What is technical analysis?
Technical analysis is a type of trading that identifies opportunities by historical patterns such as price action and volume.
In this guide will cover indepth the different types of technical analysis and how they can be used for trading including:
- Support and resistance
- Moving averages
- Momentum indicators
- Price breakouts
- Trend changes
- Group analysis
How to use support and resistance levels in trading
One enduring feature of market analysis is the imposition of lines on charts. Two popular ones are support and resistance trendlines. But how useful are these trendlines? Do they really improve our market analysis and trading success?
To answer these questions, we first need to know what support and resistance are. Consider this price sequence:
Immediately, you can see that the support is at 20 and the resistance at 50. In other words, a support is an area of demand, whilst a resistance is an area of supply. Logically, prices fall from resistance; and rise from support.
In actual financial markets, however, randomness pervades. This means that prices are more likely to look like:
Where are the support and resistance (S/R) now? Far harder to know. The resistance could be 50, 48 or 45.
Our next question, then, is this: Which sequence would you bet? I suspect the first one. Why? Because it offers relatively more ‘certainty’ due to its better defined price pattern. This certainty gives you, as an investor, more confident that prices will continue to behave 20—50—20—50…
Therefore, just with these simple observations we note:
Observation 1 – S/R trendlines are one way to see ‘patterns’ in financial prices. Nothing more, nothing less. Trade management still counts.
Observation 2 – S/R trendlines are ‘self-reinforcing’, meaning that the more people look at it, the more significant it will be. And the better defined the chart patterns are, the more people will look at it. So pick the most obvious ones.
Observation 3 – Peaks and troughs are seldom ‘exact’. Prices don’t peak at 7000.00 but at 7012.15. So when drawing S/R, remember to give prices room to move. ‘Trend bands’ are slightly better than trendlines.
Application – FTSE 100 Index
To tie these observations into chart analysis, we look at the UK FTSE 100 Index.
During 1998-2018, where do you think was the obvious resistance level? 7,000 of course. Thrice the index rallied to this level and failed twice to break above this level. And support? Hmmm, I would pick 3,500 – a level reaffirmed twice, in 2003 and 2008. But on recent data, 5,000 or 6,000 are two candidates.
Without going into a deep analysis on Footsie’s valuation or UK’s macro performance, which directional bias is the FTSE 100 on: Up or down? Certainly up. This is because prices are closer to its long-term resistance than support.
Note further that, in late 2016 when Footsie cleared the 7,000 resistance, this made headlines (eg, ’FTSE in Uncharted Territory’) and drew in many momentum buyers. The breakout at 7,000 gave way to a year-long, 800-point rally. This leads us to the next two S/R observations:
Observation 4 – S/R trendlines that coincide at big round number levels attract the most attention.
Observation 5 – A break of these levels generates price momentum in the direction of the breakout. So join the crowd.
S/R are useful charting tools to analyse markets. But they are not everyone’s cup of tea. If you are keen on them, do keep in mind the above observations and make S/R trendlines really simple. In my experience, over-complicated trendlines often lead to ‘analysis paralysis’, which is detrimental to investment success. A consistent, logical application of long-term S/R trendlines will make your analysis far more efficient – and makes you better attune to the prevailing trends.
Using Moving Averages Effectively – Part 1
One observable market fact is that prices are pretty much random. Random in trends; random in changes. No surprise, then, a best-selling market book is called ‘A Random Walk Down Wall Street.’
Such randomness makes financial prices notoriously ‘noisy’. It makes markets harder to read and trading much more difficult. So much so that any analytical tools that can reveal, track, or determine price trends becomes immensely popular. One such tool is the moving average.
In its simplest form, a moving average is just a running sum of prices divided by a number (the ‘parameter’ M). The most popular parameters are 50, 150 or 200. Simply, a moving average smooths prices; follows the price trend; and create reference points for visual analysis.
How ‘smooth’ a moving average depends on the parameter M. Generally, a larger M equals a smoother moving average. So a smaller M = a noisier moving average. If M = 1, then it becomes the actual price – and will be meaningless.
How exactly does one use a moving average? Many ways. For example:
- Trend determination. If prices are higher than a long-term moving average (MA), the stock is said to be in an uptrend. If prices are below the MA, the stock is in a downtrend. We can, for example, use this to separate stocks within a universe into bullish and bearish camps.
- Uptrend = Prices above MA
- Downtrend = Prices below MA
- Trading signals. If a stock is in an uptrend, buy. If a stock is in a downtrend, sell.
- Contrarian reference. If a stock is significantly above its long-term MA – say 20% – label it ‘risky’. Stop trading the instrument as it is vulnerable to a sharp correction back to its long-term MA.
- MA as support and resistance. A long-term MA often acts as support or resistance during a trending phase. (see last week’s piece on S/R)
How good is a moving average? To some, they are indispensable. Because it is a widely-used indicator, easy to compute, and reasonably useful, many variations of the MA have been devised. One such variation is the so-called Golden Cross – a cross generated when an instrument’s 50-day MA crosses the 200-day MA from below.
