[Shaw] Success in the stock market comes by minimizing risk. But, unfortunately, many look at the market from the viewpoint of reward only, sometimes taking unnecessary risk to achieve it. Buying a stock with apparent strong fundamentals and little regard for the stock's technical position can easily result in a quick loss. Many stocks can "top-out" when, as the saying goes, "business couldn't be better". On the other hand, undue risk is also taken when making a commitment strictly on technical grounds. Many good-looking stocks have fallen out of so-called base formations due to an unexpected poor earnings report. Therefore it seems logical that a combination of both types of securities analysis should result in better decision making and the results that follow. Since technical analysis is primarily a timing tool, it could be said that fundamental analysis represents the "what" input, while technical analysis is the "when". (Warren Buffet had noted as early as in 1966: "The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right", oded)

Cutting losses short is crucial for long-term investment success. We have often referred to a simple philosophy whereby we look at our decision making as an exercise that can result in only one of five eventual outcomes. We can experience an unchanged position, a large profit, large loss, small profit, or a small loss. If we can possibly eliminate one of these outcomes, obviously the large loss, then we are merely left with the other four. Over a number of years the small profits, losses and unchanged positions will "offset" each other. Therefore we are left with the enjoyment of occasionally booking the large profit. Many technical methods can be employed as long-term disciplines to guard against the large loss. We are sure that other analytical inputs can be loss-inhibiting procedures as well, but the author believes the technical approach seems to lend itself quite readily to such an application.

Technical analysis is based upon the study of supply and demand, or the price movements within the general stock (or other) market's framework. Although the market is, of course, concerned with day-to-day business developments and worldwide news events, it is primarily concerned with future expectations. In this regard, the market is therefore looked at as more of a barometer than a thermometer. Specifically, it has not been uncommon to witness a stock rising in a viable uptrend when current news concerning the company is not all that positive. By the same token, one can witness a stock initiate a major downtrend while earnings are most favorable. To carry our thesis a step further, it would be most uncommon to witness a stock begin a major upside just before earnings start to deteriorate. The reverse oddity would occur if a stock commenced a major downtrend just before earnings began to show substantial recovery.

The technical study of price in evaluating the force of supply and demand does not immediately presents the reason why a trends exists. Since the market is a discounting mechanism, those reasons are unlikely to clearly emerge until many months, even years, later (Historically, the equity market tends to lead, improving in advance of the economy. Over the past 80 years, the Dow Jones Index has bottomed from 3 to 9 months ahead of an economic recovery. The average lead time for the Dow to turn up before the end of recessions has been 5.2 months).

Let us review what we consider to be the three basic and necessary assumptions regarding technical analysis:

Assumption 1: In Price there is Knowledge
The market and/or an individual stock acts like a barometer rather than a thermometer. Events are usually discounted in advance with movements likely the result of "informed" (not to be confused with an insider) buyers and sellers at work. We should never forget, as we explore the technical implications of market analysis, that the price formations or patterns (as they are called by some) that evolve due to supply/demand behavior are, for the most part, the result of fundamentalists, speculators, technicians, or whomever, putting their money to work based upon their established convictions. Market (and stock) tend to move to extremes in a psychological sense. On one end, you have "greed", which is normally associated with a top (nobody left to buy), while on the other extreme you have "fear" (nobody left to sell). One technical theory that we have supported concerns the "five-leg" pattern associated with a major trend, up or down. As the discounting mechanism matures, and more believers emerge to support a major trend, eventually the above extremes are reached. Figure 1 attempts to portray the discounting scheme. At first, as the stock begins to climb, the advance is fraught with skeptics abounding. We call this the disbelief phase (Leg 1). Profit taking develops (Leg 2), which in turn is followed by another upturn (Leg 3). By now future fundamental improvement may be more widely accepted (function of stock price?). We call this the belief leg. Another correction occurs (Leg 4) which is then followed by the "everyone's-got-to-own-it" stage (greed - Leg 5). A major bear trend develops most often with the opposite psychological implications. The stock tops out when the fundamentals look good, and begins a serious break which is not recognized by most as a new bear market (disbelief). After a brief rally, a renewed trend of deterioration commences, breaking the prior lows, and possibly accompanied by the first tangible signs of fundamental (earnings) deterioration (belief). The belief phase is finally a call to action - a recognition of risk and a reversal of the immobilizing "deer frozen in the headlight" disbelief phase. As the "belief" spreads, more and more investor participants begin to take serious action to preserve capital, and remaining positions are sold. Recognized losses are offset by profit taking anywhere that gains remain in place, putting all equities at risk of absolute price decline (including those that have heretofore outperformed). Usually, this stage will be expressed in media views like, "this is the worst bear market in a generation". This belief phase brings the structural bear market a step closer to its ultimate low. But there is one final, third, phase on the way down. That is the counterpart to the third and final phase on the way up, the "greed" phase, for the structural bull trend - after another short interim rally, the stock breaks down again, instituting the fear syndrome (Leg 5). The common experience is that of capitulation, when "the baby is thrown out with the bath water" in a final fury of selling (margin calls could very well play a role in such a trend, where stock is sold to meet equity requirements). The fear phase generally incorporates the final low (the first segment of the bear trend) and allows the initiation of the second segment - the "repair" years.

