Technical Analysis Explained

by Martin J Pring

  Major Technical Principle Reversals in the direction of the discount rate offer reliable signals of primary trend reversals in short-term interest rates.

  Effect on Short-Term Rates Market rates usually lead the discount rate at cyclical turning points. In 2003, the Fed changed the basis on which the discount rate was offered. Consequently, the series plotted in Chart 31.6 represents the post-2003 data spliced to the originally reported series.

  CHART 31.6 3-Month Commercial Paper Yield, 1970–2012, and the Adjusted Discount Rate

  The objective of the chart is to show that a discount rate cut after a series of hikes acts as confirmation that a new trend of lower rates is under way. The same is true at cyclical or primary-trend bottoms. It is often a good idea to monitor the relationship between the discount rate and its 12-month MA because crossovers almost always signal a reversal in the prevailing trend at a relatively early stage, as flagged by the arrows.

  Effect on the Stock Market Since the incorporation of the Federal Reserve System, every bull market peak in equities has been preceded by a rise in the discount rate, with the exception of the Depression, the war years of 1937 and 1939, and more recently, 1976. The leads have varied. In 1973, the discount rate was raised on January 12, 3 days before the bull market high, whereas the 1956 peak was preceded by no fewer than five consecutive hikes.

  There is a well-known rule on Wall Street: Three steps and stumble! The rule implies that after three consecutive rate hikes, the equity market is likely to stumble and enter a bear market. The “three steps” rule is, therefore, a recognition that a significant rise in interest rates and tightening in monetary policy have already taken place. Table 31.1 shows the dates when the discount rate was raised for the third time, together with the duration and magnitude of the subsequent decline in equity prices following the third hike.

  TABLE 31.1 Discount Rate Highs and Subsequent Stock Market Lows, 1919—2012

  Cuts in the rate are equally as important. Generally speaking, as long as the trend of discount rate cuts continues, the primary bull market in stocks should be considered intact. Even after the last cut the market usually possesses enough momentum to extend its advance for a while. Quite often, the last intermediate reaction in the bull market will get underway at the time of or just before the first hike.

  Most of the time, the cyclical course of discount rate cuts resembles a series of declining steps, but occasionally it is interrupted by a temporary hike before the downtrend continues. The discount rate low is defined one that occurs after a series of declining steps has taken place, and that either remains unchanged at this low level for at least 15 months or is followed by two or more hikes in 2 different months. In other words, if the series of cuts is interrupted by one hike, the trend is still classified as downward unless the rise occurs after a period of 15 months has elapsed. Only when two hikes in the rate have taken place in a period of less than 15 months is a low considered to have been established. Since the data are available for almost 100 years, they cover both inflationary and deflationary periods and are, therefore, reflective of a number of different economic environments.

  Table 31.2 shows that there have been 17 discount rate lows since 1924. On each occasion the market moved significantly higher from the time the rate was cut.

  TABLE 31.2 Discount Rate Lows and Subsequent Stock Market Highs, 1924—2012

  A discount rate cut is only one indicator, and while it is invariably bullish, the overall technical position is also important. For example, the low in the discount rate usually occurs just after the market has started a bull phase. If the market is long-term overbought, the odds that the ensuing rally will obtain the magnitude and the duration of the average are slim. It should also be noted that while each discount rate low has ultimately been followed by a bull market high, this by no means excludes the risk of a major intermediate correction along the way. Such setbacks occurred in 1934, 1962, and during 1977–1978 and 1998. In the 1977–1978 period the market as measured by the NYSE A/D line did not correct, but moved irregularly higher. Chart 31.7 shows the relationship between the equity market and the discount rate for the decades spanning the turn of the century.

  CHART 31.7 S&P Composite, 1970–2012, and the Adjusted Discount Rate

  While cuts in the discount rate usually precede market bottoms, this relationship is far less precise than that observed at market tops. Note, for example, that the rate was lowered no fewer than seven times during the 1929–1932 debacle, whereas it was not changed at all during the 1946–1949 bear market.