Note that since the long-term MA of major stock indices is a closely watched indicator, it can create a self-reinforcing loop.
Application – Nasdaq Composite
To show how a moving average can be used, let’s take a look at the Nasdaq Composite Index (featured above). Since mid-2016, prices have been traded consistently above its 200-day MA. So any investor who took the buy signal in Jun ’16 and long IXIC would be in-the-money. [MA as buying signal]
Nasdaq’s smooth uptrend lasted for some months. But the moment prices accelerated away from the MA, eg in January this year, the index was slammed back down to the indicator shortly after. [MA as a contrarian indicator]
More remarkably, the index’s correction paused right at the 200-day MA. Prices bounced off this MA several times before picking up upward momentum again to new all-time highs. [MA as technical support]
What more can you ask from an indicator?
Of course, during a trendless, sideways range, a MA is less likely to do well. Simply because prices are meandering sideways, cutting through the MA several times from above or below, without leading to any meaningful trends. ‘Whipsaw’ is what traders call this phenomenon. To prevent such whipsaws from decimating your equity account, make sure each trade is small enough as not to cause too much damage to the overall portfolio if it goes awry. Also, you might want to look MA filters before deciding on a trade.
Trading is a tough game. Any indicator that could give you an edge should reused and incorporated into your analysis. In this respect, a moving average is an extremely useful tool that should be investigated thoroughly by traders. Indeed it has. But how to use it in your actual portfolio decision will depend on your preferences. Once the setup is tested and done, you can run the analysis/trading on an auto-pilot mode – and free up your time for other things.
Using Moving Averages Effectively – Part 2
Above we introduced a popular indicator called the moving average (MA). This superb indicator is widely used by both amateur and professional alike. Simple to compute; easy to use.
This week, we highlight two more applications of the MA for investment and trading. The first is the so-called Ivy Portfolio – introduced by Mebane Faber (see here). The second is the Coppock Indicator. In both, the critical component is the MA.
This is an investment strategy that uses the monthly MA as the guiding point. Simply, you buy the market index (e.g. FTSE 100 or S&P 500) when it advances above its 12-month MA and sell into cash when the index drops below the MA.
By restricting the rebalancing frequency to a monthly basis, you have only twelve chances per year to change your portfolio. Low trading activity reduces transaction costs.
How did the strategy perform?
A cursory look at the FTSE 100 Index and its 12-month MA shows clearly that the strategy kept you in bull markets and, more importantly, out of devastating bear markets. For example, you would have been out of the market during the global financial crisis in 2007-8 when the index plunged from 6,500 to 4,000.
This is an important point. Avoiding big bear markets is as important as – if not more important than! – riding bull markets. It is a fact that you accumulate capital faster when you don’t lose too much money during a downturn.
Of course, you will point out that, since 2009, the strategy had generated a few whipsaws – meaning that the trend shows a buy signal then a sell signal two months later, and then another buy signal shortly after – so on. This is unavoidable. Simply because UK’s equity market did not product a clear runaway trend after the ’08 crisis like it did in 2003-’07.
The second application of the MA is the Coppock Indicator, namely after the author ES Coppock. It was first published in 1962.
Calculations of the indicator are very simple. It uses monthly prices. And sums two rate of change (of closing prices) and apply an weighted moving average method to it. You can read about this here.
What is this indicator use for, you wonder? To find entry signals for long-term buys.
To show how this is used, we compute the Coppock indicator of the FTSE 100 Index and plot it below the monthly closing prices. The conditions for the buy signal are: (1) A turning point at the bottom (e.g., -50, -100, -20) and (2) The turning point must occur at negative levels.
Coppock buy signals do not come by every month. For example, in the last twenty years we saw only six such signals. The last three signals were May-2009, Jul-2012, and May-2016.
How did these signals do? Quite well. In each signal, the FTSE 100 Index rallied shortly after and was kept in uptrend for months. Profits were sizeable.
An important point worth mentioning about the timing of the signals. They emerged when the market sentiment was still very negative. In May’09, for instance, stock markets around the world were reeling from the banking crisis. In May’16, uncertainties about Brexit were very high. But if you had followed the Coppock signals you would have bag plenty of gains.
Now, we show you how derivatives of the moving average are used. They are simple – but highly effective. You could use the monthly MA to determine your positions in the market and use the Coppock to add or confirm positions.
On a last note, when using MA indicators you must be discipline enough to use each signal, simply because you will never know how profitable the signal will be. Using stops is crucial when the signal is not working. When the signal is working, simply let the position run.
Momentum indicators and trends change
Anyone who runs a marathon knows that momentum matters. It matters a lot because the sheer force of momentum can carry runners further than expected.
Similarly, momentum in prices can stretch a stock beyond what is ‘reasonably’ valued. With great momentum, a stock can go up 10x – the proverbial ten bagger! – within a short space of time.
