Technical Analysis, a branch of stock market analysis, is built on the premise of studying past data to arrive at some meaningful interpretation (trends) to help forecast future stock price behaviour.
The branch is at loggerheads with fundamental analysis that studies the business prospects of a company. It attempts to arrive at the future earnings, which may or may not be reflected in the current market price. Technical analysis or charting is also not very popular with believers in the random walk, which states that future prices are independent of past price behaviour. Further, if price movements are random then there are no trends.
Despite a strong lobby against the study, technical analysis has held its fort and is an integral part of any stock market analysis. The Dow Theory, is one of the earliest studies based on technicals or charting. As per the theory, movements in stock market aggregates or individual stock prices can be expressed in three types of ways. Primary, Secondary and Minor moves.
These are major moves of the aggregates or individual prices, which can either be bullish or bearish.
A secondary move is an important decline in a bull rally or an advance in a bear market. These movements are considered to add further strength to the underlying primary move. The secondary move generally last for 3 weeks to several months during which time the move retraces between 33% to 66% of the primary move since the last secondary.
These are the daily fluctuations in the market and last for a maximum of 3 weeks. They do not imply or impact the current trend.
In the case of market aggregates or stock prices trading within a band. The theory hypothecates that such movements could indicate one of the two cases.
Accumulation: Stocks flowing into the hands of the knowledgeable investor, which is a positive sign.
Distribution: Stock flowing into weak hands, which is not a healthy sign for the markets or the stock.
Indication of a new trend is established when the line (market aggregate or stock price) breaks the floor or ceiling of the band. If the line has broken the floor then it signals a bearish trend. While a move above the ceiling denotes a bullish signal.
Price - Volume Relationship
The normal relationship between market aggregates or stock price and volumes is direct. Volumes should expand on rallies and contract on declines. Rallies on low volumes or vice - versa are not a healthy trend and one can expect a reversal.
Further, a bull signal is indicated if every primary peak surpasses the previous peak and every subsequent decline is above the previous secondary. A bear signal is when every decline surpasses the previous bottom and intervening advances are lower than the previous one.
Bull & Bear Markets - The theory also defines a bull and bear market and the stages involved.
Bear Market: A long decline interrupted by important advances. It starts with participants abandoning expectations on which the stocks were first purchased. This is followed by companies failing to meet their earning targets, which leads to another round of sell off. Finally, there is complete gloom, as selling prevails irrespective of the inherent value. This could be due to depressed conditions or forced liquidations, which occur as a result of stop loss or for meeting margin calls. Feels like déjà vu.
Bull Market: A long advance interrupted by important declines. The rally starts with market aggregates or stock prices reflecting the worst possible scenario and outlook on the future begins to revive. This followed by companies surpassing the expectations of investors leading to further optimism in equities. The last stage is when there is excessive optimism, which leads to speculation and market aggregates and stock prices reflect the best possible or impossible (bubbles) future scenario.
Technical analysis is not concerned with the state of the economy or the future earnings capacity of a company. Therefore, it is not concerned with the true value of a stock or a market aggregate and is not a tool for determining the same. However, technical analysis could facilitate in identifying short-term trends, which can assist the investor in timing his equity transaction.