Breaking the Neckline

Breaking the Neckline
The real tip-off appears when activity fails to pick up appreciably on the third
rally, the right shoulder. If the market remains dull as prices recover (at which
stage you can draw a tentative “neckline” on your chart) and if, as they
approach the approximate level of the left shoulder Top and begin to round
over, volume is still relatively small, your Head-and-Shoulders Top is at least
75% completed. Although the specific application of these pattern studies in
trading tactics is the province of the second part of this book, we may note
here that many stock traders sell or switch just as soon as they are sure a lowvolume
right shoulder has been completed, without waiting for the final
confirmation which we named under D as the breaking of the neckline.
Nevertheless, the Head-and-Shoulders is not complete, and an important
Reversal of Trend is not conclusively signaled until the neckline has
been penetrated downside by a decisive margin. Until the neckline is broken,
a certain percentage of Head-and-Shoulders developments, perhaps 20%,
are “saved”; i.e., prices go no lower, but simply flounder around listlessly
for a period of time in the general range of the right shoulder, eventually
firm up, and renew their advance.

Finally, it must be said that, in rare cases, a Head-and-Shoulders Top is
confirmed by a decisive neckline penetration and still prices do not go down
much farther. “False moves” such as this are the most difficult phenomena with
which the technical analyst has to cope. Fortunately, in the case of the Headand-
Shoulders, they are extremely rare. The odds are so overwhelmingly in
favor of the downtrend continuing once a Head-and-Shoulders has been confirmed
that it pays to believe the evidence of the chart no matter how much it
may appear to be out of accord with the prevailing news or market psychology.
There is one thing that can be said and is worth noting about Head-and-
Shoulders Formations that fail completion or produce false confirmations.

Head and Shoulder

The Head-and-Shoulders
If you followed closely and were able successfully to visualize how the foregoing
example of distribution would appear on a chart, you saw a Head-and-
Shoulders Top Formation. This is one of the more common and, by all odds,
the most reliable of the Major Reversal Patterns. Probably you have heard it
mentioned, for there are many traders who are familiar with its name, but
not so many who really know it and can distinguish it from somewhat similar
price developments which do not portend a real Reversal of Trend.
The typical or, if you will, the ideal Head-and-Shoulders Top is illustrated
in Diagram 2. You can easily see how it got its name. It consists of:
A. A strong rally, climaxing a more or less extensive advance, on which
trading volume becomes very heavy, followed by a Minor Recession
on which volume runs considerably less than it did during the days
of rise and at the Top. This is the “left shoulder.”
B. Another high-volume advance which reaches a higher level than the
top of the left shoulder, and then another reaction on less volume
which takes prices down to somewhere near the bottom level of the
preceding recession, somewhat lower perhaps or somewhat higher,
but, in any case, below the top of the left shoulder. This is the “Head.”
C. A third rally, but this time on decidedly less volume than accompanied
the formation of either the left shoulder or the head, which fails
to reach the height of the head before another decline sets in. This is
the “right shoulder.” D. Finally, decline of prices in this third recession down through a line
(the “neckline”) drawn across the Bottoms of the reactions between the
left shoulder and head, and the head and right shoulder, respectively,
and a close below that line by an amount approximately equivalent to
3% of the stock’s market price. This is the “confirmation” or “breakout.”
Note that each and every item cited in A, B, C, and D is essential to a
valid Head-and-Shoulders Top Formation. The lack of any one of them casts
in doubt the forecasting value of the pattern. In naming them, we have left
the way clear for the many variations that occur (for no two Head-and-
Shoulders are exactly alike) and have included only the features which must be present if we are to depend upon the pattern as signaling an important
Reversal of Trend.

Closing Prices

Only Closing Prices Used — Dow Theory pays no attention to any
extreme highs or lows which may be registered during a day and
before the market closes, but takes into account only the closing figures,
i.e., the average of the day’s final sale prices for the component
issues. We have discussed the psychological importance of the endof-
day prices under the subject of chart construction and need not
deal with it further here, except to say that this is another Dow rule
which has stood the test of time. It works thus: suppose an Intermediate
Advance in a Primary Uptrend reaches its peak on a certain day
at 11 a.m., at which hour the Industrial Average figures at, say, 152.45,
and then falls back to close at 150.70. All that the next advance will
have to do in order to indicate that the Primary Trend is still up is
register a daily close above 150.70. The previous intraday high of
152.45 does not count. Conversely, using the same figures for our first
advance, if the next upswing carries prices to an intraday high at, say,
152.60, but fails to register a closing price above 150.70, the continuation
of the Primary Bull Trend is still in doubt.
In recent years, differences of opinion have arisen among market
students as to the extent to which an Average should push beyond a
previous limit (Top or Bottom figure) in order to signal (or confirm or
reaffirm, as the case may be) a market trend. Dow and Hamilton evidently
regarded any penetration, even as little as 0.01, in closing price as a valid signal, but some modern commentators have required penetration
by a full point (1.00). We think that the original view has the
best of the argument, that the record shows little or nothing in practical
results to favor any of the proposed modifications. One incident in June
of 1946, to which we shall refer in the following chapter, shows a
decided advantage for the orthodox “any-penetration-whatever” rule.

