Technical Analysis and Trend Identification

Technical analysis involves a study of the action of markets, it is not concerned with the difficult and subjective tasks of forecasting trends in the economy, or assessing the attitudes of investors toward those changes. Technical analysis tries to identify turning points in the market's assessment of these factors.

Since technical analysis can be applied successfully to any freely traded entity such as stocks, market averages, commodities, bonds, currencies, and so on, I will frequently use the term security as a generic one embracing all of these entities, thereby avoiding unnecessary repetition.

Price patterns, trend-lines, moving averages (MAs), momentum, and so on are "Trend-Determining Techniques," techniques used to determine trends and identify their reversals.

A study of market character is a cornerstone of technical analysis, since reversals of price trends in the major averages are almost always preceded by latent strength or weakness in the market structure. Technical analysis looks further than the price trends of the popular averages. Trends of investor confidence are responsible for price movements, and this emotional aspect is examined from four view­points or dimensions, namely, price, time, volume, and breadth.

Changes in prices reflect changes in investor attitude. Price, the first dimension, indicates the level of that change. Time, the second dimension, measures the recurrence and length of cycles in investor psychology. Changes in confidence go through distinct cycles, some long and some short, as investors swing from excesses of optimism toward deep pessimism. The degree of price movement in the market is usually a function of the time element. The longer it takes for investors to move from a bullish to a bearish extreme, the greater the ensuing price change is likely to be.

Volume, the third dimension, reflects the intensity of changes in investor attitudes. For example, the level of enthusiasm implied by a price rise on low volume is not nearly as strong as that implied by a similar price advance accompanied by very high volume.

The fourth dimension, breadth, measures the extent of the emotion. This is important because as long as stocks are advancing on a broad front, the trend in favorable emotion is dispersed among most stocks and industries, indicating a healthy and broad economic recovery and a widely favorable attitude toward stocks in particular. On the other hand, when interest has narrowed to a few blue-chip stocks, the quality of the trend has deteriorated, and a continuation of the bull market is highly suspect.

Technical analysis measures these psychological dimensions in a number of ways. Most indicators monitor two or more aspects simultaneously; for instance, a simple price chart measures both price (on the vertical axis) and time (on the horizontal axis). Similarly, an advance/decline line measures breadth and time.