Chart patterns show the emotions of traders. Technical analysts combine the price action seen on charts with indicators designed to measure momentum and other characteristics of the market. Combined, these techniques can provide a trading strategy.
To begin the development of a trading strategy, traders can look at a price chart of a broad stock market index such as the S&P 500 or the Dow Jones Industrial Average. Price trends in indexes are highly correlated with each other so traders can benefit from an analysis of any major index.
The Chart Shows a Down Trend
The S&P 500 Index is shown below.
At the highest level of analysis, the index is in a down trend. Prices have been falling since the beginning of October. The initial sell off was rapid, almost panicky. But prices bottomed and rallied before stopped at an important technical level.
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The horizontal blue line in the chart connects the tops of the two rallies that have followed the initial sell off. The second rally stopped precisely at the level of the peak of the first rally.
The high of the first rally would be expected to offer resistance to subsequent rallies by technical analysts. Resistance is a byproduct of buyers’ remorse. As prices rallied in October, traders were, in effect, buying the dip. They had seen the initial decline and expected the up trend to continue.
But the rally was short lived and prices resumed their decline. This resulted in those who had bought the dip showing losses. Often when traders face a loss shortly after buying they decide to sell if they can get even. That appears to be what happened in the second rally attempt after the initial sell off.
This would indicate a shift from a bullish market to a bearish one. To confirm that, many traders will want to determine how momentum indicators are faring in the market decline.
Momentum Indicators Make the Analysis Less Clear
The next chart shows the stochastics indicator, a popular momentum indicator that consists of two moving averages of price action.
The decline pushed the indicator to oversold territory, a normal reaction for the indicator. Stochastics and other momentum indicators tend to move between overbought and oversold extremes, providing short term trading signals to traders comfortable with aggressive strategies.
For now, this indicator is providing hope for the bulls. The chart includes a thin blue line drawn at the midpoint of the indicator’s range. Stochastics is calculated in a manner that limits its range to a value between 0 and 100.
In bullish markets, the indicator is generally above 50. In bear markets, it spends a significant amount of time below 50. The chart below shows the indicator during the bear market that ended in 2009.
In this chart, the indicator was below 50 more often than it was above 50. Right now, the indicator is at a critical level. A decisive break below 50 would confirm the bear market. But, for now, that conformation is not present in the momentum indicator.
At this point, technical analysts would see that the price action is bearish and momentum has not yet confirmed that. They could wait for confirmed signals or they could turn to a potentially tie breaking indicator and look at sentiment.
Sentiment Tells Us to Expect More Down Side
Sentiment indicators are designed to help us spot times when bulls or bears are at extremes.
One group of sentiment indicators are based on surveys. Every week the American Association of Individual Investors (AAII) asks members, “do you feel the direction of the market over the next six months will be up (bullish), no change (neutral) or down (bearish)?”
The chart below shows the most recent data.
Only extremes in the data provide useful information. As of this week, the latest AAII data from November 4, is slightly bearish as AAII explains:
“Pessimism among individual investors about the short-term direction of the stock market rose, extending its streak of above-average readings. The latest AAII Sentiment Survey also shows a drop in optimism and higher neutral sentiment.
Bullish sentiment, expectations that stock prices will rise over the next six months, pulled back by 6.2 percentage points to 35.1%. The drop puts optimism back below its historical of average 38.5% for the eighth time in 10 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 1.4 percentage points to 28.9%. Even with the increase, neutral sentiment remains below its historical average of 31.0% for a third consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, rose 4.8 percentage points to 36.0%. The increase keeps pessimism above its historical average of 30.5% for a sixth consecutive week and the ninth time in 10 weeks.
At current levels, all three indicators are within their typical ranges.
The recent decline in stock prices likely played a role in dampening the increased optimism recorded by our survey last week.”
In other words, investors are becoming concerned but the levels of concern are not enough to signal a bottom in the stock market. When prices are near a bottom, the number of bulls is likely to be extraordinarily low, perhaps in single digits.
The bottom line is that the charts are, for now, advising caution. It is likely investors will face additional downside risks before the bull market resumes. Charts will eventually offer a clear buy signal.
But chart analysis takes time and a willingness to change market positions when the market action dictates that a change is warranted. All market trading tools will require time and commitment to use.
Many individuals discover that they are not able to complete the required amount of research because that can take an extended amount of time and they have other personal and professional commitments competing for their time.
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