Forecasting financial markets the psychology of successful investing 5th ed

11/06 2:56 pm wd alysis in nd the Far gree from terbury the s He is a echnical actitioner ing “This book will entertain and intrigue keen investors.” FORECASTING FINANCIAL MARKETS “This book will entertain and intrigue keen investors.” Financial Times “Tony Plummer… has written a book that is almost breathless in its enthusiasm for his chosen craft.” The Independent “A brilliant, original, insightful work… deserves to be read by all serious technical analysts.” The Independent “Should interest not only practitioners and skeptical economists, but also countless thoughtful managers who are rightly impatient with expert ‘forecasts’, which are, alas, not always worth the paper they are printed on.” Sir Adam Ridley (writing in the Foreword) Kogan Page US 525 South 4th Street, #241 Philadephia PA 19147 USA Investment and securities FORECASTING FINANCIAL MARKETS 5TH EDITION The Psychology of Successful Investing In Forecas Plummer p into the ps behaviour instinct can individual i money in m an individu independe such indep acquire the • understa logical te • recogniz emotiona fluctuatio • design a trading s objective The book e dimensions This fifth e Financial M updated to author’s lat the implica and rhythm financial m deal with: • • • • the phen the three economi recurren activity; • forecasti • finding c PLUMMER £45.00 US $79.95 Kogan Page 120 Pentonville Road London N1 9JN United Kingdom www.kogan-page.co.uk Financial Times 5TH EDITION FORECASTING FINANCIAL MARKETS of is a Bank Ltd ment PLC rket assets 1999, currencies, dent d rhythms Page TONY PLUMMER i FORECASTING FINANCIAL MARKETS ii This page intentionally left blank iii FORECASTING FINANCIAL MARKETS The Psychology of Successful Investing 5TH EDITION TONY PLUMMER London and Philadelphia iv To Glenys First published in 1989 Revised edition 1990 Second edition 1993 Third edition 1998 Fourth edition 2003 Fifth edition 2006 Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the Copyright, Designs and Patents Act 1988, this publication may only be reproduced, stored or transmitted, in any form or by any means, with the prior permission in writing of the publishers, or in the case of reprographic reproduction, in accordance with the terms and licences issued by the CLA Enquiries concerning reproduction outside those terms should be sent to the publishers at the undermentioned addresses: 120 Pentonville Road London N1 9JN United Kingdom www.kogan-page.co.uk 525 South 4th Street, #241 Philadelphia PA 19147 USA © Tony Plummer, 1989, 1993, 1998, 2003, 2006 The right of Tony Plummer to be identified as the author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988 ISBN 7494 4749 British Library Cataloguing in Publication Data A CIP record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Plummer, Tony Forecasting financial markets : the psychology of successful investing / Tony Plummer – 5th ed p cm Includes index ISBN 0-7494-4749-4 Stock price forecasting Investment analysis Investments I Title HG4637.P57 2006 332.63’2220112–dc22 2006013221 Typeset by Saxon Graphics Ltd, Derby Printed and bound in the United States by Thomson-Shore, Inc v Contents Foreword Preface to the fifth edition Acknowledgements Introduction vii ix xiii Part One: The logic of non-rational behaviour in financial markets Wholly individual or indivisibly whole Two’s a crowd The individual in the crowd The systems approach to crowd behaviour Cycles in the crowd Approaches to forecasting crowd behaviour 15 26 33 41 54 Part Two: The dynamics of the bull–bear cycle 10 11 12 The stock market crowd The shape of the bull–bear cycle Energy gaps and pro-trend shocks The spiral and the golden ratio The mathematical basis of price movements The shape of things to come 73 86 107 123 140 153 Part Three: Forecasting turning points 13 The phenomenon of cycles 14 The threefold nature of cycles 15 Economic cycles 165 176 201 vi Contents 16 17 18 19 20 21 22 23 Recurrence in economic and financial activity Integrating the cycles Forecasting with cycles Finding cycles: a case study Price patterns in financial markets The Elliott wave principle Information shocks and corrections The confirmation of buy and sell signals 217 232 245 256 270 