Japanese Candlesticks Foretold the Decline in Merrill Lynch Shares

The story of the decline in Merrill Lynch shares since early 2007 bears an uncanny resemblance to that of Bear Stearns.  From a high of $98.68 on January 18, 2007, Merrill shares fell to a low of $22.00 on July 29, 2008.  Could such a drastic decline have been foreseen?  The answer lies in the Japanese Candlesticks; and the answer is Yes.

But first: a short primer on the Candlesticks.  What are they all about, and why is it that they can predict important changes in price trend?  They are a method of price display that goes beyond the simple bar chart style.  They show everything that the bar chart does, but in an enhanced manner, in pictorial form which the eye perceives instantly.  The key lies in showing the distance between the opening price and the closing price in the form of a cylinder, which is left hollow (or “white”) if the close is higher than the open or is filled in “black” if the close is lower than the open.  This shows the viewer, in a visual flash, the overall trading mood of the time period which is represented by the candle.  It is especially useful when prices are being shown on the computer screen in “streaming data,” so that the viewer can see in real time the way in which the buying pressure and the selling pressure is constantly changing.

The patterns laid down by the Candlesticks also have meaning.  They can be a single bar or multiple bars, and they have varying connotations.  One pattern which often has particular predictive ability is the “Evening Star,” which is a three-bar affair in which (assuming a rising price trend) the first bar is a tall white candle, showing a closing higher than the opening, and a strong day as well.  The second bar (the “Star”) will ideally be a smaller candle, situated at a higher price level than the first.  The third bar will be a tall black candle, showing a closing lower than the opening, situated at a lower price level than the Star.  The three, together, display a substantial change in trend.  Often, the appearance of an Evening Star means that prices can be expected to move lower.

The Candlestick bars of Merrill’s stock price for the months of December 2006, January 2007, and February 2007, all together, show a near classic Evening Star.  In fact, the Star itself is a “Shooting Star” (which is aptly named; use your imagination and you will be correct), which in itself is bearish.  The Evening Star pattern formed by price action for those three months, together, predicted a downturn in prices.

This was followed up by a second Evening Star, being Merrill’s stock prices as shown in the Monthly charts for April, May, and June 2007, confirmed by a strong downturn in prices for the month of July.  Prices continued downhill almost without strong interruption all the way through July 2008.

The bottom line is this: an observer knowledgeable in Japanese Candlestick technical analysis could have known with a strong sense of conviction at the end of July 2007 that the price of Merrill Lynch shares was likely to continue on a strong decline, and could have taken action accordingly.