  Applying Technical Analysis at the Long End

  Bond yield series tend to be very cyclical. We can take advantage of this situation by comparing a series such as Moody’s AAA corporate bonds to an ROC. An example is shown in Chart 31.8, where the arrows show that overbought/oversold crossovers of the 12-month ROC have consistently flashed excellent buy and sell signals. This approach cannot be used as an actual system because offsetting signals may not be given. For example, during the 1940–1981 secular or very long-term uptrend, no buy signals were given between the 1950s and 1981. This contrasts to the post-1981 secular downtrend where several buys were triggered. It is a classic example of how oscillators tend to move and stay at overbought levels during a bull market and reverse the process during bear markets. In this case, the bull market was the secular trend and the overbought readings representedprimary trend peaks.

  CHART 31.8 Moody’s AAA Corporate Yield, 1955–2012, and a 12-Month ROC

  Chart 31.9 expresses a similar idea, except that this time the oscillator is a short-term one, an 8-day MA of a 9-day relative strength indicator (RSI). The arrows above the yield show the primary trend environment. You can see quite clearly that overbought conditions are far more common in the bull phase and oversold during the bear trends. Note also that the 200-day MA can serve as an additional arbitrator of the direction of the primary trend. At the tail end of the chart the oscillator reaches an overbought condition and the yield crosses above its MA, suggesting the probability that a new bull market is under way.

  CHART 31.9 The 30-Year Government Bond Yield, 1997–2001, and a Smoothed RSI

  Finally, Chart 31.10 compares a perpetual contract of the U.S. Treasury bond futures against two ROC indicators. Between the opening of the year 2000 and the end of the chart, the primary trend was bullish. The four arrows attached to the 10-day ROC indicate oversold or close to oversold conditions. Each was followed by a worthwhile rally. The ellipse in the furthest right part of the chart indicates a failure to respond to an oversold condition and offers the first hint that a new bear market has begun. Several joint trendline breaks in the price and momentum are also indicated on the chart. The adoption of this combination is quite useful because the 10- and 45-day spans are separated by a considerable distance. In this way characteristics not shown by the 10-day series may show up in the 45-day one and vice versa. Of course, it’s even better when all three are indicating a trend reversal, as was the case in April 2000.

  CHART 31.10 The 30-Year Government Bond Yield, 1999–2001, Two ROC’s

  Summary

  1. Interest rates influence stock prices because they affect corporate profitability, alter valuation relationships, and influence margin transactions.

  2. Interest rates have led stock prices at major turning points in virtually every recorded business cycle.

  3. It is the ROC of interest rates, rather than their actual level, that affects equity prices.

  4. Short-term interest rates generally have a greater influence on stock prices than long-term ones.

  5. Changes in the trend of the discount rate offer strong confirmation that a primary trend change in money-market prices has taken place.

  6. Reversals in the trend of the discount rate offer early bird warnings of a change in the primary trend of stock prices.

  32 USING TECHNICAL ANALYSIS TO SELECT INDIVIDUAL STOCKS

  A useful systematic approach for stock selection is what is
known as the top-down approach. In this case, the “top” represents an analysis of whether equities in general are experiencing a primary bull or bear market. Since most equities rise during a bull trend and decline during a bear trend, the first step establishes whether the overall environment is likely to be positive or negative.

  The next involves an appraisal of the various sectors and below them, industry groups, since equities in the same industry generally move together, as do industry groups in their sector. Once an attractive industry group has been isolated, the final stage involves the selection of individual stocks. This approach is discussed later, but first, some general observations.

  All investors and traders would like their selections to appreciate rapidly in price, but stocks that may satisfy this wish tend to be accompanied by a substantially greater amount of risk than most of us are willing to accept. Stocks that move up sharply in price usually have a high beta (i.e., they are very sensitive to market movements), a very small float (i.e., are illiquid and very price sensitive to a small increase in volume), or a very strong earnings momentum, resulting in constant upward revisions in the price/earnings multiple. Others may be experiencing a turnaround situation in which the price has fallen to unrealistically low levels so that the slightest good news has an explosive effect on the price.