But what exactly is momentum? In markets, price momentum is intricately linked to the rate-of-change (ROC) concept. it measures how fast or slow prices are changing. For example, a one-day ROC takes the 1-day change in prices, while a 10-day ROC is the price difference over ten days.
Consider this monotonically increasing price sequence:
Each step is $10 higher. In dollar term, the 1-day ROC is $10. (Note: in percentage term, the rate of change is dropping.) If you reverse the sequence, then the ROC becomes a negative -$10 as prices drop by this amount per step.
Of course, you can increase the parameter (which we talked about two weeks back) to 10 days, meaning you take the price difference of prices now against ten days ago – and roll this price difference forward.
But how does one use the ROC/momentum? Broadly speaking, the ROC indicator is used to detect a general change in price movements and the price trend. For example, if a stock’s ROC is $10 for some time and this increase drops to $5, $3, $1 – you know immediately that the uptrend is losing momentum. It is vulnerable to a correction.
On the flip side, if a stock’s ROC is -$10, then rises to -$5, -$3, -$1, you’ll see the downtrend is losing momentum and a rebound is possible.
Using Rate of Change to Detect a Trend Change
We show an example of ROC time series with the FTSE 100 Index. To compute the ROC. I take the price difference to be 10 days (bottom chart).
One immediate observation is that FTSE 100’s ROC behaves rather rhythmically. This is a byproduct of FTSE 100’s steady rally post Brexit referendum. The ROC indicator swings to and fro around zero.
But things get far more interesting as the ROC jumps outside its normal range. For example. during February’s correction FTSE’s ROC slumped to its lowest level in many years. But a subsequent retest of its January lows (lower low) was not accompanied by a lower ROC.
This non-confirmation is marked by bold coloured lines in the chart. Soon enough, prices rebounded strongly for a few weeks. The FTSE 100 rallied a thousand points during Mar-Apr.
This is to say, while the FTSE 100 index was hovering near its multi-month lows, its downside momentum is actually contracting. This is a classic example of a ‘bullish divergence’.
Practical Applications of Momentum
- The ROC is just the price difference between two points in time. You can use dollar-ROC or percentage ROC. But given this simplicity, you must recognise its limitations as a momentum measure.
- You can, however, improve upon the basic ROC by:
- Combining different ROCs together – say, average the 20, 50, 100-day ROCs
- Pair ROC with other indicators – such as the moving average
- Set further conditions on the ROC – say, the indicator must rise/fall to x-level before you would consider using it
- Vary the ROC calculations
- From my experience, ROC/Momentum indicators appear to work better on the downside than the upside. This is to say, momentum indicators detect non-confirmation better after a strong decline.
- Lastly, the ROC does not give signals every day. Its usefulness lies in non-confirmation of trend assertions, which takes place over many weeks or months.
In a nutshell, the ROC is a useful indicator for measuring price momentum. But to use this indicator effectively, you will need to backtest – or at least visually inspect – its behaviour over many instruments across a period of time. Personalise the ROC configuration to compliment your other favourite indicators. Keep practicing on this indicator until you’re comfortable with it – and know when to use it.
Understanding Price Breakouts and its Significance
In the lexicon of market analysis, an often-used term is a ‘breakout’. But what is a breakout? In short, it describes the moment a stock trades at a new price level, relative to its own history.
Consider the Nasdaq Composite Index. It has been breaking out to new all-time highs. This means the index is trading at a level that has not been traded before. New 52-week highs led to many subsequent breakouts.
Knowing a breakout is only the first step. For a breakout to be actionable, we need to know what type of breakout we are looking at. For example, is the breakout significant? Is the breakout the 25-th one this year? Are the breakouts short- or long-term ones?
- New All-Time Highs/Lows Very, very important
- New Long-term Highs/Lows (say 52-week) Very important
- New Medium-term Highs/Lows (say 12/26-week) Some importance, depending on trends
Also, I would pay attention to the manner a stock breaks out. Was it forceful? Was it accompanied by good results? etc.
Why, you may wonder, is a long-term breakout significant?
The Psychology Impact of New Highs
In financial markets, psychology matters. Investors are all too human – driven by greed and fear.
Anything that boosts the psychological makeup of markets is positive. And the best booster is in-the-black position, propelled higher by all-time breakouts. How so? When a stock is hitting all-time highs, every investor in that stock is sitting on sizeable profits. Profits generate excitement – and greed. It hits front-page news. New highs bring out the feel-good factor.
Another thing that an all-time high breakout generates is FOMO: Fear Of Missing Out.
Imagine this all-too-familiar conversation between two traders. Trader A: “I’m in XYZ. It’s unbelievable, up 40% last month! What – you’re not in?! Listen to me…” Immediately, peer pressure will force other traders to pile into stocks that are breaking out. Similarly, fund managers will have to justify why they did not buying stocks that were at new highs and up 100% last year. FOMO will create additional price momentum – until the last available buyer is in.