Assumption 2: Accumulation precedes uptrends & Distribution precedes downtrends
This assumption should not be too difficult to understand or accept as it deals with basic stock market dynamics or the law of supply and demand. First, we should define the terms that are used. We know there is a buyer for every seller of stock. But one of these forces is usually stronger or more influential - especially in the long run. For instance, if 50,000 shares of stock were to change hands on a downtick trade, especially with a concession representing a large spread from the last sale, we would consider that the seller was a stronger influence that the buyer. For, if a buyer (or buyers) were all that anxious to purchase the stock, it would be logical to expect that the trade would have taken place with little or no concession of price at all. In periods of a more vibrant market atmosphere, a trade would, in all likelihood, occur on an uptick. A major concession in price on a large block trade is usually looked upon as evidence of distribution, and it can be a sign of the stock moving from strong to weak hands. Accumulation by definition occurs when a stock moves from weak to strong hands or, more importantly when supply is eliminated from the marketplace. Such a trade could take place on an uptick in price. Our second assumption reads: before a stock experience a markup phase, whether it be minor or major, a period of accumulation usually will take place. Conversely, before a stock enters into a major or minor downtrend, a period of distribution usually will be the preliminary occurrence. Accumulation or distribution can occur within neutral trading trends. Accumulation is often referred to as the building of a "base", while a trend of distribution is also call a "top". Obviously an uptrend in prices denotes on-balance buying, while a downtrend is indicative of extreme supply. The ability to analyze accumulation or distribution within neutral price patterns is a price technical challenge. It can allow a technician to anticipate a move, rather than wait to react to a "breakout".

Assumption 3: The Bigger the Base, the Higher in Space...
This third assumption is tied into the first two discussed. It is an observation that can be readily made by any student willing to expend the time and effort. It deals with the scope and extent of market movements in relation to each other. As an example, in most cases, a short phase of stock price consolidation - or backing and filling - will be followed by a relative short-term movement, up or down, in the stock's price. On the other hand, a larger consolidation phase can lead to a greater stock price move. Figure 2 should aid in the understanding of this assumption. In Example A, the minor downtrend movement in price was followed by a short-term consolidation phase before the stock began to move up once again. In Example B, however, the downside adjustment was somewhat more severe than in the former case and thus the consolidation pattern was slightly longer in perspective. Example C is an extreme, reflecting a major downward trend. Simply stated, when the bulldozer, crane, steel ball, and wrecker visited this scene, it took longer for the masons, plumbers, carpenters, and electricians to accomplish their rebuilding process (see also end note *, oded); the consolidation pattern was of longer duration. Assumption 3 therefore states: Usually, movements in the market tend to have a relationship to each other - "the bigger the base, the higher in space; the bigger the top, the bigger the drop; and the bigger the drop, the longer the need for repair".