  These are all fundamental factors and really fall outside the scope of this book. However, it is important to understand that investors can be very fashion conscious when it comes to stock ownership. After prices have been bid up to unrealistically high levels and the media are covering positive developments in cover stories, major articles, etc., the chances are that the bullish arguments are understood by virtually all market participants. At this point, effectively everyone who wants to buy has already done so and the stock is said to be overowned. This happened to the pollution control group (waste management) in the late 1960s, the so-called glamour growth stocks in 1973, the oils in 1980, and technology in the spring of 2000. When the news is so bad that it appears that profits will never recover, or that the company might file for bankruptcy, the opposite condition sets in and the stock is said to be underowned. Real estate investment trusts in 1974, tire stocks in 1980, and financials in 2009 are examples of underownership. Not all companies move to such extremes, but it is important to recognize that this psychological pendulum nevertheless exists.

  A position of overownership usually develops over several major advances after a secular rise. Similarly, a position of underownership, in which a stock becomes totally out of fashion, usually takes many years to evolve.

  Stock Selection from a Secular Point of View

  General

  It makes sense to start off with a very long-term or secular point of view, gradually working down to the short-term aspects. Ideally, the selection process should begin by determining whether the stock in question is in a secular advance or decline in order to gain some idea of where it might be in its ownership cycle. Chart 32.1 shows Cominco, a Canadian mining company, that went through many cycles between the 1970s and the turn of the century. Stocks in resource and basic industries such as Cominco are called cyclical stocks since they offer great profit opportunities over one or two business cycles but are rarely profitable using the buy-hold approach.

  CHART 32.1 Cominco, 1970–2001

  Because of the long-term growth characteristics of the global economy, most stocks exhibit characteristics of a long-term secular advance interrupted by mild cyclical corrections or multiyear trading ranges.

  An example is shown in Chart 32.2, featuring Coca-Cola. A couple of secular trends are evident. The termination of the first was signaled by a joint trendline break in the price and the relative strength (RS) line in 1999. Note this was preceded with a negative divergence where the price touched a new high but the RS line did not. The second was a sideways trading range for the ensuing 13 years. The direction of the ultimate breakout may well be signaled by the RS line.

  CHART 32.2 Coca-Cola, 1980–2012, and Relative Strength

  All the RS lines in this chapter are relative to the S&P Composite unless otherwise stated. I have incorporated them into most of the charts in this chapter for two reasons. First, RS trends and divergences can be very helpful in understanding the strength or weakness in the underlying technical structure. Second, when a stock is purchased, it is far better for it to be in a trend that is outperforming than underperforming the market. Chart 32.3 offers a classic example of this.

  CHART 32.3 Reliant Energy, 1980–2001, and Relative Strength

  During the 20-year period covered by the chart, Reliant Energy was in a secular uptrend. This looked good on the surface, but a quick glance at the RS line indicates that it was in a secular downtrend in terms of relative performance. Note that it was possible to construct two trendlines for the price. The dashed one is an extremely good example of why it is a smart idea to extend a trendline once it has been violated. Note how the extended line became formidable resistance several times in the mid-to-late 1990s. Even when the price broke above the line at the turn of the century, the retracement move found support there.

  Finally ADM experienced a secular break to the downside in 1998 (Chart 32.4). Its RS line also completed a downward head-and-shoulders top. Note that in ADM’s case, advance warning of potential weakness was given first by the failure of the RS line to confirm the new high in the price in 1995 (at the tip of the horizontal arrow) and then to diverge negatively with the late-1997 high.