286 302 326 Part Four: The trader at work 24 25 26 27 28 The psychology of fear The troubled trader The psychology of success The mechanics of success Summary and conclusions Index 351 361 377 393 405 409 vii Foreword The last two decades have witnessed dramatic changes in the behaviour of the free world’s financial markets The fundamental causes of these changes must embrace both the end of fixed exchange rates in the early 1970s and the progressive removal of controls on international financial flows However, whatever the precise reasons may be, the symptoms are evident: ᔡ a very marked increase in the volatility of prices and volumes in most markets; ᔡ sharp and growing clashes between short-term developments and long-term trends; ᔡ striking contradictions between market sentiment and economic fundamentals The practical consequences have sometimes daunting and sometimes humiliating challenges for forecasters but, far more importantly, much greater risk and uncertainty for businesspeople and traders Despite the vast flow of data and major advances in computing and applied statistics, conventional forecasting and economic analysis are all too often not providing the guidance market operators need So, it is clear that we should now ponder on why this is and consider, in an open-minded way, what can be done to broaden and strengthen the techniques we rely on We need to widen our horizons so as to be able to heed the methods and results of technical analysis The minimum argument for doing so is the cynical or expedient one that many professionals in the financial markets draw heavily on technical analysis in one way or another in their dealing as well as their viii Foreword writing and advising A stronger argument is that technical analysis involves a serious attempt to reflect phenomena such as peer-group pressure, fashion, crowd psychology and much else, which are ignored or assumed unreliable by conventional theory Regrettably, there has been little common ground sought between conventional forecasters and technical analysts Tony Plummer’s book is, in part, a contribution to that debate However, it is also a serious attempt to state systematically the basis of technical analysis in a way that should interest not only other practitioners and sceptical economists, but also countless thoughtful managers who are rightly impatient with expert ‘forecasts’, which are, alas, not always worth the paper they are printed on Sir Adam Ridley Director General, London Investment Banking Association Special Adviser to successive Chancellors of the Exchequer 1979–85 ix Preface to the fifth edition We learn from our mistakes, and we interpret the world in the light of our own experiences Forecasting Financial Markets is a result of both these truths In 1979, I was forced to learn that the economic theory that I had learnt at the University of Kent and the London School of Economics did not always work in the real world At the time, I was trading in the gilt-edged market in London Prime Minister James Callaghan had been overseeing a major inflationary episode, fuelled by rising government spending and accelerating monetary growth Basic economics taught me that the UK needed a significant tightening of monetary policy and that bond prices were in a serious bear market However, in early 1979, gilt-edged stock prices rallied by about 20 per cent in the space of a few weeks, thereby retracing a good two-thirds of the previous year’s fall The rally was triggered by what was subsequently referred to as the ‘Battle of Watling Street’: representatives of City institutions literally fought to get into the Bank of England’s debt issuing office prior to a 10 am deadline, in order to cover massive short positions For a while, the civilized atmosphere of the City of London degenerated into the physical behaviour of a crowd Many missed the deadline: demand for bonds exceeded the supply of bonds, and prices soared Extraordinarily, however, the rally was not just a normal, shortlived bear squeeze It extended over eight weeks Day after day, prices went up, almost without pause It was as if ‘fundamentals’ didn’t 404 The trader at work As indicated above, using moving averages in this way may be supplemented by using an average directional indicator