movement, there is a normal sequence of events that takesplace internally in the market as the topping process occurs. What do Imean by internally? In Chapter 1, I discussed the analogy of statisticalmechanics in physics with the movement of many stocks in the stockmarket. It is easier to predict the whole stock market than to predict anyindividual stock, just as it is easier to predict the overall movement of allthe gas molecules than the movement of any individual molecule. By internal market, I mean looking at and categorizing statistically what theindividual stocks are doing that make up the whole market.
Internal market consists of the statistical measurements, such as thenumber of stocks making new highs or lows and the number of advancing stocks versus decliners, that describe what is happening tothe mass of individual stocks as the overall market moves up or down.
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To understand this, remember that the market is the average of allstocks. The S&P 500, for example, is the average of the price activity ofthe 500 largest stocks. Everything is summarized by one simple number,but it is a one-dimensional view. When the S&P 500 is up, it doesn’tmean that all 500 stocks are up; it means only that a mathematical average of the 500 is up. But there are a large variety of different internalmarkets that can calculate to the same number.Let me clarify this. Suppose that on two consecutive days, the S&P500 is up 1%. From this one number both days look the same. If we wenta little deeper and statistically measured what the individual componentswere doing, we might see a different picture. Maybe on one day, only 20of the 500 stocks are up, but those 20 are up a lot, and the other 480stocks are down but down just a bit. On the second day, all 500 stocks areup, but they all are up just a little bit. Both days produce the same 1%mathematical average gain and look the same on the outside, but an internal look presents a completely different picture. Therefore, technicians are always looking inside the market, at the market internals.They look at how many stocks are making new highs and new lows asthe major market indexes are advancing. They also look at the number ofstock advancing versus those that are declining. They are looking for divergences. For example, it is not a good sign to see more stocks hittingnew lows than new highs while the major indices are hitting all-timehighs. Similarly, it’s not a good sign to see total volume contracting whileprices are breaking to new highs.Recognizing a Normal Market CycleWhat occurs internally in a normal market cycle? Usually, at the start ofa major advance, most stocks move up together. The pattern continuesfor some time. This is good, and it’s the way it should be.This pattern is measured by market breadth. Market breadth measures the number of stocks advancing each day versus the number declining. It doesn’t matter how much a stock has advanced or declined; a1/8th-point advance is just as important as a 10-point advance. Any stockthat advances at all is an advancing stock. If the market averages aregoing up, technicians like to see good breadth, in which the number ofstocks advancing is a large number, not a small number.History teaches us something. Usually, as a stock market advancematures, the averages continue to go up, but fewer stocks participate,which means that investors are starting to narrow their focus. A few
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stocks are going up a lot while many other stocks are languishing or declining a little. This is not good.The volume of trading also stops expanding and actually starts toshrink as the averages move to their final highs. Normally in the beginning of a move, the volume of trading continually grows. At a certainpoint, the market makes new highs, but the volume contracts. This setsup a divergence between volume and price.
The Perfect Indicator?Investors and technicians often search through countless investingbooks looking for the one indicator that reliably predicts the market.Although this can be very instructive, heed my admonition: Whenyou evaluate all the technical indicators, don’t lose track of the general concept on which each indicator is based. Those concepts arethe important points. If you pay too much attention to the fine details and the intricate wiggles of some indicator, you often lose sightof the big picture. Any indicator is just there to help you see thelarger story the market is telling; don’t give that indicator some magical importance beyond that. Indicators are just tools to help you seewhat is happening in various segments and sectors of the market.After searching for more than 30 years, I have learned that thereisn’t a perfect indicator. You will not find it. But there is also a weakness in searching through all the indicators and something to warnyou about.Remember that the market is, more often than not, unpredictable. During these long unpredictable periods, investors andtechnicians often become frantic trying to figure it out. They investigate all the indicators looking for some subtle clue. They often startstretching things and magnifying subtle unimportant indications outof proportion trying to find the answer. However, the market at thatmoment is simply saying it is unpredictable. Don’t push it.Be careful—this is a major trap. At those moments, it is best toback away and say, “I don’t know,” and then wait until the picture becomes clear and conclusive. Before every major move, the market willtell you very clearly what is happening. The indication is never somesubtle obscure wiggle in an indicator. When it happens, you’ll see it.
