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Definition of technical analysis
Technical analysis as defined by the Market Technician's Association is: "..the study of data generated by the action of markets and by the behavior and psychology of market participants and observers. Such study is usually applied to estimating probabilities for the future course of prices for a market, investment or speculation by interpreting the data in the context of precedent."

Evidence that the U.S. Federal Reserve Board uses technical analysis in policy making decisions
In a recent speech Alan Greenspan noted that: "But, although there doubtless have been profound changes in the way we organize our capital facilities, engage in just-in-time inventory regimes, and intertwine our newly sophisticated risk-sensitive financial system into this process, there is one important caveat to the notion that we live in a new economy, and that is human psychology.

'The same enthusiasms and fears that gripped our forebears, are, in every way, visible in the generations now actively participating in the American economy. Human actions are always rooted in a forecast of the consequences of those actions... To be sure, the degree of risk aversion differs from person to person, but judging the way prices behave in today's markets compared with those of a century or more ago, one is hard pressed to find significant differences. The way we evaluate assets, and the way changes in those values affect our economy, do not appear to be coming out of a set of rules that is different from the one that governed the actions of our forebears.
' Hence, as the first cut at the question 'Is there a new economy?' the answer in a more profound sense is no. As in the past, our advanced economy is primarily driven by how human psychology molds the value system that drives a competitive market economy. And that process is inextricably linked to human nature, which appears essentially immutable and, thus, anchors the future to the past."

So, the Fed Chairman's speech suggests that the root of technical analysis, crowd behavior, is also the root cause of actions by humans in general that lead to price movement in the markets. If there ever was a reason to believe that you should be using technical analysis in your market forecasts, then I suggest you study Mr. Greenspan's speech, for it is obvious that in one form or another, the Federal Reserve Board uses it in its own policy decisions. This is exactly why I was able to forecast the 15-October-1998 rate cut before anybody else!

Finding Market Bottoms

There has been a whole lot of talk about finding the bottom in the stock market. People are looking under every rock to find a market bottom. The big word these days has been "CAPITULATION". I speak of capitulation in a different sense in the section on open interest. Here, capitulation is supposed to mean that nobody cares about owning stocks anymore. Unfortunately, as I wrote in "New Thinking in Technical Analysis: Trading Models from the Masters" on page 174, I do not see this as a bear market that will require a capitulation. For those of you who are Elliott Wave Theory fans, this is a fourth wave down and fourth waves do not reverse amidst capitulation. If it was capitulation, given the size of the bull market we'd be reversing, I'd expect to see stock ownership back to 10-25% of the population, the Dow at about 3,000, the Nasdaq at about 300 and the S&P 500 at a similar level. VIX would have traded above 100%, but by the time we bottomed, would probably be very low SINCE NOBODY WOULD CARE ANY MORE ABOUT STOCKS! It just is not as easy as everybody seems to want you to think to find a bottom. Believe me, it does not come up and bite you in the rear and say, "Here I am, the bottom you have been looking for!" So, until everybody (except for us E-Wave types) stops talking about finding a bottom, and until the clueless wonders, the Street's so-called strategists stop telling people stocks are cheap and start saying to SELL SELL SELL, there is no capitulation!"

By the way, I am still quite confident of my overall market call. Back in 1999 and 2000 I said that the A/D line would not be as bad as all expect during the drop, and that there might even be a major rally in much of the market. I was ridiculed by other technicians for that thinking. Meanwhile, equal weighted indices rose until 2002 in many cases to new highs. That fits with my overall picture. This leg is different as it is the end of this bear phase (if wave-4 idea is correct) and so most stocks should now fall.

Elliott Wave Theory

The best way to learn this is by buying my book! For more information go to: PoserGlobal Bookstore

A brief introduction:

The Elliott Wave Theory was developed by Ralph Nelson Elliott in the 1930s when he took ill and was unable to fulfill his regular duties as an accountant. Elliott discovered that stocks move in cycles of five wave impulse moves with the currently active trend and then correct these moves in three legs or waves. A common misconception about Elliott is that five waves must be higher and three waves lower. That is, a bull market is in five waves and a bear market in three waves. This is out-and-out wrong. An impulse move is merely the direction of the larger currently active trend. So, when the market is in a bear run lower, the impulse moves (five wave action) is to lower prices. The 1st, 3rd and 5th waves are down, the 2nd and 4th are up. The three odd numbered waves subdivide into five waves while the two evened numbered countertrend (correction) waves should develop in three waves, or as triangles.

The basis of the Elliott Wave Theory (EWT) is market psychology. This is why Elliotticians (those that use EWT to forecast the markets), are usually more interested in market sentiment than other technical analysts. This is also why GOOD Elliotticians should also make sure they understand what is driving the markets. This can help them to more quickly identify changes in the current lay of the land before other technical or fundamental analysts.

MORE TO COME!

Understanding Open Interest
Let's think about this.

FACT: For open interest to fall, an old long must close a position with an old short closing a position.

FACT: Prices are falling. For prices to be falling, the sellers need to be more aggressive than the buyers. In this case, that means the longs that are liquidating are more anxious to get out of their longs (and losing positions) than the sellers are, who are taking profits as the market plumbs new lows.

FACT: When open interest falls, both longs and shorts are liquidating.

SO, HOW IS IT BULLISH THAT OPEN INTEREST IS FALLING AND PRICES ARE FALLING?

1) We have just established that both shorts and longs are liquidating. That is the only way o.i. can fall.

2) For a market to bottom, the last seller must have sold.

