Market Psychology and Prices: Why Patterns Work
The more I work with markets, the more it becomes apparent that prices are determined by one thing and one thing only, and that is people’s chang-ing attitudes toward the emerging fundamentals. In other words, prices are determined by psychology. The great technician of the 1940s, Garfield Drew, once wrote, “Stocks don’t sell for what they are worth, but for what people
think they are worth.” If it were not for the fact that these changing atti-tudes move in trends and that trends tend to perpetuate, market prices would be nothing more than a random event, which would mean that tech-nicians would be out of business.
Changing Attitudes and Changing Prices
A classic example of changing attitudes that affected prices developed in the 1970s and early 1980s. In 1973, a group of stocks known as the “Nifty Fifty” peaked after a phenomenal rise during the 1960s. These were known in the trade as “one-decision” stocks, because their earnings went up every year, as did their prices. People came to the conclusion that there was only one decision to make where these stocks were concerned: just buy! These stocks included such growth names of the time as Kodak, Xerox, McDonald’s, and IBM. During 1973 and 1974, they declined substantially in price, along with the rest of the market. Over the course of the next nine
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4 Part I: Basic Building Blocks
years or so, the earnings for the group as a whole continued to rise, but the index did not make a new post-1973 high until nine years later.
Thus we arrive at a situation where prices bear no reality to the earnings trend. Perhaps prices were too high in 1973 relative to the earnings; per-haps they were not, and they should have continued rising throughout the 1970s as earnings rose. Who knows? Who can tell? Technicians would say, “Who cares?” Why? Because technical analysis assumes that the changing attitudes toward these emerging fundamentals are reflected in
price action as displayed in charts. It’s not dissimilar to a medical technician looking at a patient’s chart. He doesn’t have to know that the patient is groaning with pain to diagnose a problem. It’s all there in the chart. The chart tells him that the patient’s vital signs are deteriorating to the point where danger lies ahead and that remedial action should be taken. In a similar way, to the tech-nician, poor
price action signifies a weak price trend and the probability of trouble ahead in the form of a serious price decline. The technician does not have to know the reason why; he merely observes the condition and takes the necessary action.
Chart 1-1 shows the 1990s
price action for Key Corp., a money-center bank. The bank’s earnings are shown in the lower panel. Note that there are two periods when the price came down for a prolonged period, the first in the 1980s and the second in the late 1990s. In both cases the earnings rose, demonstrating once again that it is the attitude of market participants toward the emerging fundamentals rather than the fundamentals them-selves that is important. This is not the same thing as saying that earnings are not important; of course they are. If we had known that earnings were
