Structural Theories

The structural theories of technical analysis are based on repetitions of previous price patterns. Price patterns are believed to be regular over long periods. Many structural theories exist, some of which are esoteric, such as lunar phases or hemlines on dresses to predict the direction of the stock market. These types are not discussed in this book.

Seasonal Patterns

The January effect is a theory that small-cap stocks post large returns in January. Technical analysts monitoring the DJIA monthly have found seasonal patterns occurring in December, January, July, and August. Some attribute the seasonal pattern in December and January to tax planning. In December, many investors sell stocks whose values are depressed to produce capital losses that can then be offset against other capital gains. This action of selling further depresses the prices of these stocks, which presents opportunities for investors to buy them back in January, which results in a surge in their stock prices. This is known as the January effect. Historically, the prices of small-cap stocks have risen slightly in January. Gottschalk reported that during the period 1982–1987 small stocks increased by 4.2 percent annually as compared with 3.8 percent for larger stocks in January (Gottschalk, 1988, pp. C1, C16). The following questions give some perspective on the gravity of the January effect: Which stocks will increase in January? Will they include the stocks in your portfolio? Maybe, maybe not! What about a bear market? During the bear markets of 1978 and 1982, the prices of small-cap stocks lost ground in January. Will the small percentage increases cover the transaction costs of buying and selling? The same questions can be asked about summer rallies in the markets. The theory of a summer rally says that the stock market rises during the summer months.

Research by Hugh Johnson, chief investment officer at First Albany, showed net gains from May 31 to August 31 in the DJIA for 21 of the past 33 years, during the period 1961–1994 (Kansas, C1). Birinyi Associates also found support for the summer rally premise with a longer study going back to 1915. In only four periods from 1915 to 1993 did the Dow Jones Industrial Average report losses in all three summer months—June, July and August. The gains on the industrial average were reported to be 0.41 percent, 1.31 percent and 1.06 percent on average per year for June, July and August, respectively over the period from 1915. Surprisingly, even in 1929 a summer rally took place, where the Dow Jones Industrial Average surged 11.5 percent in June, 4.8 percent in July and 9.4 percent in August (Kansas, 1994, p. C2).

In the weekend effect, stock prices peak on Fridays and decline on Mondays. According to this theory, investors should sell their stocks at the end of the week rather than at the beginning.

Elliott Wave Theory

The Elliott wave theory is based on the premise that stock prices move in a five-wave sequence when they are following a major trend and in a three-wave sequence when they are moving against a major trend. Long waves can last longer than 100 years, and subwaves have short durations.

The Elliott wave theory gained a following after technicians used it to correctly forecast the bull market of the 1980s. However, the theory lost much of its following when the theory predicted a bearish market in the late 1980s and early 1990s, missing out on the continuing bull market.

The problem with this structural theory is that what is considered to be a wave by some analysts is considered a subwave by others. The Elliott wave theory may be too broadly defined to be conclusive, and many of its followers often include their successes while discounting their failures.

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