Of course, if a stock is breaking down to new all-time lows, the psychological impact will be different. Investors are haemorrhaging capital. Fear – known or unknown – is stalking the company. Staring at a potential calamity, investors have three options: Do nothing, cut losses, or average down. If a significant number of investors choose to bail out of the stock, price pressure will increase, leading to more price declines, which lead to more stop triggers, creating more price pressure…..The vicious cycle is set.
How To Use Breakouts
There are many ways to use a price breakout. We highlight two. (1) buy (or sell) on a price breakout. (2) wait for a reaction to initiate trading buys.
For example, if a stock breaks out to new highs at $50, you either buy at market price or wait for a pullback to buy. There are pros and cons for each. If you buy immediately, you may not get a good execution price because of high demand. But this guarantees that you’re in the stock.
However, if you choose to wait for better prices, you may not get the chance to buy at $50 again. For example, the stock was range trading at $40-49 for months. Once it broke $50, it immediately jumped to $55. The $50 level may not be seen again after the stock completes its bull run. This may take some months (or years). By then, there is no point in buying the stock any more.
You could combine (1) and (2) – by buying half on a new breakout and half on retracements. This will ensure you’re at least in the instrument. Or you could set buy orders at certain prices, when the stock is nearing a breakout. Obviously, to do this you must do your homework before hand.
Financial markets are dynamical. While fundamentals matter, perception matters even more. A new-high price breakout can change the perception towards the stock overnight – even though the fundamentals have not. A breakout can even trigger a self-reinforcing loop. So, as a rule of thumb, when a stock’s fundamentals have not confirm its rising stock price, I would emphasise the latter. After all, you trade market prices, not fundamentals.
Price Patterns FAQ
Q: What are price patterns?
Price patterns are recurring price behaviour that are observed visually (and can be modelled by computers). This key here is ‘recurring’. If a price pattern is not repeating, then it is just random noise.
The act of finding price patterns is called “pattern recognition”.
Q: How can price patterns be used in market speculation and investing?
When a pattern is repeating, it can be predictive and harnessed for profitable trading activities. To do this, the pattern must be (a) identified, (b) measured, and (c) traded upon profitably.
However, there are times when (a) and (b) are satisfied, but not (c). A pattern may exist, but it still can not be traded profitably because of, say, high transaction costs.
Q: What is the best place to start looking for price patterns?
I would say charts. A lot of price patterns are found visually. You can use line, bar or candlestick charts. The point-and-figure chart is also useful.
Next, you might want to vary the frequency of the charts. Some patterns could be more obvious if you switch to Weekly Bar charts, for example. Some are more applicable on Daily Candlestick. You can split pattern by frequency:
- Daily Pattern – Pattern 1, Pattern 2,… etc
- Weekly Pattern – Pattern 2, Pattern 2,… etc
Q: How do you determine if a price pattern has emerged?
To check if you have found a pattern, you need to ask:
- Have you seen this before? Where?
- What happened then? Describe it.
- What were the actions preceding the pattern? This could be important as you’re determining the factors leading to the pattern.
Once you answer some of these basic questions, you will know quickly if the pattern is indeed a pattern.
Q: Once you have identified a pattern, what is the next step?
Verify the pattern. Is the pattern random or regular? How big are the price returns pre- and post-pattern? Is the pattern long-, medium-, or short-term (duration)? Can you act fast enough to capture it? Is the pattern profitable once transaction, spreads, and other costs are factored in?
To answer these questions, you will need to be able to describe the idea, then backtest the idea. The action flow is something like this:
Observe -> Pattern Found -> Description of Pattern (Models) -> Backtest -> Results (Analysis) -> Trade
Q: What sort of price patterns are there?
There are many hundreds of price patterns used by traders, funds, or investors. For obvious reasons, the more profitable ones are probably kept hidden from the public. In general,
- Calendar Based – eg, Month of the Year or January Effect
- Sequence Based – eg, Runs Analysis
- Trend Based – e.g., Head-and-Shoulders
- Return Based – e.g., Daily/Weekly Returns, 52-Week Returns
- Short-Term Pattern – e.g., Price Gaps, Reversal Day
- Plot Based – e.g., Point-And-Figure
- Cycle Based – e.g., early/mature bull markets
etc. One of the simplest calendar pattern I can think of is the Quarterly Effect in equity indices. For example, the ‘Santa Claus’ rally is evident in the DJ Industrial Index, whereby the last quarter of the year generates, on average, the highest return compared to other quarters.
Q: How do we choose which patterns to incorporate into our trading plan?
One important consideration is consistency. Is the pattern reliable?
Reliability here refers to behaviour of returns. If a pattern generates lots of small profitable trades and then proceed to lose big in one trade, then one has to be really careful about using it. If a pattern has lots of small unprofitable trades and win big in a few signals, it might still be viable.
The next issue is its scalability. Is the pattern applicable to other markets, sectors, or asset classes? Can it be scaled up with more capital? This issue has to be researched and tested rigorously – simply because it is dependent on the actual pattern, depth of markets, and capital deployed.