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Divergence is a sign that the topping process has begun. Recall thatmarket tops are usually large, rounded, fan formations and are more aprocess than an event. Different stocks and different stock groups usuallytop at different times. Various market divergences are a sign that this isoccurring. The problem is that the process can take some time; there isno way of knowing how long the process will take—it could take twomonths or two years. It is common to take a bearish posture two or threetimes before the real decline begins.Making TopAs I stated before, in the process of the market topping, certain eventsusually happen before the general averages make top (Figure 4.5). First,as the bull market matures, the number of stocks making new highs hitsa peak number. In other words, even though the market averages aregoing up and continuing to make new highs, the actual number of stocksmaking new highs does not increase.
FIGURE 4.5 The normal sequence of indicator divergences as the market goesinto the topping process. (A–D line = advance-decline line.)Stock Index Peak
New High Peak
A-D Line Peak
Volume Peak
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Second, as the popular averages continue to new highs, the advancedecline line, which is the difference between the number of stocks advancing and the number declining, fails to confirm (i.e., it fails to make anew high). This sets up the popular technical indication of the divergence between the advance-decline line and the popular averages.Finally, the daily trading volume fails to expand, which sets up thethird divergence. As a bull market continues, the volume of trading usually grows. At a certain point, prices continue to new highs, but the volume of trading stops growing and actually contracts. This can happen fora little while without cause for worry, but if it continues, it is usually thefinal important indication that the topping process is just about complete. Thus the long-held observation that price follows volume.Where is the top? It is spread out over time and has been occurringall along at different points for different stocks. Many stocks made theirhighs around the time the number of new highs peaked. Other stocksmade their highs when the advance-decline line made its high. Still others will make their highs after the averages have peaked. The action ofvarious stock groups topping at different points in time is the fan formation, the topping process I referred to earlier. It is important to notethat the process usually goes this way, but there are so many variationsthat the variations are really the rule.Topping Often Starts in Wave FourFrom my experience through many markets, the process of toppingoften starts in the fourth wave of the Elliott wave movement, especiallyif it is a complex horizontal movement. (In Chapter 6, you will learnmore about the Elliott wave.) For now, let’s just say that any major advance takes place in three thrusts separated by two pullbacks. The thrusting waves are labeled waves one, three, and five; the separating pullbacksare waves two and four. You can see this basic pattern in Figure 4.6.Sometimes, if the first two advancing waves are big and of long duration, the second correction, wave four, is often long and very complex.When wave four is protracted and complex, the divergences mentionedoften start at the top of wave three, not the top of wave five, which is theactual top in the major indexes. If this happens, the divergence lasts along time before the wave five top.This event is the cause of more prognostication errors by markettechnicians than any other. I’ve seen it so often that I have come to lookfor it as a market indicator itself. Here is what happens: As the market
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FIGURE 4.6 After a long advance, there is often an extended fourth-wavecorrection before the final fifth wave to new highs. Market divergences oftenstart during this wave four, indicating that many stocks peaked at the top ofwave three and will not make new highs when the final, fifth wave occurs. It iscommon for some market technicians, seeing the divergences, to becomebearish too soon and get confused when the market breaks to new highs.