* Why does it take so long to rebuilt the damage? Arnold Van den Berg of Century Management explains the fundamental basis of Shaw's observations, as follows: Rebuilding takes so long because debt has to be liquidated and paid off, companies have to be restored and the excess capacity that was built up, has to be used up. So it takes many years, when you have bubbles, to bring things back.

Smoke and Mirrors? Charting and Technical Analysis
Both the anecdotal and the empirical evidence seem to suggest that investors often are irrational, at least based upon the economic definition of rationality. Consolidating all of the irrationalities that have been attributed to financial markets, we have created five groupings:
1) Market participants over react to new information.
2) Market participants are slow learners.
3) Investors change their minds frequently and often irrationally, causing significant shifts in demand and supply, causing prices to move.
4) There are a group of investors who lead markets, and finding out when and what they are buying and selling can provide a useful leading indicator of future price movements.
5) There are external forces that govern up and down movements in markets that override fundamentals and investor preferences.

If we were to summarize the assumptions that underlie technical analysis, we would list the following:
1) Market value is determined solely by the interaction of supply and demand.
2) Supply and demand are governed by numerous factors, both rational and irrational. The market continually and automatically weighs all these factors.
3) Disregarding minor fluctuations in the market, stock prices tend to move in trends that persist for an appreciable length of time.
4) Changes in trend are caused by shifts in demand and supply. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself. This is at the core of technical analysis. Charts, the believers argue, send advance warning of shifts in demand and supply in the form of price and volume patterns.

Charting and Technical Analysis, Damodaran
The Basis for Price Patterns: 1. Investors are not always rational in the way they set expectations. These irrationalities may lead to expectations being set too low for some assets at some times and too high for other assets at other times. Thus, the next piece of information is more likely to contain good news for the first asset and bad news for the second. 2. Price changes themselves may provide information to markets. Thus, the fact that a stock has gone up strongly the last four days may be viewed as good news by investors, making it more likely that the price will go up today then down".

The Mechanisms of Market Inefficiency: An Introduction to the New Finance, STOUT, 2004
"During the 1970s and early 1980s, the Efficient Capital Market Hypothesis (ECMH) became one of the most widely-accepted and influential ideas in finance economics. More recently, however, the idea of market efficiency has fallen into disrepute as a result of market events and growing empirical evidence of inefficiencies. This Article argues that the weaknesses of efficient market theory are, and were, apparent from a careful inspection of its initial premises, including the presumptions of homogeneous investor expectations, effective arbitrage, and investor rationality. By the same token, a wide range of market phenomena inconsistent with the ECHM can be explained using market models that modify these three assumptions. In illustration, this Article explores three important strands of today's finance literature: (1) the expanding body of work on asset pricing when investors have heterogeneous expectations; (2) recent theoretical and empirical scholarship on how and why arbitrage may move certain types of publicly available information into price more slowly and incompletely than earlier writings suggested; and (3) the exploding literature in behavioral finance, which examines what happens to prices when market participants do not all share rational expectations. Taken together, these three bodies of work show signs of providing the essential framework on which can be built a new and more powerful working model of securities markets".

Stock trade patterns could predict financial earthquakes, MIT News, 2003
Large-scale events in the stock market adhere to distinct patterns. The patterns found by the scientists are "power laws", which describe mathematical relationships between the frequency of large and small events. In short, the scientists have shown that stock markets have a mathematical elegance frequently found in natural systems. "We have found that the artificial world of the financial markets follows a pattern similar to one found in our natural world. Trading on the stock market has a lot of randomness, but at the end of the day you find that a pattern emerges that matches power-law patterns found empirically in data from systems as diverse as earthquakes and human language. The scientists show that--for the market as a whole and for an individual stock--the daily volume of stocks traded, number of trades and price fluctuations follow power laws. For example, the number of days when a particular stock price moves by 1 percent will be eight times the number of days when that stock moves by 2 percent, which will in turn be eight times the number of days when that stock moves by 4 percent, which will in turn be eight times the number of days that stock moves by 8 percent, and so on". see the Nature article