The last issue is shelf-life. How long has the pattern been observed? Is there any studies on it? Is it widely known? Generally, the more capital chasing the pattern, the shorter its shelf-life will be. This is due to a principle of capitalism: Returns fall as capital employed rises.
Q: What about combining patterns?
As a rule of thumb, the simpler the pattern the better. A complex pattern will probably contain too many variables and this may impact its effectiveness. For example, is a complex head-and-shoulders really better than a normal head-and-shoulders? I doubt so.
In the realm of market analysis, price patterns are an important part of it. But not all patterns are equal. Some are profitable; some are money-losing. Some work for a time, then fade away. Some work in stocks, but not in others. So a lot of research is required to extract good trading/investing ideas.
Lastly, if you found one good pattern, try to develop little trades around this pattern to maximise its usefulness. In my experience, it is better to focus on a few good patterns rather than a lot of marginal ones. Diversify, but only to a point.
The Importance of Group Analysis
There is an old saying that ‘birds of the same feather flock together.’ In financial markets, this is particularly true.
Behind this groupthink is pure human psychology. Investors think in concepts; they act in concert. If the sentiment is bullish on a theme, why stop at buying a single stock? Surely more money could be made by buying the whole sector.
Indeed. The fact that investors are enamoured by FAANGS (or BRICS) show the pulling power of investment themes. Funds have been setup to do this sort of group investments for investors.
Another force behind group movements is risk consideration. Smart investors care about diversification. They know that picking the ultimate winner in a bull market is difficult. So they buy the whole thing – either with index or sector ETFs (exchanged traded funds), or the largest, or most profitable, or the highest-yielding stocks within the sector. This way, some individual stock-picking risks are reduced.
The third factor driving sector-wide moves is the channeling of accumulated profits. If stocks A,B,C are in the same industry and A‘s share price suddenly tripled, investors of A will now have excess profits to play with. They can either take profits, do nothing, or increase exposure to the sector via higher leverage. Human nature, often drive by fear and greed, dictates the latter. So investors of A will likely use profits from A to buy B and C, thus pushing up their share prices.
A pertinent example of this is the Cryto-Currency boom in 2017. As Bitcoin’s price surged ten-fold, wealthy Bitcoin owners went in search of new opportunities in the same sector. This triggered a frantic buying of other currencies, sending their prices stratospheric.
Initiating Sector Analysis
How does one identify a sector that is about to take off? Conducting a group analysis is straightforward. The first few steps are:
One, know the broad sectors within the equity market. According to the Global Industry Classification Standard (GICS), there are eleven industry groupings* (see below). Obviously, some markets are stronger in certain sectors. For example, British equity markets are inclined towards financials and property while Germany is stronger in industrial groups. In the US, the technology sector is extremely large and powerful.
Two, know the sector indices (if any) and its constituents. This is important because within a broad sector there are many subsectors. This binds stocks even closer. For example, within the Financial sector there are banks, asset managers, insurance, brokerages etc. Stocks within a subsector have a higher correlation.
Three, know the sector ETFs (if any). This is to build an investable universe.
Questions for Sector Analysis
Once we have the above information, we can conduct the actual group analysis. In particular,
- Which GICS sector is performing? Rank their simple returns (e.g., 2/4/10/26/52-week performance)
- For each GICS sector:
- rank constituents by their simple returns (2/4/10/26/52-week).
- calculate which constituents have been making upside or downside breakouts (as discussed earlier).
- calculate which constituents above or below their long-term, medium-, or short-term moving averages (ase discussed earlier).
- calculate constituents are making unusual price patterns (such as dynamics or gaps).
- Which stocks are the sector leader? Which stocks are the sector laggard?
- Which subsectors within GICS sector is doing well?
Once these questions are answered, you will know (roughly) which sectors are performing or underperforming against the market, and which stocks are doing well in each sector.
Example – UK Housebuilders
In the chart below, we plot the performance of UK housebuilders stocks since the Brexit Referendum (24 Jun 2016). First, it is clear that these stocks moved together. Note the timing of their advances. Secondly, not all stocks peaked at the same time – even if they’re in the same subsector. Some earlier; some later. Third, a stock’s relative performance tend to persist. For example, Barratt has been underperforming the sector since Nov-’17; while Redrow has been leading the sector higher since Feb-’17.
Group analysis is an important part of market examination. Simply because it leads naturally to mob psychology and crowd behaviour analysis. At the heart of Group Analysis is this: Buy strength, avoid weakness. All the techniques we have discussed above lead to this strategy. Once a leader is identified, ride with it until its trend run out of strength.
*GICS Sector Groups: Industrials, Financials, Technology, Consumer Discretionary, Consumer Staples, Telecommunications, Energy, Materials, Healthcare, Utilities + Property.
