TRADING JOHN MURPHY

[TREND1]

Wed, Dec 5 2018 11:48 AM ET by John Murphy

REVIEWING THE PHILOSOPHY OF TECHNICAL ANALYSIS -- CHARTS ACT AS LEADING INDICATORS OF FUNDAMENTAL INFORMATION -- THIS WEEK'S PLUNGE IN BOND YIELDS SUGGESTS ECONOMY WEAKENING -- FALLING STOCKS TOLD US THE SAME THING A MONTH AGO -- SO DO A LOT OF OTHER INTERMARKET CHARTS -- AND INVESTORS ARE ACTING ON THEM
By John Murphy
WHY WE LOOK AT CHARTS ... I've written several messages since the start of October about why the sharp stock market drop that month was most likely the start of a major topping process. Previous messages used Elliott Waves, the unusually old age of the current bull market (and economic expansion), as well as negative long-term chart indicators as reasons to start taking market selloffs more seriously. A October 13 message also explained that while bull markets may not die of old age, old age increases the odds of bad things happening. In other words, stock market selloffs in the late stages of an aging bull market are more dangerous and have to be taken more seriously. That message also challenged the idea that a strong economy would keep the bull market alive. That's because stocks are a leading indicator of the economy and usually peak first.


YIELD CURVE FINALLY GETS THEIR ATTENTION... My November 17 message asked how financial analysts know that the fundamentals remain bullish when there's no current fundamental data to back up that claim. We know a lot about the third quarter, but very little about the current one (and nothing about the next). That message ended with an explanation of why we look at charts. That's because charts reflect current trends in forward-looking financial markets, while fundamentals give us backward-looking data. After ignoring all the stock warning signs, economists are finally starting to question the strength of the economy for next year. What finally got their attention was this week's plunge in bond yields and the danger of an "inverted yield curve". Which appears to confirm what falling stock prices were already suggesting. Which bring me to the main point of this message. And that's the basic difference between fundamental and technical analysis, and the philosophy of technical analysis itself.

PHILOSOPHY OF TECHNICAL ANALYSIS ... I've written a lot of books on technical and intermarket analysis. The longest and most comprehensive one is "Technical Analysis of the Financial Markets". Although it was published in 1999, it's main principles remain as true today as they were then. The book is more than 500 pages long and includes 19 chapters. [Chapter 13 includes a comprehensive explanation of Elliott Wave Analysis for those wishing to learn more about that approach]. In this message, however, I'm sticking to the first chapter which may be the most important one in the book. It's entitled "The Philosophy of Technical Analysis" which is based on the premise that market prices discount (or anticipate) fundamental and economic information. The first chapter warns that unless the full significance of that claim is fully understood and accepted, "nothing else that follows makes much sense". I still believe that understanding why technical analysis works, and how it blends with fundamental analysis, is more important than knowing how the charts actually work. Because if you don't understand why charts work, there's no point in looking at them.

MARKETS DISCOUNT FUTURE FUNDAMENTALS... Nothing in my books or these messages is meant to disparage fundamental analysis. I believe that fundamental and economic data ultimately determine the direction of financial markets. The problem is how to find out what those fundamentals are while there's still time to act on them. Fundamental data tells us what happened last month or last quarter. It doesn't tell us anything about current or future conditions. So fundamental analysts are forced to deal with old data. That's where charts come in. They usually give us early warnings of future fundamentals. The first basic premise of technical analysis in my book is that "Market Action Discounts Everything". That claim forms the cornerstone of technical analysis. In other words, anything that can effect market prices -- fundamentally, politically, psychologically, or otherwise -- is reflected in the price of that market. In other words, price action is a leading indicator of fundamental information. That claim is based on the idea that price action should reflect shifts in supply and demand for any market. If demand exceeds supply, prices should rise. If supply exceeds demand, prices should fall. That principle is the basis of all economic and fundamental forecasting.

CHARTS MEASURE SUPPLY AND DEMAND... Charts show the direction of a market to determine whether supply or demand is greater. And that helps determine whether the fundamentals are bullish or bearish. If prices rise, they're probably bullish. If prices fall, that suggests that the fundamentals are weakening. The bigger and longer the drop in prices, the weaker the fundamental outlook. In other words, the technical analyst is indirectly studying the fundamentals. Some have even referred to charting as a shortcut form of fundamental analysis. So the claim made in October that the fundamentals of the economy remained strong in the face of heavy stock selling had a hollow ring to it. And now we're starting to find out why. Not every downturn in stocks signals a slowdown in the economy. But every slowdown in the economy has usually been preceded by a downturn in stocks.

OTHER CHART WARNINGS... Falling commodity prices, a rising dollar, and weaker foreign markets have also been warning of slower global growth. This week's plunge in Treasury yields is sending the same message. All of those intermarket trends can be plainly seen on charts and are already discounting economic trends for 2019. And investors are acting on them. They can't afford to wait for next year's fundamentals to find out if they're right.