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Complex Topping
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Number of New Highs
moves into a complex wave four, it gives the appearance of starting toround over. Remember, a complex wave four usually occurs after strongwaves one and three, with a short wave two correction separating them.Some people start getting nervous after this big run-up and are ready fora reaction. They begin noticing the technical divergences as the corrective wave four forms. At this point, technicians often call the top.As the market moves sideways, forming wave four, more and morepeople start taking a bearish stance, expecting the market to break. Everylittle decline during the complex wave four raises hopes that this is thebeginning of the widely anticipated decline and, although the marketlooks weak, each decline unexpectedly halts, and the market recovers alittle.The market then slowly advances to the previous peaks but looksvery weak. Volume is low. Suddenly prices break to new highs and astrong rally begins. The final wave five has started. For a short period,
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the advance-decline line again comes back to life, looking strong, andtechnical factors seem to be in gear. At this point, the majority of analystsquickly swing back to the bullish view, often saying the divergences werea false signal. They weren’t; they were just a little early. It is at this point,as investors and analysts swings back to the bullish side, that you shouldstart getting very bearish.Now psychology enters the picture. Many investors will be found tohave locked themselves out psychologically. After being bearish for sometime and then admitting an error and changing back to being bullish,they are now very reluctant to flip-flop and become bearish even if pricesstart into a decline. They are afraid to take a bearish stance again. Asprices start to decline—in other words, prices do what people originallythought they would do—these people are somewhat frozen in a bullishposture by their reluctance to reverse position.One of the most important lessons the trader has to learn is beingable to flip-flop in opinion when it is actually called for. You have to bewilling to admit you were wrong. This is an example of how you can basically be right about the market, but you are right too early, which canspoil everything. Survival in the market is often simply the effort to maintain confidence in your own judgment.Making BottomMarket bottoms are different from market tops from a technical viewpoint. Very few technical indicators, except market sentiment, are usefulat calling a bottom. Unless it’s a very rare compression bottom (as in1982), most bottoms end in some form of a climax. A climax is a type ofmarket bottom in which panic selling occurs in huge volumes, with pricescollapsing completely. The climax actually starts days earlier, and as thedecline continues, the volume in stocks rise as prices plummet, until itbecomes a panic.The actual end, or bottom, usually occurs in one day. What happensis that prices collapse on huge volume, and then, mid-trading day, reverse direction and surge upward, also on huge volume. This reversalrally dies away after a few days, after which prices go into a long, quietperiod during which nothing much happens and volume becomes extremely light. The market looks dead, which it is, but the decline is over.During a selling climax, it’s best not to look for the bottom. Take astep back, or, if you are invested and think it’s early enough, sell out and
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repurchase later. Let the market make climactic bottom and go throughits reversal rally.When the reversal rally is over, it almost always declines again by atleast 50% or more of the rally. On this pullback, the volume usually driesup to almost nothing; it’s the death after the climax. At this moment, themarket seems awfully weak, and there doesn’t seem to be any reason forit to go up anytime soon. Investor sentiment measures are extremelynegative; investors are generally expecting further price declines. Themost optimistic talk is that the market will need a lot of confidence building before anything positive happens. You’ve got your opportunity! Atthis point, it is usually safe to purchase for the long term—and you won’thave to wait for as long as you may think!
AMFLY
Changing Market Patterns
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Many possible market patterns can occur. Some of the important oneshave already been listed in books on technical analysis. The market oftensets a particular pattern that continues to recur. If you are lucky, you canoften profit from them. They are best kept to yourself because if widelybroadcast, the pattern tends to disappear.For example, suppose you notice that for the last three short-termmarket thrusts, the Dow Jones industrial averages rose sharply, but forthe first three days of each move, the NASDAQ stayed relatively flat. Onthe fourth day, the NASDAQ played catch-up, rising very dramatically.The NASDAQ doesn’t normally do this; it is something you have just noticed recently. Maybe speculators have become much more cautiousthan normal and hold back, waiting for the move to be real before theygo into the NASDAQ-type stocks. Use that observation. Maybe it isn’treal but it probably is; try it out at the next opportunity.An intermediate-term trader, noticing this pattern for short-termmoves, further notices that the market has begun what looks like alonger-term move. She notices also that the move is primarily a DowJones industrials move again, with the NASDAQ holding back. She canconclude one of two things: This move will continue (strong Dow, weakNASDAQ) or it is a manifestation over the longer term of a pattern seenpreviously in short-term moves. I’d assume the second and take a position based on that assumption. One reason to do this is that such situations allow a trader to know when she or he is wrong with the leastamount of risk.
