Author: shyam

Cover via Amazon

This is a review of the second chapter of John J. Murphy’s Technical Analysis of the Financial Markets.

Dow Theory

Most of what we call technical analysis today has its foundations in what Charles Dow proposed around the turn of the 19th century. His primary goal was to predict the course of the economy by looking at the stock market index he had created.

Basic Tenets

The averages discount everything

The sum of the transactions of the stock exchange represent the sum of all Wall Street’s knowledge of the past, present and distant, applied to the discounting of the future. The markets reflect every knowable factor that affects over all supply and demand.

The market has three trends

A trend has three parts:

• primary (tides)
• secondary (waves)
• minor (ripples)

The direction of a tide can be determined by noting the highest point reached by successive waves. When the highpoint of each successive wave recedes, the tide has turned out and is ebbing. Dow opined that market tides last for more than a year and typically run for several years.

The secondary trends last three weeks to three months. These intermediate corrections retrace 1/3^rd to 2/3^rds of the previous trend movement and most frequently about 1/2 of the previous move.

The minor trends last for less than three weeks and represent fluctuations in the intermediate trend.

Major trends have three phases

Major trends go through distinct phases:

1. accumulation: when informed buyers accumulate the stock
2. public participation: when technical trend followers start buying
3. distribution: when newspapers start printing the bullish case and informed buyers begin to “distribute”

This is similar to the Elliot Wave Principle we discussed earlier.

The averages must confirm each other

Dow would look for confirmation of a bull or bear signal from both the Industrial and Rail Averages.

Volume must confirm the trend

Volume should expand or increase in the direction of the major trend.

In a major uptrend, volumes increase as prices move higher and decrease as prices fall. In a downtrend, volumes increase as prices fall and decrease as prices rise.

A trend is assumed to be in effect until it gives definite signals that it has reversed

Newton’s law of motions: inertial drives trends.

Conclusion

Dow relied exclusively on closing prices. He believed that averages had to close higher than the previous peak or lower than the previous trough to have significance.

From 1920 to 1975, Dow Theory signals captured 68% of the moves in the Industrial and Transportation Averages and 67% of those in the S&P 500 index. An understanding of the Dow Theory provides a solid foundation for further studies in technical analysis.

This is the review of the first chapter of John J. Murphy’s Technical Analysis of the Financial Markets.

Philosophy of Technical Analysis

Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.

It is based on the rationale that:

1. Market action discounts everything. Anything that can possible affect the price – fundamentally, politically, psychologically, or otherwise – is actually reflected in the price.
2. Prices move in trends. The purpose of charting price action is to identify and follow trends. Once a trend is setup, it is more likely to continue than to reverse.
3. History repeats itself. Much of technical analysis is based on the study of human psychology, which tends not to change. The key to understanding the future lies in a study of the past.

Market price tends to lead the known fundamentals. Fundamental analysis is more of an explanation of why the price action occurred while technical analysis tries to predict that price action.

Technical analysis is rooted in statistics. It is a combination if descriptive statistics (graphical representation of data: a candlestick chart, for example) and inductive statistics (generalizations or predictions extrapolated from that data: indicators, for example).

Stay tuned for more!

I had done a chapter wise review of Tony Plummer’s Psychology of Technical Analysis a few months ago. Given the amount of interest it generated, I’ve decided to take a crack at reviewing the mother of all Technical Analysis books: John J. Murphy’s Technical Analysis of the Financial Markets.

Here’s how Amazon.com describes the book:

This outstanding reference has already taught thousands of traders the concepts of technical analysis and their application in the futures and stock markets. Covering the latest developments in computer technology, technical tools, and indicators, the second edition features new material on candlestick charting, inter-market relationships, stocks and stock rotation, plus state-of-the-art examples and figures. From how to read charts to understanding indicators and the crucial role technical analysis plays in investing, readers gain a thorough and accessible overview of the field of technical analysis, with a special emphasis on futures markets.

I suggest you get your copy today and join me on this journey toward a better understanding technical analysis!

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