Minyan Mailbag with Tom DeMark
Note: The following column was written by Tom DeMark and is shared with educational intents only. Our goal is to provide tools that allow our Minyans to make better and more educated decisions for themselves. Enjoy!
"Those who dare to use a crystal ball to forecast the future must be prepared to eat shattered glass"...Alan Abelson, Barron's
Most everyone possesses an opinion regarding the direction of the stock market. Often times the outlook is more a function of one's emotions rather than rational and deliberate thinking and analysis. Forecasts made in the media by supposed Wall Street pundits are also influential in swaying market opinion.
We have developed methodologies designed to forecast the price behavior of markets and these techniques have their roots grounded both in mathematics and in the laws of nature. The approach we employ is totally objective and mechanical. Specifically, we have concluded through extensive research and tests that once important mathematically derived levels of price support and resistance are first qualified and then exceeded, subsequent price direction is preordained and therefore the market's response is to gravitate toward its next critical level of support and resistance.
Market timing is a discipline of chart analysis that is distinguished from conventional technical analysis of price activity. Specifically, market timing has a prescribed set of rules that make it totally objective and defined, whereas conventional technical analysis is fraught with subjectivity and ambiguity. Market timing derives a single outlook and outcome, while technical analysis is often associated with a myriad of possibilities.
A review of various historical markets price movement and behavior will introduce you to the basic tenets of TD Absolute Retracement™, a handy tool for projecting, with a high degree of mechanical precision, likely levels of price support and resistance. This exercise will also enable you to apply this indicator to your own analysis in the future.
The 'golden mean' is a ratio dominant and pervasive throughout nature. Its 61.8% value is a derivative of the basic Fibonacci number series that begins with the whole numbers 1 and 2 and then proceeds to higher successive numbers that are sums of the two most recent consecutive numbers in the series. For example, 1 + 2 = 3 and that is the third number in the series. By adding 3 + 2 the fourth number '5' appears. This process continues forward and 8, 13, 21, 34, 55, 89, 144, 233, 377, etc are the consecutive numbers in the series.
As these values progress successively higher, and one were to divide a preceding number by a succeeding number, the ratio 61.8% is produced. This is the only series of numbers that possess such properties.
By subtracting this ratio from unity, or 100%, an alternative ratio of 38.2% exists. Further by averaging the two key ratios of 61.8% and 38.2%, one arrives at 50%. These three ratios are critical in projecting downside support levels when an index or market declines and likewise these same ratios are important in arriving at upside resistance levels as well.
While these ratios have become more commonly known in the markets in recent years, the distinct application of these ratios within the TD Absolute Retracement indicator makes their usage more objective and mechanical. The downside rations of 61.8%, 50% and 38.2% are applied to prices from a significant high and the upside ratios of 138.2%, 150% and 161.8% are utilized with major price lows. This approach removes the subjectivity normally associated with the application of Fibonacci ratios.
The following examples demonstrate the value of these ratios in deriving critical downside and upside levels. Upon completion of this review, one can easily conclude the important role that mathematics assumes when applied to making market projections.
Although we can cite many examples when price has traveled precisely from one TD Absolute Retracement level to another, we will highlight some major market index examples with which many traders are familiar. Unfortunately, at the time these major market reversals occurred without the TD Absolute Retracement indicator one would have had no idea nor conviction that the market was about to turn.
Important Market Price Reversals
On July 16, 1987, the London FTSE 100 Index recorded its all time high and closed at 2443.4. Multiplying this price by the TD Absolute Retracement upper ratio of 61.8% produced a downside price objective of 1510.02 and the subsequent November 10, 1987 market panic low was 1510.50.
Similarly, the August 25, 1987 DJIA all time price high was 2746.62. Multiplying this value by the TD Absolute Retracement upper ratio of 61.8% projected downside to the October 20, 1987 low of 1682.44. The actual low on October 20, was 1616.21. Once fulfilled, those twin index lows were never seen again.