If the ADX is rising, then the market trend (whether up or down) is intact Under these circumstances, closing contra-trend trades should be accompanied by the opening of pro-trend trades If the ADX is falling, then the market is not trending and a more circumspect approach is required CONCLUSION The basic system outlined in this chapter is far from being the last word in profitable trading systems The aim here has been to indicate how a profitable trading system can be developed For the individual trader, great insights can come from just trying to develop a personalized trading system Furthermore, backtracking through all the historical signals and identifying their validity encourages great confidence in the system However, it should be clear from the analysis that profitability is likely to be enhanced by a genuine understanding of how markets behave, and by use of the golden ratio to determine price objectives These, in turn, encourage patience while natural forces evolve and encourage confidence that expectations will be fulfilled These are two of the primary advantages of goal-setting, which we outlined in Chapter 26 NOTES Different analysts use different time periods for the calculation of the exponential moving averages The original ones recommended by Gerald Appel were 12-period and 26-period averages respectively The author’s own researches suggest that 13-period and 34-period averages may give better results Many analysts use nine-period averages This particular trading system has been used by the author and is one that has been refined over a long period of time See Chapter 12 These rules are for general guidance only In modern, highly leveraged markets, great care needs to be taken with risk control One of the best books on the subject is Elder, Dr Alexander (2002) Come Into My Trading Room, John Wiley, New York The moving average signal is unlikely to be correct if it is generated when the moving average is still moving sharply against the direction indicated by the signal 405 28 Summary and conclusions An analysis of universal laws can provide us with an explanation of stock market dynamics The need individuals have to obey universal laws and participate in greater wholes is the key to a fuller understanding of all social, economic and political activity In the current context, it allows us to ‘explain’ the stock market phenomenon by forcing us to adopt the assumption of non-rational crowd behaviour by market participants The important point to remember is that the ownership of investment positions in the pursuit of stock market profits creates a ‘crowd’ mentality The decision to make an investment (or disinvestment) may have been arrived at rationally, but, once a financial exposure exists, so does the potential for stress and fear Price behaviour becomes the arbiter of investment decisions and price movements can therefore trigger responses from investors that have a large non-rational dimension This non-rational response is the binding force in the crowd situation Once a crowd has been created, it has a life cycle of its own In the context of a financial market, the crowd’s behaviour during this life cycle can be measured by changes in prices and sentiment The former can be tracked using price–time charts, while the latter can be judged by plotting variables such as volume, open interest or momentum While a crowd exists, it has natural metabolic rhythms that have both an internal and an external dimension The internal rhythms are, by definition, specific to the particular crowd and are reflected in regular, cyclical fluctuations that can be found in the price–time 406 The trader at work charts At the same time, however, the crowd has to oscillate in a limit cycle relationship with its social and economic environment Some of the environmental oscillations are themselves ‘regular’, and so the crowd oscillates in harmony with these external rhythms because, essentially, it has ‘learnt’ to so In both these situations, where the fluctuations are regular and continuous, it is possible to use observed cycles to forecast the timing of turning points in financial market prices Most of the environmental oscillations, however, will appear as ‘shocks’ to the crowd They may consist of either pro-trend