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Many of these patterns are real and can be used to make money.They originate for some reason that doesn’t have to be known, they existfor a time, then often fade away. Make these observations your own. Youwill find that once you have a correct operating model for stock prices,you will be able to see and understand them better. It will help increaseyour confidence that your model is indeed correct.Let me give you an example. By December of 2000, the market hadjust gone through a severe four-month decline. Most of the selling hadbeen in the NASDAQ. The NASDAQ-type stocks kept going down, dayafter day with no let up into the last week of the year, but the volume wasgetting low. It seemed that, after four months, the continued selling wasprimarily tax selling. More and more people who were waiting for a rallyto take their tax loss gave up each day as no rally materialized. In otherwords, the current selling was almost 100% done to realize a loss to beused against any gains taken earlier in the year.I figured the tax selling would continue right to the end of the year.Then the selling would suddenly lift. So on the last day of the year, Ibought some QQQ and some HHH; these are exchange-traded funds ofNASDAQ and Internet stocks, respectively. I figured there would be avery sudden lifting of the tax selling in these sectors and, with help fromshort sellers covering their positions, these stocks would literally besucked upward in price, as in a vacuum. They would go up not becauseof heavy buying but simple lack of selling.On the first day of trading in the year 2001, January 2, the marketcontinued down. Both QQQ and HHH declined. The next day, thingschanged dramatically: A huge advance was led by both QQQ and HHH,each making double-digit percentage gains in one day. Suddenly theQQQ was up more than 7% from the end of December and the HHH upmore than 10%. That was it—the market sagged off and the move wasover for a few days. It was a nice profit. You’ll find that these moments,in which you see something and then act on it and it proves out, are themost satisfying ones.The Pivotal PointThe pivotal point has long been discussed with regard to technical analysis. Jesse Livermore’s book How to Trade in Stocks, has an entire chapter about the pivotal point. He begins by saying, “Whenever I have hadthe patience to wait for the market to arrive at what I call a ‘Pivotal Point’
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before I started to trade, I have always made money in my operations.”The problem is that he never really defines what he means by a pivotalpoint.Essentially, a pivotal point is a price or a moment in time fromwhich you’ll know real soon which way the market will go. (For moreabout Livermore, see the sidebar about him on page 47). The trouble isthat a pivotal point for me is not a pivotal point for someone else. Thelocation of the point depends on the model one is using to understandthe market.The breaking of a trendline on a price chart is an example of by a pivotal point: It represents a clear cutoff where the trend of the market hasbeen broken or a new trend started. The reason a pivotal point is so valuable is that it allows a trader to know when a trade is wrong with the leastamount of loss. This is especially true if the trade is longer term. Supposethe market moves up and threatens to break above a long-term decliningtrendline. It then breaks through and moves up on expanding volume.The investor takes a position. The odds are that the market might pullback, but if it is the real thing, it should not break below the line again.If it does, one should then sell out with a small loss. If it does carrythrough as expected, one has entered into a long-term trade at a very favorable starting point, and done it with very little risk.If the market fails and the loss is taken, the investor might feel badabout the loss. I don’t. I understand that here was an opportunity tomake a large gain, and I tested the waters with minimal loss. This time itwas a loss; the next time probably won’t be. Remember that any trade isonly one trade in what will amount to a thousand over time. Don’t everput everything, either mentally or emotionally, into a single trade.I have observed something about pivotal points on and off for manyyears. It is this: At times the stock market can become very indecisive.Volatility dies down, and the market seems to lack direction. As this continues, more and more people start noticing the lack of direction. Thislack of direction will usually manifest in all three time domains, short, intermediate, and long term.When that happens, you start noticing that everyone, and I meaneveryone, starts looking at shorter and shorter price moves to resolve theindecision, or they look with a microscope at an impending news item toresolve the uncertainty. When an announcement comes in, the responseis normally huge, as investors take the result as a resolution of the indecision. It seldom is. Beware when it seems that all of Wall Street is look-