Three Chart Characteristics That Precede A Trend Change
Catching the peak and buying the bottom are stuff of dreams for many investors. How many traders do you know sold the Nasdaq on Mar 10, 2000, or bought the market on Mar 9, 2009? Very few. In fact, it is so difficult that one should be discouraged from ‘peak catching’. A better speculative method is to act as the trend changes, or, after a trend has peaked.
The question is: How does one assess that a trend’s character has changed? Over the short term, price fluctuations are pretty random. Over the long term, a trend change is fairly distinguishable. In this article, I summarise three chart characteristics that often precede a trend change.
(1) Trend Acceleration
One reliable trait that suggests a long-term trend is fulfilling its potential is trend acceleration. What, exactly, is price acceleration? I defined it as a sudden, substantial, and sustained price rise outside its norm. Very often, price acceleration comes at the end of its long-term bull move.
Why is trend acceleration an ending signal? Because the price acceleration pulls forward all the stock’s future buying potential. When the last buyer has bought, there is no new buyer. Prices can only go one way – down.
I turn to a concrete example. With just a quick glance at Spirax Sarco Engineering PLC, are you detecting a whiff of price acceleration? Prices gained 1,000p in less than 10 weeks. Previously, SPX took twice as long. If history is of any guide, SPX may find some selling pressure at 7,000p or 8,000p after such a hefty rise. Note, too, the length of Spirax’s bull trend, which lasted almost a decade! Very few stock advances last this long.
Imagine what is happening as prices rise relentlessly for a decade. One, almost all the bears are squeezed out. Two, who’s left? Only the bulls! Investors are conditioned to buy this stock and not sell. It is likely that Spirax’s rally may prolonged.
It would be very interesting to see what happens to SPX a year from now.
(2) Trend Anomalies
Once a trend is in motion, it is usually consistent (see chart above). Corrections tend to be shallow and short. But once instability sets in, you know something is not right. I call these minor chart facts trend ‘anomalies’.
Why are these anomalies important? Because they usually precede a major move – either a breakout or trend reversal. Did you see Ocado’s sharp rally in late 2017 that took the stock above its multi-year trading range? Once above 300p, the stock never traded below this level again. The Nov-’17 rally was such an anomaly because of its (a) size, (b) technical significance (range breakout; weekly dynamic), and (c) higher-high pattern. Clearly someone knew something good is about to happen.
The last time Ocado put a sizeable weekly rally was in Nov-’15, which led to a multi-week advance to 400p.
Therefore, some technical anomalies that you should watch out are: (1) Strong counter-trend prices, and (2) Accompanied by price gaps, or breaks of key support/resistance levels.
(3) Massive Shakeouts
Boom and bust is an integral part of the market. It gives rhythms to prices. Even within a bull market, not all sectors are participating. Thus, whilst Ocado is on fire, outsourcing/retail/utilities stocks are sinking.
Massive shakeouts open the door for some bargain hunting. When bargain hunting, you would have to watch for three technical behaviours:
(a) Loss of Downward Momentum – When a bear trend is motion, stand aside. As the trend losses momentum, be prepared.
(b) Positive Catalyst – Equity dilution, bankruptcies, and forced mergers are distress signals. Once this is over, you will have some green shoots – although these positive developments may be covered by the continuing bearish sentiment.
(c) Upward Dynamics – Depressed prices can move hugely (20-100%) over a short period. These upward dynamics will tell you that changes are afoot. The thing to bargain hunting is this: You have to be quick. Why? Buy at 5p or 10p will make a huge difference to your return if prices go to 50p. You can work out the difference in returns.
Price trends change all the time. More importantly, they give clues when they change. This week, I discuss three trend behavioural traits that often precede a trend change.They are accelerations, anomalies, and big shakeouts. Rather that spending the effort to find the exact peak or trough, I think it is better to concentrate on the trend flows.
Thoughts on trading the market via Breadth
A question for you: Do you analyse every market instrument every day? I suspect not. The volume of news these days is bigger than what our brains can handle efficiently. Not to mention the dynamic correlations between asset classes, linkages between politics and economics, and the complexities of trade and capital flows.
In pursuit of profits, however, humans can be extremely ingenious. We build tools to aid, expand, and improve our analytical capability. In chart reading, there is such a tool called breadth.
The idea of breadth is very simple. It attempts to measure the total strength of the market. In doing so, investors hope to gain insights into the internal movements of a market and, in turn, lead to some predictive views and profits.
Types of Breadth
There are many breadth charts. For example:
- # of issues advancing vs falling
- # of issues at long-term highs/lows (e.g. 52-week High)
- # of issues above some technical indicators (e.g. moving averages)
- average value of certain indicators (e.g. distance to 52-week highs, RSI)
… et cetera. Of course, there are other ways to build breadth charts.
To give a visual example of breadth, in the chart below, I plot four breadth charts using the simplest universe – FTSE 100 Index. This is like the S&P 100 (100+ stocks).
Top-left (Chart, black) – percentage of stocks above 50-day exponential moving average.