information or contra-trend information – pro-trend information encourages existing trends; contra-trend information generates a correction; both generate a three-stage fluctuation as the crowd seeks to assimilate the information This three-wave response is the basis of what we have called the ‘price pulse’ Each phase of the price pulse is defined by the golden ratio and its derivatives The golden ratio has long been recognized as an intrinsic part of nature in terms of both the relationship between different aspects of the same spatial structure and the growth and learning processes of that structure It follows that price movements in financial markets are subject to the ‘constraints’ of the golden ratio and it is therefore possible to forecast the extent of price movements using this ratio Finally, the alternating up and down movements created by the combination of rhythmic cycles and contra-trend shocks are reflected in a limited number of price patterns These have long been identified by traditional technical analysis and can be used to deduce trading signals that have a low risk of being incorrect and a high probability of being profitable Of course, no system is perfect There will be occasions when the messages being given are either inconclusive or conflicting On these occasions, investors should not anticipate reversals if to so means ‘moving away from base’ At the simplest level, this implies that longterm investors should always stay in the market until definite sell signals are given, and that short-term investors should always stay out of the market until definite buy signals are generated On most occasions, however, technical analysis will confirm the presence of a reversal while it is in the process of developing The crucial requisite for wealth accumulation is for a trader to be properly positioned for large market movements It is important to remember that large movements are created, essentially, by the failure of the majority of investors to anticipate all developments fully, and by the consequent reaction en masse to largely unforeseen events Summary and conclusions 407 Substantial price movements simply cannot occur if everybody is getting the market right all of the time Technical analysis focuses attention on what the majority of investors are doing at any given moment, while simultaneously enabling successful investors to stand aside from the crowd mentality It is a rational approach to a nonrational environment Hence, technical analysis should, at the very least, ensure that no major mistakes are made When used properly, the techniques will not give strong buy signals just prior to a price collapse, nor strong sell signals just prior to a rally More generally, there are always clear warning signals that a terminal juncture is approaching and these signals subsequently translate into some form of appropriate buy or sell signal just prior to the major part of the relevant impulse wave It has been the objective of this book to show that technical analysis is an accurate and theoretically justifiable method of forecasting behaviour in financial markets Only putting theory into practice will, however, demonstrate the validity of the technique Investors who follow the rules outlined in this book should, after a little experience, find that it is entirely possible to embark on a long-term programme of accumulating wealth 408 409 Index acceleration 119,171–71, 173–74 A/D (Advance–Decline) line 341–42 adaptation cycles 214, 220, 221, 226, 234, 246 ADX (Average Directional Indicator) 341, 397, 398 affirmations 384 alternation, rule of 298 see also Elliott wave principle altruism 29 American Civil War 218, 219, 220, 222, 223, 230, 233–34, 244 amygdala 22,29 anxiety 351, 358, 359 Australian All Ordinaries 187–89 Average Directional Indicator (ADX) 341 averages (see moving averages) avoidance compulsions 374, 375 368–69, base cycle 191,192, 193, 196, 197, 198, 207, 208, 231, 233, 262–63, 264 see also cycles Bateson, Gregory 19, 33, 41, 169 bear see bull–bear cycles behaviour, human 361–76 see also personality types beliefs 12, 357–58 and goal setting 378–83 groups 15–23 Berry, Brian 202 Berry cycles 204–05, 209–12, 214–15, 222–26, 228–31, 246, 247, 250 Bloom, Howard xi bond markets 144–59, 257–69 UK 144–48, 