Likewise the December 1989 Japanese Nikkei high was 39,820 and in October 1990 the low held the 2nd downside, or 50%, TD Absolute Retracement level of 19,457.94 and in both July and August 1992 price held the 3rd and final downside level at 38.2% of 14,865.86 and then again in June and July 1995 and a number of months in 1998 only to succumb to the weight of the market in 2001 and to breakdown below the lowest TD Absolute Retracement level.
However, the TD Absolute Retracement indicator can be applied both upside, as well as downside, to arrive at price projections. While the downside ratios are 61.8%, 50%, and 38.2%, the upside ratios are 138.2%, 150%, and 161.8%. From the October 1998 low of 12,780 the TD Absolute Retracement 3rd upside objective upside of 161.8% was 20,690 and that was only slightly exceeded in March of 2000. Since the market was able to rally upside to a TD Absolute Retracement minimum threshold level of 138.2% of the low, the projection downside can be re-initialized and recalculated and the new projection downside becomes 7792.80. From that low the market has since rallied.
Let's evaluate the US stock index market from more recent tops and bottoms. The S & P cash index made its all time high on March 24 2000. The close that day was 1527.46. By multiplying this close by the upper TD Absolute Retracement ratio of 61.8% and the high that day by the middle ratio of 50.0%, two downside objectives are calculated-943.97 and 776.43. The September 21, 2001 terrorist low was less than 1.00 point away at 944.75 and subsequent to a rally, the S & P cash declined just below the 50.0% downside level of 776.43 by 0.75 points on July 24, 2002 and then again on October 10, 2002 when it once again declined intraday below this level. During the same period, the Dow Jones Industrial Average high was recorded on January 14, 2000. By multiplying the close that day of 7,261.6 by 61.8%, a downside price projection was calculated and fulfilled for one day only on October 10, 2002. (see chart #5-August 1999 to March 2004) Amazingly, this low was projected back in early 2000, almost 3 years earlier.
The FTSE 100 made its all time high on December 30, 1999. By multiplying the close and high this day by the 61.8% and 50% TD Absolute Retracement ratios, the downside objectives were fulfilled on September 21, 2001-just as the S & P had done-and then in & late January and in early March in 2003.
Now let's apply the key ratios of this important indicator to the recent markets' significant highs and lows. By multiplying the two lower TD Absolute Retracement upside ratios --138.2% and 150%, by the S & P Cash Index October 10, 2002 low, one arrives at 1062.24 and 1153.00 as the upside price projections. Both these levels served to repel price for a period of time. The second higher level was resistance just recently in early 2004.
What is TD Absolute Retracement™ projecting NOW?
When placed in context of the 1929-30 DJIA stock market decline/crash, one can see that the S & P cash rally from October 2003 is mimicking the 1929-30 rally remarkably closely.
The 1929 market high was recorded on September 3, 1929. The TD Absolute Retracement upper two downside projections from that high were 238.60 and 193.00, respectively. By November 13 of the same year both downside projections had been fulfilled. Projecting upside from that low day's close, there were two lower upside ratio objectives of 274.46 and 297.90. By April 16 1930 the DJIA had topped above 297.20. From that price, it is all history with the DJIA bottoming below 40 in July 1932. These two successively higher highs are equivalent to the S & P cash recent successive upside highs of 1062.40 and 1163.23.
If the current S & P cash index has in fact recorded its high on March 5, 2004 at 1163.23 then expect the lowest ratio level that was calculated by multiplying the March 2000 high close by 38.2% from the March 2000 high to be fulfilled. Also since the recent rally from the S & P cash October 2003 low to 1163.23-150.02%-- has been able to move sufficiently high to reinitialize the TD Absolute Retracement projection downside, these calculations amazingly confirm what the March 2000 projections were.
Off of the recent March 5, 2004 high of 1163.23, the 61.8% downside projection is now 718.87 while 50% ratio projection is almost identical to the 38.2% ratio projection made in March 2000-it is 581.61 versus 583.48. Whereas there may be no comfort whatsoever in knowing that the S & P currently possesses risk of 50% from the recent high, there is mathematical comfort knowing that both important highs project downside to a level that successfully confirms one another, thereby lending credibility to its derivation and likelihood.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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