3) For a market to bottom, you need strong buyers.

4) The longs that are liquidating are the weak buyers.

5) For a market to bottom, you need capitulation. THAT IS YOU NEED LIQUIDATION BY ALL THE LONGS TRYING TO PICK A BOTTOM. It is much like what we see in equities. It climbs a wall of worry. As long as there is a cadre of folks trying to call tops, it can grind higher. It is when these people are finally converted to being bulls and there is nobody left to buy that the stock market can go south. For futures, when there is nobody left to sell, the market will rally. That is:

6) When the smart money is covering its old shorts, and the dumb bottom picking money is done getting flat, you are setting up for a market turn. This is more aggressive, scared and dumb bottom pickers selling to smart, savvy shorts.

7) Then, open interest starts rising as the dumb bottom pickers say, "Hey, the trend is down, let me get short!" Then, the smart, savvy shorts who were buying back (and liquidating their old shorts at a profit from the LONGS LIQUIDATING their losing positions say, "Hey, the dodos are getting short now. Cool, I will buy everything they have to sell." So, price and open interest goes up, since it is these smart buyers ACCUMULATING aggressively from the bozos who kept banging their heads trying to pick a bottom, while the smart trend followers were making money all along.

Note that sometimes, initially, you will see o.i. fall as the price turns. This is because there might be some short covering too. It is possible that some folks jumped on the short bandwagon too soon. If o.i. has expanded sharply into a bottom, there are late and weak shorts that will get flushed out as prices reverse. But, the trend followers are not aggressively buying yet as there is no trend apparent. This will allow o.i. to fall briefly even though the trend may have changed. But, then, prices will be going higher, not lower.

The Directional Movement Index
This is actually a suite of indicators meant to measure whether or not the market is in a trending mode. It is a fairly slow indicator and one must be careful in applying it in that it takes time to adjust to market moves. Whipsaws are possible, and in fact likely if the market is in a wide trading range.

The components of the index are:

Directional movement (+DM and -DM) represents the largest part of today's move that is outside the previous day's range. So, for example, if yesterday's price range was 18-22 and today's is 17-24, then +DM is two and -DM for the day is zero. On an inside day, there is no directional movement. This system does not care where the close is, so in the example above, even if the close was on the low, the directional movement is considered to be positive because the largest part of today's range is above the previous session's range. Note that -DM is always positive, so if today's range is 17-20 and yesterdays was 19-19 1/2, the -DM is 2 and +DM is zero.

Directional Movement Indexes (+DI and -DI) ) are computed by using the daily +DM and -DM discussed above and taking a ratio with the daily true range. The daily true range is the largest of the following: The absolute value of:
A. The distance from today's high to today's low.
B. The distance from today's high to yesterday's close.
C. The distance from today's low to yesterday's close.

What the true range does is adjust for gaps, in essence adding them back in to today's trading range. We then compute today's +DI and -DI as the ratio of the DM's to TR, so:

+DI =+DM/TR and -DI = -DM/TR.

This is then telling you how powerful today's move was in comparison to the day's range. On a day that prices gap higher, and close at the high, that day's +DI would be 1.00. Remember, on an inside day, both DI's will be zero and if there is positive directional movement there can be no negative directional movement.

Smoothed DI's are then computed. The standard computation is to do a 14-day moving average of the individual DI's (exponential preferred, but it does not make that much of a difference).

Directional Indicator (DX) is the ratio of the difference between the smoothed +DI and -DI and the total directional movement. That is:

DX = [+DI(14) - -DI(14)] / [ +DI(14) + -DI(14)]

Note- +DI(14) is the 14-day smoothed positive directional movement index and -DI(14) is the 14-day smoothed negative directional movement index. These are the standard numbers.

Average Directional Index (ADX) is just the smoothed DX (again typically a 14-day exponential smoothing factor).

What does it all tell you?

First of all, remember that this is a very slow indicator, so it is not going to turn at tops or bottoms. I mostly use ADX as a secondary indicator to tell me whether we are in a trend. Then I will look at the +DI and -DI to see what the components look like. The classic rules are that a move past 20 in ADX says that the trend is real and that moves above 40 should be treated suspiciously and might mean that the move is stretched. Some people get into a directional move on a run past 20 in ADX.

Alexander Elder, in his book Trading for a Living suggests going with the trend whenever ADX breaks from a low level and from beneath both directional lines and then ratchets up four points, it is a sign of a new trend starting. It warns that when ADX is above both DI lines, the trend is ahead of itself. He suggests getting out of a trade when ADX turns lower from such a position.

ADX in bonds has been falling since 8-October. It continues to fall, but right now it is beneath both DI's. (I am glad you asked me about this because somehow my ADX settings had gotten clobbered and I was giving you bad data on the ADX.) +DI is still above -DI, so as long as we do not fall too much more, ADX will continue to slip. Given the smoothing constants, it will probably take a move toward 121 or lower to get ADX to ratchet strongly higher in a down move, which is another reason to believe that the long term trend remains higher. Short term though is certainly down, though ADX is not useful for that determination.

I mostly use ADX to see the direction of the three lines as compared to the current trend. When ADX starts to turn from an extreme level, that can be a warning of a change in the trend for the next several months. It is often late, as it was in October, but it did indicate range trading for a while, which is what we are getting right now. ADX is never a determinant in my thinking because it is slow, but I do use it to see how well my larger wave counts fit with the indicator.

In the coming weeks I will be adding further educational materials on technical analysis.

If you have comments or suggestions, email Steven Poser at: swp@poserglobal.com

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