153–56, 257–69 US 149–51, 156–59 410 Index boundaries 272, 306, 308–10, 314–20 see also corrections; golden ratio Brand, Stewart 271 bull see bull–bear cycles bull–bear cycles 78, 86–106, 288, 326 and the economy 90–91 and emotions 78, 80 price pulse 101 prices and sentiment 87–89, 92, 102 reversal 97–99 shocks 91–94, 102–03 Character see personality types closing positions 397, 400, 403 collective consciousness 20 complex corrections 295–96 see also Elliott wave principle consciousness 19–21 confidence 88, 327, 328, 331 see also sentiment confirmation 326–47 direct, principle of 342–46 and second price index 342–45 conflict 29, 77 corrections 302–24 alternation and 298 boundaries 272, 306, 308–10, 314–20 complex 295–96 flat 294, 295, 298 inverted 298 running 294–95 triangles 293, 296–97 see also Elliott wave principle crash 57–58, 59, 64–65, 84, 154, 187–89, 190, 221, 243, 266, 314 crisis cycles 214, 222, 223, 224, 237–38, 243, 248–49, 250 see also cycles crowd leader 26, 28–29, 37–38, 81–82 crowds 4, 15–23, 73–84, 111, 118, 195 financial markets 73–84 and individuals 16, 30 intelligence 19, 23 life cycles 41–43 see also groups cycles adaptation 214, 220, 221, 226, 234, 246 and economy 201–15, 272 and evolution 119–20, 213–14, 306 base 191,192, 193, 196, 197, 198, 207, 208, 231, 233, 262–63, 264 behavioural traits 195–97 Berry 204–05, 209–12, 214–15, 222–26, 228–31, 246, 247, 250 characteristics 191 crisis 214, 222, 223, 224, 237–38, 243, 248–49, 250 disruption 214, 233, 234, 235, 242, 250–51 dyads 185–87 and energy gaps 107–21, 185–89, 191, 195–95, 212, 231, 243, 266, 303, 328 functions 191–92 and industrial production 217–31 innovation 214, 220, 229, 231, 247–48 Index Juglar 204, 209–13, 220, 221, 224–25, 227, 229, 233, 234, 235, 236, 241, 246, 247–49, 250 Kitchin 204, 205, 230, 251–55 Kondratyev 205, 206, 238–44 Kuznets 205 recuperation 214, 229, 235, 236, 241, 242 regeneration 214, 221, 229, 230, 236 Strauss and Howe 204, 206, 222, 225, 228, 243–44 terminal 191, 192, 193, 197, 198, 208, 223, 233 translations 192–95 trend 191, 192, 193, 196, 208, 220, 233 triads 179–99, 204–05, 207–09, 219, 222–25 see also bull–bear cycles; life cycles; limit cycles data see information Dawkins, Richard 18 disruption cycles 214, 233, 234, 235, 242, 250–51 direct confirmation, principle of 342–46 directional indicator (DI) 340–41 dollar 281, 283–84, 315–17, 319–24 double retracements 292 see also Elliott wave principle doubling sequence 124 Dow 174, 176–79, 181–86, 190–198, 254–55, 311, 314, 342, 345 Dow theory 342–45 411 economic cycles 201–15, 272 economic theory 206 problems with 61, 166, 202–03 rational expectations 63 ego Elder, Dr Alexander 341 Elliott, Ralph N 138, 286 Elliott wave principle 5, 274–75, 284–300 alternation, rule of 298 basic wave patterns 287 corrections 288, 290, 292, 294–98 derived rules 289–90 double retracements 292 failures 291–92 and impulse waves 290 natural phenomenon 289 and price pulse 287 problems with 299–300 variations 290 corrections 293–98 fifth wave 291–93 emotions 76, 78, 331, 355–56 bull–bear cycles 78 influence 355–57 see also fear energy gaps 92–93, 107–21, 185–87, 191, 194–95, 212, 231, 243, 266, 303, 328 anticipating 327 bridging 110–14 confirmation 190 and information flows 117–18 and momentum 186–87 evolution 119–20, 213–14, 306 economic 213–14 evolutionary metamorphosis 114 extensions 291 412 Index failures 291–92 fear 99–100, 197, 331–32, 351–59, 373–74, 375 feedback loops 36–38 Fibonacci sequence 124–27 First World War 220, 221, 234, 235 five-wave patterns see Elliott wave principle; price pulse flat corrections 294–95 fractals 160, 217, 228 Gartley, H M 139 Gilded Age 220, 234 gilt-edged market 144–48, 153–56, 257–69 goal-setting 378–86 golden measure 128–29, 138–39 golden ratio 123–39, 218, 282–84, 307–24 boundaries 308–09, 315–17 price targets 282–84 retracement targets 310–313, 316 support and resistance see boundaries see also ratios golden rectangles 130–31 golden spiral 123–39 Great Depression 209, 219, 222, 235, 236–37, 243 groups 12, 15–23, 166–67, 195 see also crowds habits 353–54 health 387–89 Ichazo, Oscar 362, 367 information 35–37, 112, 117–18, 134–35, 302–24 crowds and 42–43 learning 107–09, 113, 319, 323 and trends 303–04 see also shocks innovation cycles 214, 