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Intermediate
trend Minor
trend




Primary trend




F I G U R E 19.2
Dow theory trends
Source: From Melanie F. Bowman and Thom Hartle, “Dow Theory,” Technical Analysis of Stocks and Commodities, September 1990, p. 690.
Bodie’Kane’Marcus: VI. Active Investment 19. Behavioral Finance and © The McGraw’Hill
Essentials of Investments, Management Technical Analysis Companies, 2003
Fifth Edition




662 Part SIX Active Investment Management




F
.....................................................................................................................................................
2180 D
.....................................................................................................................................................
2160
.....................................................................................................................................................
2140
.....................................................................................................................................................
B
2120
.....................................................................................................................................................
2100
.....................................................................................................................................................
2080
.....................................................................................................................................................
2060
.....................................................................................................................................................
2040
.....................................................................................................................................................
2020
.....................................................................................................................................................
2000
.....................................................................................................................................................
E
1980
.....................................................................................................................................................
1960
.....................................................................................................................................................
1940
C
.....................................................................................................................................................
1920
.....................................................................................................................................................
1900
.....................................................................................................................................................
A
1880
Jan. Feb. Mar. Apr. May June July Aug. Sep. Oct. Nov.




F I G U R E 19.3
Dow Jones Industrial Average in 1988
Source: From Melanie F. Bowman and Thom Hartle, “Dow Theory,” Technical Analysis of Stocks and Commodities, September 1990, p. 690.




resistance level because the recent intermediate-trend high price was unable to rise above C.
Hence, piercing the resistance point is a bullish signal.
Technicians see resistance and support levels as resulting from common psychological in-
vestor traits. Consider, for example, stock XYZ, which traded for several months at a price of
$72 and then declined to $65. If the stock eventually begins to increase in price, $72 will be a
natural resistance level because the many investors who originally bought at $72 will be eager
to sell their shares as soon as they can break even on their investment. Therefore, whenever
prices near $72, a wave of selling pressure will develop. Such activity imparts to the market a
type of “memory” that allows past price history to influence current stock prospects.


>
1. Describe how technicians might explain support levels.
Concept
In evaluating the Dow theory, don™t forget the lessons of the efficient market hypothesis.
CHECK
The Dow theory is based on a notion of predictably recurring price patterns. Yet the EMH
holds that if any pattern is exploitable, many investors would attempt to profit from such pre-
dictability, which would ultimately move stock prices and cause the trading strategy to self-
destruct. While Figure 19.3 certainly appears to describe a classic upward primary trend, one
always must wonder whether we can see that trend only after the fact. Recognizing patterns
as they emerge is far more difficult.
Recent variations on the Dow theory are the Elliott wave theory and the theory of Kondrati-
eff waves. Like the Dow theory, the idea behind Elliott waves is that stock prices can be de-
scribed by a set of wave patterns. Long-term and short-term wave cycles are superimposed and
result in a complicated pattern of price movements, but by interpreting the cycles, one can, ac-
cording to the theory, predict broad movements. Similarly, Kondratieff waves are named after a
Russian economist who asserted that the macroeconomy (and therefore the stock market) moves
in broad waves lasting between 48 and 60 years. The Kondratieff waves are therefore analogous
to Dow™s primary trend, although they are of far longer duration. Kondratieff™s assertion is hard
to evaluate empirically, however, because cycles that last about 50 years provide only two full
data points per century, which is hardly enough data to test the predictive power of the theory.
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Essentials of Investments, Management Technical Analysis Companies, 2003
Fifth Edition




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19 Behavioral Finance and Technical Analysis


Other Charting Techniques
The Dow theory posits a particular, and fairly simple, type of pattern in stock market prices:
long-lasting trends with short-run deviations around those trends. Not surprisingly, several
more involved patterns have been identified in stock market prices. If stock prices were to ac-
tually follow any of these patterns, profit opportunities would result. The patterns are reason-
ably straightforward to discern, meaning future prices can be extrapolated from current prices.
A variant on pure trend analysis is the point and figure chart depicted in Figure 19.4. This
figure has no time dimension. It simply traces significant upward or downward movements in
stock prices without regard to their timing. The data for Figure 19.4 come from Table 19.2.
Suppose, as in Table 19.2, that a stock™s price is currently $40. If the price rises by at least
$2, you put an X in the first column at $42 in Figure 19.4. Another increase of at least $2 calls
for placement of another X in the first column, this time at the $44 level. If the stock then falls
by at least $2, you start a new column and put an O next to $42. Each subsequent $2 price fall
results in another O in the second column. When prices reverse yet again and head upward,
you begin the third column with an X denoting each consecutive $2 price increase.
The single asterisks in Table 19.2 mark an event resulting in the placement of a new X or
O in the chart. The daggers denote price movements that result in the start of a new column of
Xs or Os.
Sell signals are generated when the stock price penetrates previous lows, and buy signals
occur when previous high prices are penetrated. A congestion area is a horizontal band of Xs
and Os created by several price reversals. These regions correspond to support and resistance
levels and are indicated in Figure 19.5, which is an actual chart for Atlantic Richfield.
One can devise point and figure charts using price increments other than $2, but it is cus-
tomary in setting up a chart to require reasonably substantial price changes before marking
pluses or minuses.


<
2. Draw a point and figure chart using the history in Table 19.2 with price increments Concept
of $3.
CHECK
Another graphical technique used to summarize price data and aid in the identification of
trends is the so-called candlestick chart, illustrated in Figure 19.6. The box with the vertical
line drawn through it allows the chartist to ascertain the open and close price for the day, as



F I G U R E 19.4
50
Point and figure chart
for Table 19.2
48

46

44

42

40

38

36

34
Bodie’Kane’Marcus: VI. Active Investment 19. Behavioral Finance and © The McGraw’Hill
Essentials of Investments, Management Technical Analysis Companies, 2003
Fifth Edition




664 Part SIX Active Investment Management


Date Price Date Price
TA B L E 19.2
$40*
January 2 $40 February 1
Stock price history
January 3 40.50 February 2 41
January 4 41 February 5 40.50
42* 42*
January 5 February 6
45*
January 8 41.50 February 7
January 9 42.50 February 8 44.50
46*
January 10 43 February 9
January 11 43.75 February 12 47
44*
January 12 February 13 48*
January 15 45 February 14 47.50
46†
January 16 44 February 15
41.50†
January 17 February 16 45
44*
January 18 41 February 19
40* 42*
January 19 February 20
January 22 39 February 21 41
40*
January 23 39.50 February 22
January 24 39.75 February 23 41
38*
January 25 February 26 40.50
35* 38*
January 26 February 27
36†
January 29 February 28 39
36*
January 30 37 March 1
39* 34*
January 31 March 2

*
Indicates an event that has resulted in a stock price increase or decrease of at least $2.

Denotes a price movement that has resulted in either an upward or downward reversal in the stock price.




F I G U R E 19.5 129
128
Point and figure chart
127
for Atlantic Richfield
126
X
X0 X X 125
X0X X 0 X X 0 124
X0X 0 X 0 X 0 X 0
123
X0X 0 X 0 X X 0 X 0
Resistance X0X 0 0 X 0X 0 0 122
Support
X0X 0 X 0X 0 121
0 0X 0
X0
X
120
0X 0
X0 X X
0X
0
X X 0 X 0X 119
0 X0
X 0X 0 X 0 X 118
0 X0
X 0X 0 X 0 X
X 117
00
X X 0 X 0X 0 X 0 X Small Rally
0X

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