  CHART 32.4 ADM, 1980–2001, and Relative Strength

  These examples point up the differing life cycles and characteristics of individual stocks. Investors who are able to identify secular trend reversals in price and relative action are in a position to profit from extremes in the ownership cycle. Consequently, a very long-term chart can provide a useful starting point for stock selection.

  Major Price Patterns (Long Bases)

  In Chapter 8, the relationship between the size of the formation and the ensuing price move in both terms of magnitude and duration was established. The bigger the base, the further they can race! Or the greater the top, the more they’ll drop!

  By definition, there are few points in a stock’s lifetime where this condition is prevalent, but when it can be spotted, it is well worth while taking action based on this information. Sometimes, as in the 1940s and the 1982–1983 period, for example, there are an unusually large number of such issues breaking out of large bases. The more this is so, the stronger the foundation for the next bull market. The 1940s were followed by the very strong 1950s and early 1960s, and the 1982 low was followed by the 18-year secular bull, with its final top in early 2000.

  Chart 32.5 shows an example for Andrew Corp. breaking out from a 6-year base in 1991. A good rally, more than meeting the objective of the pattern, followed. Later on, the joint penetration of 6-year up trendlines indicated that the strong advance was unlikely to continue. In the case of the price, this was followed by a consolidation, and for the RS line, an actual trend reversal.

  CHART 32.5 Andrew Corp, 1980–2001, and Relative Strength

  Applied Materials experienced a breakout from a 10-year base (Chart 32.6) in late 1992. The uptrend in the price continued until at least the spring of 2001, but the RS up trendline was temporarily violated in 1998 and 2000.

  CHART 32.6 Applied Materials, 1980–2001, and Relative Strength

  Large tops are, of course, the opposite of large bases, and we see one such animal in Chart 32.7 featuring Coeur D’Alene Mines. Interestingly, a clue of impending weakness was given by the persistent decline in the RS line. That’s not always the case, because it has been known for RS trends to reverse to the upside during the formation of a trading range. However, in this case, there was no indication whatsoever that the fortunes of the RS line was about to change for the better until well after the downside price break.

  CHART 32.7 Coeur D’Alene, 1980–2012, and Relative Strength

  Compare that example to Chemed
in Chart 32.8. Once again we see a multiyear trading range in the form of a consolidation reverse head-and-shoulders pattern. Throughout the formation of the range, the RS line was in a clear-cut downtrend, leaving the impression that the pattern would break to the downside. Then, as the right shoulder was forming, the RS line violated a 4-year (dotted) down trendline and started to rally at a more accelerated rate than the price. At the time of the breakout, the RS line was well below its late-1982 high, but had already violated a 20-year (solid) down trendline, thereby supporting the breakout by the price which developed in late 2003.

  CHART 32.8 Chemed Ordinary, 1980–2012, and Relative Strength

  Some Basic Principles of Stock Selection During a Primary Bull Market

  General

  A bull market has been defined as an environment when most stocks are moving up most of the time for an extended period. In this case, the extended period should be expected to last between 9 months and possibly as long as 2 to 3 years. A bear market is exactly the opposite, except the average bear market typically unfolds over a shorter period. When exposure to equities is being contemplated, it is clearly better for both investors and short-term traders with a 2- to 3-week horizon to be buying when the primary trend is positive. It is true that some stocks experience primary bull trends when the overall market is in a primary bear trend, but the law of probability indicates that it is much more difficult to make money when swimming against an overall negative environment. We must also bear in mind, of course, that because of the group rotation process, different stock groups are experiencing different phases of their bull and bear cycles simultaneously. Thus, while the S&P, for instance, may have just embarked on the first downleg of a new bear market, lagging groups, such as mines, may still be experiencing the final leg of their bull market. The selection process at this stage of the cycle is much more difficult, but there are still some opportunities offering substantial upside magnitude at this juncture. A lot will depend on whether commodities are in a secular bull or bear market. If it’s a bull trend, the inflationary part of that specific business cycle associated with the trend will generally experience greater magnitude and duration.