Sideways Market Signals

“Lines” May Substitute for Secondaries — A Line in Dow Theory
parlance is a sideways movement (as it appears on the charts) in one
or both of the Averages, which lasts for 2 or 3 weeks or, sometimes,
for as many months, in the course of which prices fluctuate within a
range of approximately 5% or less (of their mean figure). The formation
of a Line signifies that pressure of buying and selling is more or
less in balance. Eventually, of course, either the offerings within that
price range are exhausted and those who want to buy stocks have to
raise their bids to induce owners to sell, or else those who are eager
to sell at the “Line” price range find that buyers have vanished and
that, in consequence, they must cut their prices in order to dispose of
their shares. Hence, an advance in prices through the upper limits of an established Line is a Bullish Signal and, conversely, a break down
through its lower limits is a Bearish Signal. Generally speaking, the
longer the Line (in duration) and the narrower or more compact its
price range, the greater the significance of its ultimate breakout.
Lines occur often enough to make their recognition essential to
followers of Dow’s principles. They may develop at important Tops
or Bottoms, signaling periods of distribution or of accumulation, respectively,
but they come more frequently as interludes of rest or
Consolidation in the progress of established Major Trends. Under
those circumstances, they take the place of normal Secondary Waves.
A Line may develop in one Average while the other is going through
a typical Secondary Reaction. It is worth noting that a price movement
out of a Line, either up or down, is usually followed by a more
extensive additional move in the same direction than can be counted
on to follow the “signal” produced when a new wave pushes beyond
the limits set by a preceding Primary Wave. The direction in which
prices will break out of a Line cannot be determined in advance of
the actual movement. The 5% limit ordinarily assigned to a Line is
arbitrarily based on experience; there have been a few slightly wider
sideways movements which, by virtue of their compactness and welldefined
boundaries, could be construed as true Lines. (Further on in
this book, we shall see that the Dow Line is, in many respects, similar
to the more strictly defined patterns known as Rectangles which appear
on the charts of individual stocks.)

The Bear Market

The Bear Market — Primary Downtrends are also usually (but again,
not invariably) characterized by three phases. The first is the distribution
period (which really starts in the later stages of the preceding Bull
Market). During this phase, farsighted investors sense the fact that
business earnings have reached an abnormal height and unload their
holdings at an increasing pace. Trading volume is still high, though
tending to diminish on rallies, and the “public” is still active but
beginning to show signs of frustration as hoped-for profits fade away.
The second phase is the Panic Phase. Buyers begin to thin out and
sellers become more urgent; the downward trend of prices suddenly
accelerates into an almost vertical drop, while volume mounts to
climactic proportions. After the Panic Phase (which usually runs too
far relative to then-existing business conditions), there may be a fairly
long Secondary Recovery or a sideways movement, and then the third
phase begins.


This is characterized by discouraged selling on the part of those
investors who held on through the Panic or, perhaps, bought during it
because stocks looked cheap in comparison with prices which had ruled
a few months earlier. The business news now begins to deteriorate. As
the third phase proceeds, the downward movement is less rapid, but
is maintained by more and more distress selling from those who have
to raise cash for other needs. The “cats and dogs” may lose practically
all their previous Bull Advance in the first two phases. Better-grade
stocks decline more gradually, because their owners cling to them to
the last. And, the final stage of a Bear Market, in consequence, is frequently
concentrated in such issues. The Bear Market ends when everything
in the way of possible bad news, the worst to be expected, has
been discounted, and it is usually over before all the bad news is “out.”