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ing at one short-term event or one news item to tell them what is goingto happen long term. These widely agreed-to pivotal points are seldomthe real ones.Unstable MarketsUnstable markets, in which feedback loops are on the verge of being triggered, usually have the common characteristic of a lack of volatility rightbefore the triggering. In my experience, the following occurs: The market will have advanced to a new high and seem to be holding that position very well. Sell-offs, when they occur, are moderate and don’t seemto amount to anything. These weak sell-offs often induce people to observe how strong the market looks after the recent advance; they say thatit doesn’t seem like it wants to go down. Slowly, the market becomes verycalm, then it gradually moves to new highs on very light volume. Pricesoften seem to go right out on a ledge, slowly rolling over and picking upsteam as trading volume rises. The decline often catches people offguard. The stock market has lulled investors into complacency. Thesedeclines start with low volatility, often becoming very severe in terms ofprice, and end with high volatility.The best indication of an unstable market ready to be triggered isthe following: low volatility, low volume and either extreme bullish orbearish investor sentiment. (You will see the importance of sentiment inthe next chapter, which is on the theory of contrary opinion.) It is normalto have extreme bearish sentiment as the market goes into a steep decline with high volatility. If the market quiets down, however, and thebearish sentiment is still very high while volume is very low, you havea situation that is actually very unstable, and a major move to the upsideis imminent (a positive feedback). Likewise, it is normal to have highbullish sentiment as prices roar forward and hit new highs. However,when prices quiet down at a high price level while volume dries upand sentiment stays extremely bullish—watch out. That is a very weakmarket.Obscuring the ObviousProbably more than half of the technical market indicators are oscillatorsof one kind or another. I find oscillators far overrated. Twenty-five yearsago, I used and tested hundreds of them; now I never use them. I
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stopped because I found that they are a form of esoteric mathematicsthat often prevent a person from seeing what is happening. Using themoften encourages a person to put something more into the market thanis really there—a major weakness that I warned about earlier. I followthe wisdom of a famous physicist: “Don’t fall in love with beautifulmath.” If you can’t see what is happening in the market, you won’t discover a deeper truth by studying an oscillator; it can’t tell you anythingmore than the original statistic on which the oscillator is based.I know I’m being overly critical here, but I’m trying to make a point.For example, many oscillators are calculated from the advance-declineline. The advance-decline line is simply the difference between twonumbers: the number of stocks advancing and the number declining.There is no greater truth buried in this number. The creation of the advance decline line was originally intended simply to pinpoint market divergences, periods when the popular averages were going up while moststocks were going down. That’s all. Then people started taking movingaverages of the line. They began subtracting one moving average fromanother moving average and plotting this line. They started adding thesedifferences and plotting the sum. They even started looking for trendlines of this measure.You can see how this process can slowly remove a person from a simple and direct observation of the market. Doing this is a little like takinga simple equation, such as 1 + 1 = 2, squaring it, taking the fifth root, andthen adding 3 to it. Doing more to this number won’t give you anygreater truth than the original simple equation of 1 + 1 = 2. It is unnecessary mathematical complexity to find some deep meaning underneathall the data, but there isn’t any. That is not the direction to proceed todiscover what the stock market is going to do.Just by looking at the advance-decline line, I can tell you what any oscillator will look like. The oscillators are calculated from the advancedecline line, so they can’t tell you anything that the line itself can’t tellyou. With many oscillators, technical analysts are simply bottling up tapwater, adding bells, whistles, and a little mystery, and selling it as a magical potion. It’s just plain tap water.
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Computers as TradersI’m expecting that a new investing rage will emerge after the market has been in a trading range for some time: computer programsthat do all the trading for us. These programs will monitor the financial markets 24 hours a day, automatically call up an Internet account, and make the trades when and as they see fit. If a computercan now beat the world chess champion, a computer that can consistently do better than the best human trader is not far off.When a trading range market sets up and becomes accepted asthe new investment reality and when trading programs start producing consistently better returns than their human counterparts,the movement toward this type of computer program will quicken.Humans will just stand back and watch, much like they now do atthe computer chess tournaments. I think this could happen by theyear 2005.
PARADOX 3 RESOLVEDWe are now in a position to resolve Paradox 3 of the investing paradoxespresented in the Introduction.Paradox 3: The technician says up and the fundamentalist saysdown—yet both are right. The fundamental analyst, after looking at theeconomic situation, proclaims that all is well and says that stocks will advance. The technician, after studying new highs and lows, the advancedecline line, and price patterns says that the stock market will decline.Both are right. How can this be?Both analysts can be correct because they are referring to—orshould be referring to—different time frames. It is unfortunate that thispoint is seldom clarified, not clarifying it is the cause of half of the seemingly contradictory advice you hear from analysts.
