The Wyckoff and Lowry Methodologies: A More In-Depth Look
Richard D. Wyckoff, in his studies, set out to dispel the common belief that the stock market is a complex machine. This perception of complexity largely evolves from fundamental analysis, which requires the deciphering of dense and often verbose earnings and annual reports, among other things, in order to assess the probable fair value of a company. In contrast, technical analysis, the Wyckoff and Lowry Methods in particular, uses readily available data of a stock's own price action and volume to form logical assessments of market conditions.
The Wyckoff Method
The foundation of the Wyckoff Method of stock market analysis consists of three basic principles: The Law of Supply and Demand, The Law of Cause and Effect, and The Law of Effort vs. Result. It is a common misconception that because for every buyer in the market there is a seller, the Law of Supply and Demand does not apply to equities. To the contrary, the buyer and seller involved in every trade have different objectives, thereby causing Supply/Demand imbalances. For example, if an investor is holding shares of stock and wants to sell them, and is willing to accept a price lower than a previous seller of the stock in question, the price will fall. Simply stated, when Supply is greater than Demand, prices will fall, and when Demand is greater than Supply, prices will rise. The Supply/Demand relationship can be monitored by watching price and volume using a simple bar chart.
The Law of Cause and Effect deals with determining the degree or "effect" of an upcoming price move based on prior price action termed the "cause." For an effort to manifest itself in the form of a change in price, there must first be a cause. The Law of Cause and Effect moves hand-in-hand with the Law of Supply and Demand, with Demand representing a period of accumulation within a trading range and Supply representing a period of distribution over a similar period of consolidation. The effect realized by a cause, or period of accumulation or distribution, will be in direct proportion to that cause. Point and figure chart counts are used in the Wyckoff Analysis to measure a cause and project the likely extent of the subsequent effect.5
The Law of Effort vs. Result brings volume into the analysis process. Although price is often thought to be the key component in technical analysis, the volume behind price action is just as, if not more, important than the price action itself. Divergences between price action and volume often signal trouble. Specifically, when the amount of effort (volume) and extent of the result (price action) are not in sync, positions should be protected against a potential reversal of trend.6
Using a combination of these three basic principles, various stages of the formation of major market tops and major market bottoms can be identified, with the objective to allow the investor to enter the market in early stages of an important move higher or exit the market and perhaps enter the short side in the early stages of a major market decline. By capturing the "meat" of major market trend and exploiting the direction of that trend, investors can reap superior returns in their investment portfolios.
The Lowry Analysis
Few investors ever buy or sell a stock because of what they know about it. It is what they think will happen to it that causes them to act. Traders and investors are constantly trying to anticipate and discount the future with the objective of realizing profits at some later date. Their conclusions could be based on many factors including estimated earnings, taxes, interest rates, inflation, news events, economic conditions, or just plain hunches. The end result is that some buy, thinking the stock price will advance. Others sell, believing prices will be lower in the course of time. Some will be right, and some will be wrong because the market trend cannot simultaneously proceed in both directions. In the final analysis, the market can only be expected to move in the direction of the greatest money influence.7
It has already been noted that the relationship between the total buying desire and the total selling desire determines the direction of the trend, and these two desires can be factually measured using four basic calculations:
- Total point gains for stocks closing higher on the day
- Total volume for all stocks closing higher on the day
- Total point losses for all stocks closing lower on the day
- Total volume for all stocks closing lower on the day
These four essential tabulations, which are factual and unbiased, provide the statistical foundation for the Lowry Analysis. These metrics are also the foundation for the two indicators Lowry Research Corporation is most known for, the Buying Power and Selling Pressure Indexes. It is the trends of these two indicators that help determine the intermediate-term trend of the broad market.
Buying Power is an intermediate to longer-term measurement of the effect buyers are producing (Demand), as evidenced by the gains and volume registered by advancing stocks. Buying Power is a multiple-time-period index which, in its final construction, not only takes into account the number of stocks registering advances, but includes and evaluates such upside action both in terms of actual points gained and related upside volume. The average time period for its several components is approximately 50 trading days. Selling Pressure is Lowry's principal measure of the intermediate to longer-term trend of the force of Supply. It is computed in the same manner as the Buying Power Index but is constructed from the actions of declining stocks in terms of points lost and downside volume.8
The Buying Power and Selling Pressure Indexes act as leading indicators for the actions of the broad market, and the trends of these indicators can be used to identify the various stages of bull and bear markets. For example, in the strongest stage of a bull market, Buying Power will steadily rise while Selling Pressure steadily falls. Then, as the uptrend enters its latter stages, Selling Pressure will establish an uptrend, reflecting the increased profit taking that tends to occur as a bull market matures and a major topping formation begins. As the major top forms, the uptrend in Selling Pressure will eventually be joined by a turn lower in Buying Power, reflecting distribution and a lack of Demand typically seen in the early stage of a new bear market. Finally, as the bear market nears completion, the upward trend in Selling Pressure will start to wane and fail to confirm lows in the market itself, implying that the desire to sell is becoming exhausted.
In the chapters that follow, the melding of the Wyckoff and Lowry methodologies to identify major market bottoms and major market tops is presented using numerous examples dating as far back as 1966. Some supplementary indicators are also presented in the analysis in an effort to refine even further the ability to identify major market trends and turning points.