The three Bear Market phases described in the preceding paragraph
are not the same as those named by others who have discussed this
subject, but the writers of this study feel that they represent a more
accurate and realistic division of the Primary down moves of the past
30 years. The reader should be warned, however, that no two Bear
Markets are exactly alike, and neither are any two Bull Markets. Some
may lack one or another of the three typical phases. A few Major
Advances have passed from the first to the third stage with only a
very brief and rapid intervening markup. A few short Bear Markets
have developed no marked Panic Phase and others have ended with
it, as in April 1939. No time limits can be set for any phase; the third
stage of a Bull Market, for example, the phase of excited speculation
and great public activity, may last for more than a year or run out in
a month or two. The Panic Phase of a Bear Market is usually exhausted
in a very few weeks if not in days, but the 1929 through 1932 decline
was interspersed with at least five Panic Waves of major proportions.
Nevertheless, the typical characteristics of Primary Trends are well
worth keeping in mind. If you know the symptoms which normally
accompany the last stage of a Bull Market, for example, you are less
likely to be deluded by its exciting atmosphere.

Bull Market

The Bull Market — Primary Uptrends are usually (but not invariably)
divisible into three phases. The first is the phase of accumulation during
which farsighted investors, sensing that business, although now
depressed, is due to turn up, are willing to pick up all the shares
offered by discouraged and distressed sellers, and to raise their bids
gradually as such selling diminishes in volume. Financial reports are
still bad — in fact, often at their worst — during this phase. The
“public” is completely disgusted with the stock market — out of it
entirely. Activity is only moderate but beginning to increase on the
rallies (Minor Advances).
The second phase is one of fairly steady advance and increasing
activity as the improved tone of business and a rising trend in corporate
earnings begin to attract attention. It is during this phase that the
“technical” trader normally is able to reap his best harvest of profits.

Finally, comes the third phase when the market boils with activity
as the “public” flocks to the boardrooms. All the financial news is
good, price advances are spectacular and frequently “make the front
page” of the daily papers, and new issues are brought out in increasing
numbers. It is during this phase that one of your friends will call
up and blithely remark, “Say, I see the market is going up. What’s a
good buy?” — all oblivious to the fact that it has been going up for
perhaps two years, has already gone up a long ways, and is now
reaching the stage where it might be more appropriate to ask, “What’s
a good thing to sell?” In the last stage of this phase, with speculation
rampant, volume continues to rise, but “air pockets” appear with
increasing frequency; the “cats and dogs” (low-priced stocks of no
investment value) are whirled up, but more and more of the top-grade
issues refuse to follow

Dow Theory

Dow Theory

The Major (Primary) Trends in stock prices are like
the tides. We can compare a Bull Market to an incoming or flood tide which
carries the water farther and farther up the beach until finally it reaches highwater
mark and begins to turn. Then follows the receding or ebb tide,
comparable to a Bear Market. But all the time, during both ebb and flow of
the tide, the waves are rolling in, breaking on the beach, and then receding.
While the tide is rising, each succeeding wave pushes a little farther up onto
the shore and, as it recedes, does not carry the water quite so far back as did
its predecessor. During the tidal ebb, each advancing wave falls a little short
of the mark set by the one before it, and each receding wave uncovers a little
more of the beach. These waves are the Intermediate Trends, Primary or
Secondary, depending on whether their movement is with or against the
direction of the tide. Meanwhile, the surface of the water is constantly agitated
by wavelets, ripples, and “cat’s-paws” moving with or against or across
the trend of the waves — these are analogous to the market’s Minor Trends,
its unimportant day-to-day fluctuations. The tide, the wave, and the ripple
represent, respectively, the Primary or Major, the Secondary or Intermediate,
and the Minor Trends of the market.
Tide, Wave,


A shore dweller who had no tide table might set about determining the
direction of the tide by driving a stake in the beach at the highest point
reached by an incoming wave. Then if the next wave pushed the water up
beyond his stake he would know the tide was rising. If he shifted his stake
with the peak mark of each wave, a time would come when one wave would
stop and start to recede short of his previous mark; then he would know
that the tide had turned, had started to ebb. That, in effect (and much
simplified), is what the Dow theorist does in defining the trend of the stock
market.
The comparison with tide, wave, and ripple has been used since the
earliest days of the Dow Theory. It is even possible that the movements of
the sea may have suggested the elements of the theory to Dow. But the
analogy cannot be pushed too far. The tides and waves of the stock market
are nothing like as regular as those of the ocean. Tables can be prepared
years in advance to predict accurately the time of every ebb and flow of the
waters, but no timetables are provided by the Dow Theory for the stock
market.