5Of BABES, O’BUCS,and Contrary Opinion
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he theory of contrary opinion is a trader’s most important decisionmaking tool. Whenever I’m away from the market for any lengthof time, the first thing I check when I get back are my contraryopinion indicators. Many investors and analysts consider contrary opinion important but, in my opinion, not important enough. Most of themhave trouble applying it correctly.To successfully navigate the trading range market that I believe wehave entered, contrary opinion will at times be the only guide pointing tothe correct course of action. To apply contrary opinion successfully, wemust understand why people have trouble using it. The primary reasoninvestors have trouble applying the theory is because they have to rejectthe obviously correct story that is making everyone so bearish or bullish.This difficulty is explained by what I call BABES and O’BUCS.THE THEORY OF CONTRARY OPINION
In March 1972, the well-known market analyst, Marty Zweig, wrote anarticle for Barron’s called “The Dearth of Short Selling.” In it, he predicted a stock market decline, arguing that the lack of short selling indicated too much investor optimism. (Short selling is a way to make moneyif stocks decline. The extreme lack of it means investors are very optimistic about higher prices.) That March was the month when the majority of stocks hit their peak, and nine months later, the popular averages96
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began their greatest decline of our generation, producing the two-yearbear market (1973 to 1974).Two and a half years later, with the market at the bottom, a brash 29year-old market student (me) walked into his broker’s office and declared that the current market represented the “buy of the decade.”Because my broker’s business had declined so severely, my declarationseemed like a grim joke; in fact, it almost got me thrown out of the room!Even though I believed what I said and was ultimately right, it felt verystrange saying the words, like coming in after a devastating tornado andenthusiastically declaring, “Aren’t we going to have fun rebuilding everything from scratch!”What gave me the courage to say something so outrageous? I waslooking at the same short-selling indicator that Marty Zweig had highlighted two years earlier. This time, however, it was indicating the opposite situation—it was showing one of the highest levels of short selling inhistory, reflecting pessimism so deep that it just had to be a major market bottom. Such is the power of the theory of contrary opinion.What Is the Theory?The theory of contrary opinion is very simple: When the vast majority ofmarket participants think stock prices will advance, they usually decline.Likewise, when the vast majority thinks prices will decline, they advance.In other words, prices will move contrary to what investors expect whenthose expectations have reached an extreme. I want to emphasize the lastpoint: The theory applies only when those expectations have reached anextreme. Notice that the theory does not consider the general economicsituation. It simply states that the necessary and sufficient condition fora major market top or bottom is the existence of extreme bullish or bearish sentiment. That’s quite a statement.
The theory of contrary opinion states that when the vast majorityof market participants think stock prices will advance, they usuallydecline. When the vast majority thinks prices will decline, they usually advance. The importance and truth of the theory is best summarized by the statement: the necessary and sufficient condition tosignal the start of a major movement up or down in stock prices isextreme investor sentiment.
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Both history and experience have shown me that an investor’s bestchance of success at predicting stock prices is the theory of contraryopinion. When you have an extreme reading in market sentiment, youmust elevate that fact above all other indicators and economic data. Itdoesn’t mean that these other indicators aren’t important, it just meansthat when they conflict with an extreme reading in sentiment, you alwaysdefer to contrary opinion. When you make this mental adjustment, however, it forces you into an interesting inversion of thinking that I callBABES and O’BUCS.BABES and O’BUCSIf contrary opinion is a fundamental theory in predicting stock prices, as Iand many others say, then it follows that there must be a BABES and anO’BUCS. BABES is my acronym for a broadly agreed to but essentiallywrong scenario. O’BUCS stands for occluded but ultimately correct scenario. The basic idea is that, at moments of extreme readings of investorsentiment, the obvious economic explanation behind that expectationmust be wrong—there must be some holes in the data or thinking aboutthe data. Thus, in applying the theory of contrary opinion, you use it to direct your attention to discovering the true and correct economic scenario—finding the O’BUCS idea. Locating the O’BUCS idea is the actionof finding today the economic explanation that will emerge in the future toexplain why stock prices moved opposite to what everyone expected.These concepts about BABES and O’BUCS evolved during my reading of Barron’s magazine for 30 years, but I also give credit to Alan Abelson and his ideas in Up and Down Wall Street. As a contrarian, Abelson
BABES Broadly Agreed to But Essentially wrong Scenario. The economic reason, or story, that has been constructed to explain why thestock market will do what the majority of investors expect it to do. It isthe economic why that supports the extreme bullish or bearish feeling.O’BUCS Occluded But Ultimately Correct Scenario. The obscured or hidden economic reason that will emerge in the future to explain whystock prices went in the opposite direction to what everyone thought.
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would often point to an indicator that showed enormous investor optimism and then discuss, with that wonderful s