Top-right (Chart, black) – average value of the momentum of each stock.
Bottom-left (Chart, black) – percentage of stocks in bullish point-and-figure columns.
Bottom-right (Chart, black) – average distance of each stock relative to its 52-week price high.
As you can see, the way each breadth moves is different. Some are more volatile; some are smoother. Some bottomed out latter.
As a comparison, I create an equal-weighted equity index (blue line) based on the daily return of the universe component stocks (FTSE100). Because this is just a rebased, equal-weighted index, its movement differs from that of the actual FTSE 100 Index.
Using Breadth – Tips and Advice
- Remember, breadth charts are just tools. There are not crystal balls. It can not and will not predict every turning point of the market.
- The most important thing about breadth is divergence. A divergence means that the trend of a breadth differs from that of a representative index on the same universe.
- A bullish divergence means that the breadth is improving already while the index is still falling. This suggests some potential for a rally. A bearish divergence is the opposite – a rising index not accompanied by a rising breadth. This indicates internal weakness.
- For some reasons, breadth divergence works better on the downside than the upside, ie, breadth charts are better at bullish divergence. Why is that? One reason I can think of is length. Generally, bull markets are longer. So overbought conditions will persist regardless of breadth readings. As such, market breadth can weaken but the index remains strong for some time.
- Be careful when comparing breadth readings with indices. This is because every equity index is calculated differently (such as Dow vs S&P 500). Most of the time, breadth calculations are simple arithmetic whilst an equity index is weighted by different factors.
- Each breadth has its own characteristic. Pay attention to its ‘quirkiness’.
- Some breadth works better on certain markets – and during certain market conditions such as a bull market.
- The more component stocks we use, the better. Less component stocks will result in more volatile breadth charts.
Breadth is an important tool because it helps investors to understand markets on a broad scale – without needing to check every single stock. Once you understand breadth movements, you can derive overall market overviews with relative ease. For instance, is the market rising along with its breadth? Of course, there’s nothing to stop you from building more sophisticated breadth with basic ones, such as a ‘Breadth of Breadth’, though the KISS rule remains: Keep It Simple.
Six Market Trends To Look For Outside Individual Price Action
So far in this series, we have written about price action. This form of market analysis is the most direct and, very often, the most effective.
If someone is accumulating a stock, upside pressure will sooner or later emerge in the stock price. If a sector is under duress, its relative strength will deteriorate one way or another. If a country is being mismanaged, its currency will weaken over time.
Price action, then, is the most obvious way to ‘understand’ markets. However, is price action analysis by itself sufficient?
For many investors, the answer is no. To them, macro, fundamental, and political (MFP) factors are equally important. These ‘big things’ must be analysed because they can drive markets. For example, a stock’s price trend could change overnight when a new CEO takes over, or, a new political party wins an election. But bear in mind two things when incorporating MFP factors:
- The number of MFP factors are almost unlimited;
- MFP’s impact on markets are dynamic and time-varying. This makes modelling of MFP challenging.
For example, in 2016 markets were pricing in a Clinton win. Instead, Trump won. Markets went into a tailspin. Then, unexpectedly, it reversed and rallied hard (‘Trump Rally’). This sort of things is really difficult to predict or model.
Therefore, from a price-action perspective, we would focus on factors that are more relevant to stock market action – and applicable around the world. Note that even this self-imposed limitation, the impact of each factor will work differently depending on whether we’re in a bull or bear market. Below we show a (partial) list of these factors.
What Additional Things To Look For Apart From Price Action
- Banking Sector
- Quantitative Tapering
- Stock Buybacks
We briefly discuss each in turn.
- Anomalies – Here we look for (a) Length and size of the current trend versus its historical data, and (b) Nominal, inflation-adjusted, and currency-adjusted terms of the market. Basically, we’re determining the ‘age profile‘ of a bull or bear market. If a bull market is already extended and in parabolic trends (e.g. Gold ’11) we have to be really careful about chasing it. If a market is down 60%+ and many stocks are at rock-bottom prices, it means some buying are warranted.
- Banking Sector – Why are banks important? Because they control the credit function of an economy. If the banking sector is showing (a) weak relative strength, (b) making new 52-week price lows, and (c) are breaking important trendlines / moving averages, you know the economy will be hurt by its weakness. Credit will soon be curtailed because banks can not fulfilled adequately its credit multiplier role. Watch out for sectors that are dependent on credit such as property or car.
- Quantitative Tapering – Central banks are withdrawing from QE programs around the world, including the Bank of England. ‘Normalisation’ of interest rates will put those indebted sectors (such as consumers) under more pressure because their debt payments will increase. Therefore, watch for relative weakness in these sectors.
- Stock Buybacks – The key question is: Are companies buying back their stocks with profits or debt? If the latter, it means the firm’s leverage is rising and making them more vulnerable. Also, is the amount large – so large that it is impacting the available shares? If yes, it will inevitable crease upward pressure on stock prices.
