Buff Dormeier - The History of Technical Analysis

The market is people in action, acting like people.

Bernard Baruch

In 1958, the candy company Just Born Candies introduced the marshmallow chicken, reigniting the classic debate over which came first, the marshmallow chicken or the chocolate egg? Which developed first, technical or fundamental analysis?

Most investors assume fundamental analysis preceded technical analysis. That conclusion appears logical. It takes two opposite opinions to come together to produce a price, and a series of prices creates the chart.

Thus, one might logically expect fundamental analysis to predate technical analysis. But that logic presupposes that prices used to create the chart were exchanged based upon the items fundamental value alone. How much an item is worth is determined by how much one party is willing to pay in order to obtain it and how little another party is willing to accept to let it go. Behavior may be as much a part of the price equation as value.

The first recorded investment transaction occurs in Genesis, a fill or be killed order. Upon moving into a new territory, Abraham allowed people to believe that Sarah, his beautiful wife, was his sister. A king, Abimelech, then mistakenly sends for Sarah in order to marry her.

In the Biblical account, God tells Abimelech that he has sinned and must return Sarah back to her husband Abraham, who is a prophet. In an effort to save his live, Abimelech seeks Abrahams forgiveness over the mistake:

Then Abimelech took sheep and oxen and servantboth men and womenand gave them to Abraham, and he returned his wife, Sarah, to him. Look over my kingdom, and choose a place where you would like to live, Abimelech told him. Then he turned to Sarah. Look, he said, I am giving your brother a thousand pieces of silver to compensate for any embarrassment I may have caused you. This will settle any claim against me in this matter. Then Abraham prayed to God, and God healed Abimelech, his wife, and the other women of the household, so they could have children.Genesis 20

From the Genesis account, the accepted offer appears to have been based upon technical observations and analysis rather than fundamental value. To summarize the text, Abimelech offered Abraham an unconditional lease of property, sheep, oxen, servants, and 1,000 pieces of silver in exchange for Abrahams prayers of forgiveness.

Abimelechs bid was accepted by Abraham; he forgave Abimelech and offered his prayers to God on the kings behalf.

Was this exchange based upon fundamental value? Obviously not! One cannot put a price on the love and fidelity of a spouse. Whats more, Abimelech had to reach a figure that he believed would be immediately acceptable to Abraham. Otherwise, he would put his life in jeopardy by trying to negotiate. Remember, he believed he was facing Gods wrath. Abimelech probably had just one shot to make an acceptable offer. If Abraham were to take offense at the first offer, Abimelech assumed he might die. Thus, the first financial transaction recorded was based primarily upon technical speculations of perceived acceptancenot fundamental considerations of intrinsic value.

Another example of technical analysis in the ancient world is found in the ancient city of Babylon in the seventh century B.C., where seven commodity price logs were discovered. Charts of commodity exchange rates were found that are thought to have been used to forecast future prices. The notion of unraveling the forces of supply and demand through price trends appears to have been at work even in the earliest of days.

In more modern financial times, we know little about the underlying reasons why the first stocks were exchanged in John Castaings London coffee shop in 1698. (This initial trading activity eventually became the London Stock Exchange.) Undoubtedly, part of the reason to exchange stocks at specific prices was based upon the traders ideas of what other parties might be willing to accept and what other investors would be willing to bid.

This bid-offer premise can be seen, too, in one of the oldest books about the markets, Confusion de Confusiones, written in 1688 by Joseph de la Vega. Observing the Amsterdam exchange, de la Vega states that when prices rise, we think they will run away from us. This may be the first Dutch rendering of the traders notion that the trend is your friend.

Although historic records of market technicians are few, they do exist. There was an ancient Japanese technical trader, Munehisa Homma (1724-1803), of whom we have some knowledge. Hommas methods of recording and analyzing prices are still with us to this day in the form of candlestick charts. Using his unique charting methods, Homma became a literal samurai of trading, and made a killing trading rice.

In 1755, Homma wrote the first book to be regarded as a true work of technical analysis, The Fountain of GoldThe Three Monkey Record of Money. In this book, Homma reasons that the most important aspect of investment is gauging the psychology of the market. As such, he described the developments of bull (yang) and bear (yin) markets, and their tendencies to run to extremes and then reverse. Homma was also believed to be a practitioner of volume and weather patterns. At his peak, Homma was rumored to earn, in todays dollars, more than $10 billion a year in trading profits. His personal fortune grew to more than $100 billion!

Today, in the United States, securities analysis is dominated by fundamental, not technical, analysis. One might reasonably conclude that our modern markets and exchanges have always operated under these lines of thought. Yet, the use of technical analysis in our modern markets has a very rich history, one predating traditional fundamental analysis.

For instance, what comes to mind when you hear Barrons, The Wall Street Journal, Forbes, the Dow Jones Industrial Average (DJIA), and Standard and Poors (S&Ps)? Technical analysis? Perhaps it should. All these publications and indexes, in fact, have their roots in technical analysis.

The modern father, the root, of technical analysis is considered to be none other than Charles H. Dow, the founder of The Wall Street Journal. Dow began his career as a financial reporter in the 1870s, a time when equities were not the dominant investment vehicle. Financial information about common stocks was scarce, and the information available often was unreliable. Historical ledgers of prices were not readily kept.

Thus, much of the knowledge about the underlying companies was limited to people in the know who frequently used that knowledge to manipulate stock prices. Dow used his birds-eye position as a member of the New York Stock Exchange to change much of this by introducing a newsletter called Customers Afternoon Letter. This revolutionary letter contained stock-price ledgers and company financial information, plus the first-ever stock index, comprised of 11 stocks.

The concept of an index was revolutionary. It freed investors from tracking individual stocks, allowing them to follow the market instead. If investors knew the collective movement of just a few prominent stocks, they would have a very good idea as to how most stocks were behaving as a whole. If investors knew how stocks as a whole were performing, they might be able to predict the actions of the overall economy. These ideas gave rise to