of the above pattern (Chart 4) is the formation known as descending tops and bottoms. This denotes not only a declining market, but shows that each daily high is lower than the preceding high, with each daily low dipping below its previous low.
In the chart shown above, the points marked A-B-C-D indicate successively lower high, while G-H-I-J-K-L-M-N-O-P clearly signal descending lows.
Obviously, such a pattern has bearish significance since it shows a market heading to lower ground. Particularly is this true if accompanied by volume and other bearish indications.
A chart showing the daily range for the stock market averages for any length of time (that is, over a period of months and years) will show certain areas below which the market has not declined for some time.
Almost invariably, such areas are marked by a series of identical, or approximately equal, lows, When such a series of lows extends in a fairly straight line over a period of weeks or months, it indicates that a floor or base is being formed below which the market apparently will not decline.
Technically, such floors or bases are area at which strong buying develops. Usually, such buying is called support or accumulation. It is called accumulation because it means that stocks are being accumulated, or bought up, by professional trades.
In the Chart 6, the area market A-B-C-D-E-F shows a long base, or accumulation zone.
In the great majority of cases, such a formation is strongly bullish in significance, because it almost always is followed by a market rise of some proportions. In fact, most bull markets have their inception in just such formations, after a previous bear market has run its course.
Resistance or Distribution Area
This is exactly the reserve of the support pattern described above, for it shows a ceiling being formed above which the market finds it difficult to advance.
A series of tops at about the same figure would show a fairly straight line being formed which constitutes a barrier, at least temporarily, to a further market advance.
The area marked A-B-C-D-E-F in the Chart 6 portrays a ceiling or resistance above which the market shows inability to rise.
Because sufficient stock is sold at these critical ceiling, they are technically described as resistance, or supply areas. The term distribution means that professional are selling, unloading or distributing the stocks they had previously accumulated.
In most cases, such a formation is a bearish signal, often followed by a decline of some proportions.