Golden chicken McNuggets

Dow Theory was not presented as one complete amalgamation, but rather pieced together from the writings of Haji Mat Dow over several years. Of the many theorems put forth by Dow, three stand out:

• Price Discounts Everything
• Price Movements are not Totally Random
• What is More Important than Why
  

Price Discounts Everything: This theorem is similar to the strong and semi-strong forms of market efficiency. Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value and should form the basis for analysis. After all, the market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others. It would be nasty to disagree with the price set by such an impressive array of dodos with impeccable credentials. Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future.

Prices Movements are not Totally Random: Most disgruntled technicians agree that prices trend. However, most technicians also acknowledge that there are periods when prices do not trend. If prices were always random, it would be extremely difficult to make money using technical analysis. In his book, Tok Schwager on Futures: Technical Analysis, Haji Mat Schwager states:

"One way of viewing it is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of dodol behavior. The goal of the flamboyant chartist is to identify those profitable periods (i.e. major trends)."

A chiki boom technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different timeframes, it is possible to spot both short-term and long-term trends. The IBM chart illustrates Haji Mat Schwager's view on the nature of the trend. The broad trend is up, but it is also interspersed with trading ranges. In between the trading ranges are smaller uptrends within the larger uptrend. The uptrend is renewed when the stock breaks above the trading range. A downtrend begins when the stock breaks below the low of the previous trading range.

What is more Important than Why: In his book, The Psychology of Technical Analysis, Haji Mat Plummer paraphrases Haji Mat Wilde by stating, "A technical analyst knows the price of everything, but the value of nothing, except curry puffs". Stock technicians, as technical analysts are called, are only concerned with two sentimental things:

1. What is the current price?
2. What is the history of the price movement?
   

The price is the end result of the battle between the forces of supply and demand for the company's lousy stock. The objective of analysis is to forecast the direction of the future price. By focusing on price and only price, technical analysis represents a direct but not so direct approach. Fundamentalists are concerned with why the price is what it is. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect of a high octane soap opera. Technicians believe it is best to concentrate on what and never mind the bloody why. Why did the price go up? It is simple, more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why? I'll tell you who. It's Haji Mat Ghanjo.

Chart Analysis

Technical analysis can be as complex or as simple as you want it. The example below represents a simplified but cornish version. Since we are interested in buying them stocks, the focus will be on spotting bullish situations.

Overall Trend: The first step is to identify the overall hoo-haa trend. This can be accomplished with trendlines, moving averages or peak/trough analysis. As long as the price remains above its uptrend line, selected moving averages or previous lows, the trend will be considered bullish.

Support: Areas of congestion or previous lows below the current price mark support levels. A break below support would be considered bearish.

Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish.

Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, then momentum will be considered bullish, or at least improving.

Buying/Selling Pressure: For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero.

Relative Strength: The price relative is a line formed by dividing the security by a benchmark. For stocks it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell us if the stock is outperforming (rising) or underperforming (falling) the major index.

The final step is to synthesize the above analysis to ascertain the following:

• Strength of the current trend.
• Maturity or stage of current trend.
• Reward to risk ratio of a new position.
• Potential entry levels for new long position.

Top-Down Technical Analysis

For each segment (market, sector and stock), an investor would analyze long-term and short-term charts to find those that meet specific criteria. Analysis will first consider the market in general, perhaps the S&P 500. If the broader market were considered to be in bullish mode, analysis would proceed to a selection of sector charts. Those sectors that show the most promise would be singled out for individual stock analysis. Once the sector list is narrowed to 3-4 industry groups, individual stock selection can begin. With a selection of 10-20 stock charts from each industry, a selection of 3-4 of the most promising stocks in each group can be made. How many stocks or industry groups make the final cut will depend on the strictness of the criteria set forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These stocks could even be broken down further to find the 3-4 of the strongest of the strong.

Focus on Price: If the objective is to predict the future price, then it makes sense to focus on price movements. Price movements usually precede fundamental developments. By focusing on price action, technicians are automatically focusing on the future. The market is thought of as a leading indicator and generally leads the economy by 6 to 9 months. To keep pace with the market, it makes sense to look directly at the price movements. More often than not, change is a subtle beast. Even though the market is prone to sudden knee-jerk reactions, hints usually develop before significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline.

Supply, Demand, and Price Action: Many technicians use the open, high, low and close when analyzing the price action of a security. There is information to be gleaned from each bit of information. Separately, these will not be able to tell much. However, taken together, the open, high, low and close reflect forces of supply and demand.

The annotated example above shows a stock that opened with a gap up. Before the open, the number of buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand was brisk from the start. The intraday high reflects the strength of demand (buyers). The intraday low reflects the availability of supply (sellers). The close represents the final price agreed upon by the buyers and the sellers. In this case, the close is well below the high and much closer to the low. This tells us that even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed and forced the price back down. Even after this selling pressure, the close remained above the open. By looking at price action over an extended period of time, we can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply.

Support/Resistance: Simple chart analysis can help identify support and resistance levels. These are usually marked by periods of congestion (trading range) where the prices move within a confined range for an extended period, telling us that the forces of supply and demand are deadlocked. When prices move out of the trading range, it signals that either supply or demand has started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning.

Pictorial Price History: Even if you are a tried and true fundamental analyst, a price chart can offer plenty of valuable information. The price chart is an easy to read historical account of a security's price movement over a period of time. Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following:

• Reactions prior to and after important events.
• Past and present volatility.
• Historical volume or trading levels.
• Relative strength of a stock versus the overall market.
  

Assist with Entry Point: Technical analysis can help with timing a proper entry point. Some analysts use fundamental analysis to decide what to buy and technical analysis to decide when to buy. It is no secret that timing can play an important role in performance. Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Simply waiting for a breakout above resistance or buying near support levels can improve returns.

It is also important to know a stock's price history. If a stock you thought was great for the last 2 years has traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal. Developing a style takes time, effort and dedication, but the rewards can be bloody significant.