When will the Dow Jones crash?

Richard W. Schabacker, financial editor of Forbes Magazine with previous experiences at the Federal Reserve Bank of New York and at the Standard Statistic Company (today Standard & Poor's), wrote three important books (1) on how financial market works. He described the first price models (patterns) that can be identified on charts, to better understand the sequence of underlying psychological relationships between buyers and sellers.

Hence is the psychological aspect that drives in many situations the movement of market prices. Professor Lo of MIT, is the author of a theory related to financial markets that combines the rational aspect with the psychological aspect (2).

The "Adaptive Market Hypothesis " tells us that the markets are not always efficient, but not always irrational: they are adaptive.

Every so often, markets can collapse and the wisdom of crowds can quickly become the madness of the crowds: animal spirit, or stimulus response mechanisms instinctive emerge from the depths of our reptilian brain and trigger in certain situations. Sometimes, an apparently irrational behavior is simply a behavior that has not yet had enough time to adapt to the current environment.

So investment fixed rules that ignore environmental changes, will always have unintended consequences, and pattern recognition, in any form, could bring competitive advantages.

Hence the Technical Analysis, can be helpful to close or reduce investment positions when there are pricing models (patterns) that are able to recognize the arrival of the "madness of crowds".

One of the not so very common patterns that we can meet on a price graph, is the orthodox broadening formation; broadening formations occur when a series of three or more price fluctuations widen out of size so that peaks and troughs can be connected with two diverging trendlines (3). The whole concept of widening price swings suggests highly emotional activity. A particular broadening formation is the orthodox broadening top: this pattern comprises three rallies, with each succeeding peak higher than its predecessor, and each peak separated by two bottoms, with the second bottom lower than the first one. Orthodox broadening formations are associated with market peaks. Several of these patterns, according to Edwards and Magee, appeared at the 1929 Tops of many of the active and popular stocks of that day (4). Perhaps we can best see what this formation is, if we examine the image below. I have numbered from 1 to 5 the significant turning points.

As we can see, the pattern comprises three rallies, with each succeeding peak higher than its predecessor (1, 3 and 5), and each peak separated by two bottoms (2 and 4), with the second bottom lower than first one. This kind of pattern, is associated with markets peaks. In Technical Analysis the patterns are not predictive but probabilistic. Sometimes a pattern could be negated and also this event could be a valid information. It could be, in this case, the situation of the Dow Jones Industrial Index. If we see the chart below from 1996, we can note that the price curve formed an orthodox broadening formation started in 1998, but the point 5 has been negated.

The point 5 coincides also with the first top of a smaller broadening formation started at the end of 2014, where the prices broke out (a), with an uprising volume confirmation (b), at the end of 2016.

Now we have a divergence in the volumes (c), and an oscillator very overstretched (d), so a kind of consolidation could start in the next period. This should be the event from which could emerge the continuation of the uptrend or a false breakout as happened in the point 4 of the graph.

(1) Stock Market and Practice – 1930, Technical Analysis and Market Profits – 1932, Stock Market Profits -1934;

(2) Lo, Andrew (2004): "The Adaptive Market Hypothesis: Market Efficiency from an Evolutionary Perspective" (published in The Journal of Portfolio Management, Vol. 30, No. 5: pp. 15–29);

(3) Martin J. Pring – Technical Analysis Explained – fifth edition (2014) – Mc Graw Hill -pp. 152-158;

(4) R. Edwards & J. Magee – Technical Analysis of Stock Trends – Eight edition (2001) – pp. 151-4.

Mario Valentino GUFFANTI CFTe – SAMT Vice President – Swiss Italian Chapter – mario.guffanti@samt-org.ch

Disclaimer: the above article is for general information and educational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.