What Can Charts Tell You?

What Can Charts Tell You?

The first principle of technical analysis is that all information about earnings, dividends, and the future performance of a company is automatically reflected in the company’s past market prices. A chart showing these prices and the volume of trading already comprises all the fundamental information, good or bad, that the security analyst can hope to know. The second principle is that prices tend to move in trends: A stock that is rising tends to keep on rising, whereas a stock at rest tends to remain at rest.

A true chartist doesn’t even care to know what business or industry a company is in, as long as he can study its stock chart. A charts shaped in the form of an “inverted bowl” or “pennant” means the same for Digital Equipment as it does for MCI. Fundamental information on earnings and dividends is considered at best to be useless – and at worst a positive distraction. It is either of inconsequential importance for the pricing of the stock or, if it is important, it has already been reflected in the market days, weeks, or even months before the news has become public. For this reason, many chartists will not even read the newspaper except to follow the daily price quotations.

One of the original chartists, John Magee, operated from a small office in Springfield, Massachusetts, where even the windows were boarded up to prevent any outside influences from distracting his analysis. Magee was once quoted as saying, “When I come into this office I leave the rest of the world outside to concentrate entirely on my charts. This room is exactly the same in a blizzard as on a moonlit June evening. In here I can’t possibly do myself and my clients the disservice of saying “buy” simply because the sun is out or “sell” because it is raining.

Love and desire are the spirit’s wings to great deeds (Johann Wolfgang von Goethe). Photo by Elena.

You can easily construct a chart. You simply draw a vertical line whose bottom is the stock’s low for the day and whose top is the high. The process can be repeated for each trading day. It can be used for individual stocks or for one of the stock averages that you see in the financial pages of most newspapers. Often the chartist will also indicate the volume of shares of stock traded during the day by another vertical line at the bottom of the charts. Gradually, the highs and lows on the chart of the stock in question jiggle up and down sufficiently to produce patterns. To the chartist, these patterns have the same significance as X-ray plates to a surgeon.

One of the first things the chartist looks for is a trend. If the chartlist draws two lines connecting the tops and bottoms creating a “channel” to delineate the uptrend, than since the presumption is that momentum in the market will tend to perpetuate itself and the chartist interprets such a pattern as a bullish augury – the stock can be expected to continue to rise. As Magee wrote in the bible of charting, Technical Analysis of Stock Trends, “Prices move in trends and trends tend to continue until something happens to change the supply-demand balance.”

Suppose, however, that at about 24, the stock finally runs into trouble and is unable to gain any further ground. This is called a resistance level. The stock may wiggle around a bit then turn download. One pattern, which chartists claim reveals a clear signal that the market has topped out, is a head-and-shoulders formation.

The stock first rises and then falls slightly, forming a rounded shoulder. It rises again, going slightly higher, before once more receding, forming a head. Finally the right shoulder is formed, and chartists wait with bated breath for the sell signal, which sounds loud and clear when the stock “pierces the neckline.” With the glee of Count Dracula surveying one of his victims, the chartlists are off and selling, anticipating that a prolonged downtrend will follow as it allegedly has in the past.

Of course, sometimes the market surprises the chartlist. For example, the stock may make an end run up to 30 right after giving a bear signal. This is called a bear trap or, to the chartlist, the exception that proves the rule.

It is tendency to get whipsawed that is often the chartists’ undoing. Not only does the chartist lose money on the trade but he also pays additional transactions costs to execute the buy and sell orders called for by the trading rule. Consequently, the chartist has to be correct much more than 50 percent of the time simply to break even relative to the “buy and hold” investor.

It follows from the technique that the chartist is a trader, not a long-term investor. The chartist buys when the auguries look favorable and sells on bad omens. He flirts with stocks just as some flirt with the opposite sex, and his scores are successful in-and-out trades, not rewarding long-term commitments. Indeed, the psychiatrist Don D. Jackson, author with Albert Haas, Jr., of Bulls, Bears and Dr. Freud, suggested that such an individual may be playing a game with overt sexual overtones. And all this takes place under the pennant of that great symbol of sexuality: the bull.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.