Saturday 26 July 2014

How trends end - part 1

The ends of trends


I'm going to start with a bit more review of Crowd Money. It grieves me to say it but it is a tedious read. Too much repetition and a rather dense style. A great pity for once you have managed to plough through you have learnt so much excellent stuff.

I'm going to pick out bits and pieces in the order that I find most useful. The thesis is that the stock market is driven by human psychology and the way the psychology of market participants is driven by events. Very specifically we're talking about supply and demand. Share owners' actions a motivated by their expectations of what will happen to the prices of shares that they own and by their innate beliefs.

There is strong evidence that the most powerful driver of belief about the future is that it will be a continuation of the past. The crowds of share owners will only be forced out of their inertia when the facts force them to change. Hence Treacy's very compelling analysis of trend ending.  He identifies three types. I'll only deal with type one in this post. More soon!

Type 1 Is characterized by a sharp acceleration of price movement which is a sign that a crash is imminent.

Take a look at silver in 2010 -2011. The changes in demand and supply that this chart reveals work like this. At the end of the ranging period some new story about the prospects for silver drove up demand. The previous supply demand equilibrium was broken and prices began to rise until a point was reached when the consensus view decided that prices were high enough. More of those holding silver were encouraged to offer their holdings and/or fewer new buyers were tempted in.

The positive story persisted and demand began to outweigh supply once more. This time even more buyers were encouraged to buy because they were kicking themselves for missing the first part of the rally. They now held the belief that the market would rise because that is what it had done before. As the expectation of rising prices was reinforced by actual rising prices more and more buyers were sucked in by fear that they were missing a fabulous one way road to riches.

At this stage many participants were buying on margin - buying shares with borrowed money. Eventually there were no new potential buyers left and the price was so high that increasing numbers of holders were tempted to take profits and a dramatic reversal took place. Buyers on margin were forced out of their positions because their equity in their holdings had been wiped out, catalyzing the crash. Other late buyers saw their profits disappear and joined in the rush for the exit and supply was ramped up some more.  

A sign that often confirms a type 1 top is taking place is a key day reversal. This is a candlestick pattern in
which the daily price movement as shown by a candle, engulfs the previous candle. This means that the price starts the day up, suggesting that the upward price trend will continue. But as the day wears on supply overwhelms demand and the price ends below the previous day's open. See the chart of the DAX for an example.

In most cases a reversal of a downtrend exhibits very similar characteristics to the ones just described though the moves are in the opposite direction.

I'll post description of the other two main reversal patterns shortly.

The Dow


In the mean time the uptrend in the US market moves on with what looks like a normal pull back today. There is some narrowing of the lines that link the top and the bottom of the trend but it is too early to say if this has any significance.








 

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