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Technical Market Theory

Most people want to know a little about how the car works so they know how to drive it and when to take it in for service. Technical market theory encompasses a large body of work, rigorous testing, and decades of experience. At this stage, it is similar to the car in that the basics need an explanation. Becoming expert takes rather longer.

As technical investors, we are chart readers. The key is to think of a chart in psychological, not graphic, terms. In other words, support is the level at which the aggressive selling of the bears has waned sufficiently to be offset by the rising aggressiveness of buying by the bulls. Resistance is the level at which the aggressive buying of the bulls has waned sufficiently to be offset by the rising aggressiveness of selling by the bears.

The Basics of Technical Analysis

Chart patterns represent the behavior of the masses. They are built from actual transactions, so in effect, they represent how the pool of investors, traders, speculators, and hedgers have put their money where their collective mouths were over time.

Because the composition of the pool stays relatively stable over time and investors react the same way time and time again when presented with the same circumstances, chart patterns can be used to measure the likelihood of similar resolutions to current market conditions in the future.

Since not all players have access to the same information at the same time and they do not react at the same speed when they do get it, markets present opportunity. If everyone knew about a new product announcement from the Widget Company at the same time and they reacted the same way, the stock would only trade at the market maker's bid-ask spread until the news came out. It would then jump completely to the next level, where it would trade perfectly flatly until the next news development. Trends represent the slow dissemination and assimilation of news.

Because the market really consists of the mass of human will, it is prone to excessive swings from optimism to pessimism and back again. Technical analysis helps to measure these swings.

Humans Again—Market Psychology

This emerging field of analysis is beyond the scope of this book. However, a few of the basic concepts can be learned that directly apply to analyzing a stock or market, as well as a few that are indirectly indicated in the charts.

Perceptions

It is worth reiterating that a stock's price often does not match its fundamental value. Current market price can and does deviate from the (forgive the jargon) capital asset price model and discounted value of future cash flows. In a marketplace where humans, not computers, determine prices, it is not what it is worth; it is what people think it is worth.

How else can the phenomenon of Internet stocks be explained? In 1998 and 1999, these stocks tripled after their initial public offerings when they had no profits and unreliable revenues. And the 1987 crash? How can the fundamental value of the entire stock market be cut by almost one-third in one day when there was little change elsewhere in the outside world?

Leading into the crash, people were ignoring such important factors as soaring interest rates and the prevalence of a "buy anything" mentality. When reality caught up with perceptions, prices tumbled.

To rephrase this, the stock market or any other market never reflects calculated true value. It reflects people's perception of the value; what people think it is worth.

The Crowd Versus the Individual

People like to believe that they are independent thinkers and that rational analysis and logic often prevail. They also might be modest enough to admit that other people have valid, and even superior, opinions.

When those same, rationally thinking people are part of a crowd, they tend to conform to the crowd. It is uncomfortable to maintain a minority opinion, even when the individual's analysis is sound. As part of a crowd, humility is lost, as everyone begins to think that they (the crowd) are 100% right. There is no room for contrary opinion. Facts not confirming the mass opinion are ignored.

In the previous section, the 1987 crash was used as an example. The crowd wanted to buy stocks and the market went up. The rare dissenter was called a "doomsayer," even though the evidence for a crash was in place.

The same condition is in effect at market bottoms. The crowd sees nothing but bad news and the market continues to fall. Changing conditions are ignored as they were in 1982, even as the dawn of the greatest bull market of all time was at hand.

Technical analysts have the tools to follow the changing tide. Confidence in their analysis provides the conviction to act as an individual, against the crowd, if necessary.

Myths and Truths

A few of the myths surrounding technical analysis have been covered: the self-fulfilling prophecy, basing future price activity on past performance, and reading tea leaves. There can be some truth to self-fulfilling prophecy. After a stock breaks higher from a chart pattern, new buyers are drawn in. They push the price higher and that, in turn, draws in still more buyers.

The problem with this explanation is that it unknowingly merges short- and long-term analysis with a one-time action (breakout) into one story. Short-term analysis would have told short-term traders to buy before the breakout. If technical conditions continue to improve after the breakout, then long-term analysis would confirm it with improved momentum (prices move convincingly) and higher volume (more shares change hands, suggesting broader public participation). Investor sentiment would improve as the changes in fundamental data filtered down to all investors.

The past-performance issue is another of the critics' favorites. How can past performance determine the future? The "random walk" theory of markets says that if prices are random, then nothing can predict them. But prices are not random. Prices are based on calculated value modified higher or lower by human perceptions of value. Calculated value changes in predictable ways based on the economy and the individual company. Perceived value also changes in predictable ways.

It cannot be calculated how perceptions will change, but they can be measured based on current buying and selling in the market. Buying and selling leave measurable footprints on the charts, and because humans tend to do similar things given similar circumstances, it can be forecasted what the market, as the sum of all humans participating, will do next.

It is not the past action of stocks that is used to predict the future. Rather, it is the form and extent of current trading and the time-tested knowledge of what people have done after similar patterns in the past that determine supply and demand. This allows prices to be forecast.

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