Technically Speaking, July 2011

Tom DeMark is a well-known and widely followed market timer. During his career, the Dow Jones Industrial Average has traded below 600 and higher than 14,000 so he is a veteran of bull and bear markets and has endured years of sideways action as well. In his talk, he offered a few reflections based upon what he has seen in the markets over the past 40 years.

As he began working in the industry, Tom was following a typical career path. He began as an analyst at NN Investment services, a subsidiary of Northwestern National Insurance in January 1972. He began studying for the Chartered Financial Analyst (CFA) exam, and he commented that he had completed the C and F before realizing he wasn’t getting as much out of the program as he had hoped. Technical analysis was interesting and seemed as a practical approach to making money, and his firm supported learning as much about the subject as he could.

In the early 1970s, Tom began an education process by seeking out the very best technical analysts and discussing their work. He was able to meet many of the early members of the MTA this way, and he also spoke with Hamilton Bolton and Jack Frost about Elliott Wave. There was very little information about technical analysis in general at that time, and even less about Elliott Wave. Tom spent many hours locating experts, only to find they had little to offer in the way of practical applications despite some having a lot of entertainment value. He met people who felt Elliott must work because they had been married 5 times and had 8 children, or cited other variants of Fibonacci numbers in their lives. Despite the kook fringe that existed in the field, Tom continued in his pursuit of the Holy Grail.

He found that technical analysis often conjured negative images among the investment community, and he repackaged his work as market timing. This allowed him to gain receptive audiences in some cases. His market timing work included a generous amount of typical technical analysis. Tom studied every indicator described in the literature. In the 1970s, his tool kit included a magnifying glass to study charts, a proportional divider, and a slide rule. He worked from paper charts and concluded that there are some ideas in technical analysis that do work.

However, Tom found that many of the traditional technical tools didn’t always work as well as some simple adaptations would. For example, he found trendlines to be useful, when drawn properly. One problem technical analysts have with drawing trendlines is the subjective nature of identifying significant tops and bottoms to connect with the line. Given a chart, any number of trendlines could be drawn and considered to be correct.

Tom described an objective means of drawing trendlines in his 1994 book, “The New Science of Technical Analysis.” He draws them from right to left, instead of using the more traditional approach of starting from older data and drawing towards the right side of the chart. In an uptrend, the two most recent lows are connected with a line. A low is defined as a swing low, which is a bar or candle with a low lower than the low on the bars or candles surrounding it. Trendlines drawn this way can also be used to identify price targets once they are broken. Targets are obtained by noting that a degree of symmetry is often visible in price action and expecting to see a move below the line equal to the move that occurred above the line.

This is a simple concept to understand, and eliminates much of the confusion from traditional trendlines. The idea of applying symmetry to identify price targets is found in traditional chart pattern analysis and is the basis of finding targets with a head and shoulders pattern, rectangles, and several other patterns.

Thinking about what prices are really telling us is a hallmark of Tom’s analysis. Over the course of his career, he has developed a number of indicators to help anticipate price action, and these indicators start with an underlying logic First, he looks at what is happening and then applies techniques to quantify the behavior and take advantage of historical patterns. Perhaps his best known indicators are the. DeMark Sequential, which seek to identify severely overbought or oversold markets. The logic is simple – large traders will always need to buy weakness and sell strength.

The general rules for this indicator are found in Tom’s books, but there are a number of detailed rules defining this indicator. It is widely available on professional software platforms and the DeMark Sequential is an indicator that is followed by a number of traders. (Editor’s note: the following simplistic rules are a broad description intended to illustrate the idea. They are not Tom’s exact rules and no one should trade based on this simplistic illustration. As noted, the detailed indicators are widely available.)

For a sell signal, the DeMark Sequential is looking to identify an extremely overbought market. Traders tend to get carried away, and markets reflect this. A number of studies have shown that market overreactions occur and there are an increasing number of behavioral finance theories that try to explain this. Years ago, Tom chose to quantify extreme price action and this indicator is considered by many to be a valuable tool for that.

The DeMark Sequential begins with a setup. For a sell signal, on a daily chart, the setup involves identifying nine consecutive daily price closes which are higher than the closes four days earlier. The setup is useful in identifying an initial trend.

Once the setup is complete, the countdown begins and is moved higher each time prices close above the close two days earlier. When the countdown reaches 13, a sell signal is given after the price closes lower than the close four days earlier. This is a very general outline of the idea and there are a number of important qualifiers to determine if the signal should be taken or not.

On a chart, the DeMark Sequential can be seen below. The 9s and 13s are often significant and can easily be incorporated into a trading plan.

In his presentation, Tom offered a number of examples of his indicators. They can be applied over any time frame, and in any market. One unique example was the chicken wing market where a top was marked by a count of 13. He also showed that they can be used on economic data.

It is not surprising to see that DeMark Sequential indicators can be applied in different markets, or to economic data. The indicators were developed to identify overbought and oversold conditions. By trying to find data that has moved too far from its mean, the indicators are quantifying price and time extremes. Mean reversion can be seen in market prices and in many economic data series. By beginning with sound underlying logic, Tom developed timeless indicators. There are a number of variations that can be applied to this indicator. There are also a number of additional qualifiers that limit the risk and help identify only the best trading opportunities. The signals are not 100% accurate, but are helpful to traders.

Understanding all the rules and qualifiers is important to successful trading. Tom demonstrated this with an example related to breakout trading. Using simple 40-days highs or lows to generate trading signals is an example of the well-known trading strategy, often called the Donchian Rule. Testing usually shows this strategy can be profitable over the long-term, with about a third of the trades being winners. Tom tested a simple idea to make the system better – only take long trades if the breakout has been preceded by a down close and short trades would require an up close before the signal. This simple qualifier can almost double the number of winning trades.

In his decades-long career, Tom has identified a number of other interesting tools to help traders. He finds that at least three quarters of the time, any given market will not show any trend. His work has shown that markets do spend more time in uptrends than downtrends, an insight that can be valuable. Traders can give back a large amount of profits by holding onto a position too long in a bull market. Tom also pointed out that markets bottom because of a lack of selling. This may sound obvious, but it allowed him to develop another tool to help time markets. He defines buying pressure as:

[(C-O) / (H-L)] * volume
Where C = close, O = open, H = high, and L = low

Buyers are driving the prices when the close is greater than the open and sellers are in control when the close is below the open.

Tom tracks the rate of change of the ratio of buying pressure to the sum of buying and selling pressure. Over time, the 5-day, 8-day, and 13-day rate of change indicators will help identify market turning points. By tracking who is moving prices, the buyers or sellers, traders are in a position to anticipate the turns.

DeMark studies and indicators are followed by traders and analysts around the world. Throughout his career, Tom has focused on defining objective and mechanical approaches. His goal of anticipating price reversals was a consistent theme of his presentation and his work. For MTA Symposium attendees, the presentation was too short but offered enough ideas to fill weeks of study and testing.