220, 229, 231, 247–48 instinct 363–69 and personality types 363–69 investment advisers 82–83 Jantsch Erich 33 Juglar, Clement 202 Juglar cycles 204, 209–13, 220, 221, 224–25, 227, 229, 233, 234, 235, 236, 241, 246, 247–49, 250 see also cycles Kitchin, Joseph 202, 226, 227–28 Kitchin Cycles 204, 205, 230, 251–55 see also cycles Kondratyev, Nikolai 203, 238–44 Kondratyev cycles 205, 206, 238–44 see also cycles Korean War 226 Kuznets, Simon 202 Kuznets cycles 205 see also cycles Le Bon, Gustave 16, 17, 20, 39 LeDoux Joseph 22 learning 107, 113, 319, 323 curves 107–09 see also information life cycles 41–43, 102, 103, 113–114 see also bull–bear cycles; cycles limbic system 21, 22 Index limit cycles 44–48, 102, 104, 327, 331, 347 multiple 47 and prices 87–89, 94–98 and shocks 49–51 MACD (moving average convergence–divergence) 338–39, 396, 397, 399, 400 Maclean, Paul 21, 342 memes 18 Milgram, Stanley 29 Mills, Henry R 107–09 mind 18–20, 33, 62, 134–35 see also subconscious Missionary Awakening 220, 234, 235 momentum 88, 100, 111, 119, 156–59, 169–74, 186–88, 259, 328, 336–37, 340 and cycles 170–71, 259–60, 263 motivation 11–13 moving averages 337–38 see also MACD Naranjo, Claudio 362 neocortex 21, 22 New Deal 225 non-confirmation 172–74, 280–81, 327–29 open interest 328–35, 346, 347 opening positions 396–97, 399–400 overextended markets 327–28, 336 personality types 363–74 avoidance compulsions 368–69 basic motivations 367–68 413 characteristics 354–65 and financial markets 372–75 price movements 54–60 and crowd psychology 74–80 mathematical relationships 140–52 prediction methods 60 see also bond market; price pulse price pulse 101, 153–61 see also Elliott wave principle; price movements; shocks price reversals see reversals price targets 140–52 rational expectations 63 ratios 123–39, 141–51, 282–84 1.618 formula 282–84 2.618 formula 141–51, 282–84 4.236 formula 282–84 see also golden ratio re-tests 96, 97–98, 111, 310, 327, 332 recession 207, 208, 211, 212, 214 rectangles, golden 130–32 see also golden ratio recuperation cycles 214, 229, 235, 236, 241, 242 reductionism 10, 61 regeneration cycles 214, 221, 229, 230, 236 see also cycles Relative Strength Index (RSI) 339 see also Wells Wilder relaxation techniques 390–91 resistance see boundaries retracements 307–09, 310–13 double 292 and pro-trend shocks 319, 320 414 Index reversals 97–99 see also boundaries RSI (Relative Strength Index) 339 see also Wells Wilder running corrections 294–95 see also Elliott wave principle satiation 109, 113, 167, 212 Schumacher, Fritz 12 Schwager, Jack second price index 342–45 Second World War 209, 234 self-awareness 12, 20, 356 self-organization 17–18, 33, 65, 136–37 sentiment 62, 87–89, 94–96, 111, 328, 333 shocks 48–50, 91–94, 96, 97, 98, 99, 102, 107–21, 302–24 contra-trend 92–93 hierarchical 315 and limit cycles 48–50, 102–03 pro-trend 92, 107–21, 319–20 see also cycles; information; price pulse spirals 49, 96, 98, 123–39, 327 golden 131–32 stops 401 Strauss and Howe cycle 204, 206, 222, 225, 228, 243–44 stress 354–55 subconscious 18, 352–53, 356 support see boundaries systems theory 10 Tarde, Gabriel 107 targets see price targets technical analysis 5, 66–68, 78–79, 326, 351 terminal cycle 191, 192, 193, 197, 198, 208, 223, 233 threat responses 354–55 three-wave patterns see cycles; Elliott wave principle; price pulse trading systems 393–404 closing positions 397, 400–01, 403 design 395–96 money management 399 opening positions 396–97, 399–400, 403 reversing positions 397 spreading risk 398–99 market map 398 translation, cycle 192–95 Treasury bonds UK 144–48, 153–56, 257–69 see also gilt-edged market US 149–51, 156–59 trend cycles 191, 192, 193, 196, 208, 220, 233 see also cycles triads 179–99, 204–05, 207–09, 219, 222–25 see also cycles triangles 293, 296–98 corrections 296–97, 298 fifth wave diagonal 293 triune brain 20–21 UK gilt-edged market 144–48, 153–56, 257–69 US Treasury bond market 149–51, 156–59 velocity see momentum Vietnam War 209, 211, 226, volume 328–34 Index waves see Elliott wave principle; price pulse Wells Wilder, J 339 Yom Kippur War 227 415 zigzags 280, 293, 295, 298 see also Elliott wave principle 416 This page intentionally left blank 417 This page intentionally left blank 418 This page intentionally left blank