- Valuation – Is the stock market overvalued? Normally, a bull market ends on the higher side of the valuation scale. Where are we now?
- Excesses – Where are market excesses developing? Answers will reveal themselves when you see (a) stocks up 5x-10x from their lows, (b) sectors that are accumulating debt at a rapid pace without an equivalent increase in their earnings power, (c) sectors that recently relax credit quality, (d) underlying prices up 100-400% from their lows (e.g., property prices, raw commodity prices).
Markets do not exist in a vacuum. Its flow is shaped by a myriad of players, factors, and events – some of which are ‘black swan’ that are not expected by markets. The elements discussed above are applicable to most stocks markets around the world, including developed and emerging. Once you understand the behaviour of these factors, you could develop simple rules to evaluate their impact systematically. Setting benchmarks is the only way you can determine what to do during market turbulence.
The Key To Long-Term Investment Success – Know Yourself…
Over the past few weeks we discussed market analysis techniques. In particular, we examined:
- Indicators (e.g. moving average, trendlines)
- Price Patterns (e.g. price breakout, trends)
- Market Analysis (e.g. breadth, relative strength)
All this knowledge is important. But they are insufficient for you to generate wealth from investing. To successfully investment, there is a cardinal rule you must do: Investment Planning.
What is investment planning? In a nutshell, it is about creating a series of personal rules on capital allocation. And why is this important? Because without these ‘rules’, you will not have financial discipline. More likely than not, you will be ‘lost’ in the financial jungle and be parted from your hard-earned cash (fairly quickly). Billionaire investor Warren Buffett did not become fabulously wealthy by investing haphazardly. He has a lot of rules about how he invests his money – and he follows them strictly. So should you.
The first thing about investment planning is knowing yourself. It is not about markets, economic cycles, or indicators. It is about understanding your own strengths and weaknesses. For example, the first thing Jim Rogers, the legendary investor, admits is that he is utterly ‘hopeless’ in short-term trading. So he focussed all his energy towards long-term investments – with huge success.
Do you like short-term trading or long-term investing? Do you have some (above average) skills that you can exploit to earn investment returns? Are you knowledgeable about investment vehicles (stocks, foreign stocks, REITS, ETFs, Investment Trusts, Gilts, FX rates, etc)? Do you require investment advice or can you do it alone? Do you have time to follow markets – day in, day out? Have you had any experience bull and bear markets? Have you got any idea how market cycles behave? Can you tolerate (low, moderate, or high) price swings in your portfolio? Can you read a balance sheet well? What about economic indicators, are they your forte?
In a two-column paper, answer the above questions as honestly as you can. If you are not, you will have difficulties following your plan later. If you think you’re not really good or knowledgeable about investing, hire some experts to do it for you. Alternatively, you can learn to do it yourself.
Next, establish what you want from your investments. But be realistic about two things. One is your expected investment returns. Two is your current cash flow. The latter is tied to your personal circumstances, such as income level, current expenditure, and unexpected expenses. Why is cash flow so important? Because you can plan towards establishing a reservoir of firepower. Why is this additional firepower important? So that you can buy stocks when they trade at bargain price levels. This is the key to investment success.
‘Buy low, sell high‘ is an age-old motto. But if you have no money to buy when prices are low, then you will accumulate wealth at a far slower pace. Compare these two investors, Sam and John, who both started out in 2007 with $10,000. During the year, Sam saved another $5,000 in cash whilst John immediately bought more stocks with the same amount. Market crashed the following year. Sam used the $5,000 to buy stocks are far lower price levels whilst John watched helplessly on the sideline. Fast forward to now. Whose portfolio is larger? And, guess what did Warren Buffett frantically do in 2008?
Once you have determined your assets (knowledge + capital), you can then set basic investment strategies to pursue your objectives. This includes:
- What type of securities to buy and hold (stocks, REITS, ETFs, Gilts etc)
- How to buy (entry rules and signals)
- How to sell (sell rules and signals)
- Establishing pain levels (stop losses)
- Setting your diversification rules
- Setting your leverage rules
- Building a reserve fund to acquire securities during market panics
The last point worth stressing concerns compounding. Great investors make their capital do the work for them. ‘Making money whilst snoring’ so to speak. To prevent a break in the compounding cycle, invest capital that you should be able leave aside for years. If you consume this seed capital halfway, it would not grow to a big tree.
This week we take a break from market analysis and focus on investment planning. The three pillars of planning are (1) understanding yourself, (2) establishing your objectives and risk preferences, and (3) implementing your investment rules.
If you skip (1) and (2) and then adopt someone else’s plan it would not work. Because you will find it hard to follow the rules and signals because the plan is incompatible to you.
‘What then?’ you may ask. ‘After drawing up a plan, will I achieve investment success?’ Well, nothing is 100% guaranteed in life – especially on investments. But if you don’t have an investment plan, you’re more than likely to end up in places where you don’t want to be. With a map, you will at least have a fighting chance to reach your destination.
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