In recent days, the Dow Jones Industrial Average, the S&P 500 index and the Nasdaq Composite index have all hit all-time highs for at least five consecutive days. This was the first time a winning streak like that unfolded since January 1992. The Russell 2000, a benchmark index for small cap stocks, made a new high four days in a row. The last time these four major market indexes made new highs on four consecutive days was in June 1995.
New highs generate emotional responses for many investors. Some enjoy seeing new highs, believing rising prices are bullish and that means a stretch of new all time highs is among the most bullish scenarios possible. Others react with a sense of dread, worrying that new highs ultimately signal a major top and fearing the reversal to come will destroy a significant amount of wealth.
We believe it is possible to split the difference in those extreme responses and enjoy the new highs while preparing for the inevitable decline in the stock market.
New highs certainly are bullish simply because bullish market behavior is defined as rising prices. Technically, a bull market is a series of higher highs and higher lows. This pattern is easy to see on a chart.
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The chart above shows SPDR S&P 500 ETF (NYSE: SPY). Blue lines show the series of higher highs and red lines mark the higher lows. This is one of the patterns that will tell us when the bull market has ended.
Some of you may believe this is an overly simplistic interpretation of the chart. It is certainly a simple way to read the chart but it is not simplistic.
All chart analysis is intended to identify the direction of the trend and to spot potential turning points in the trend. The chart above uses a technique to identify the direction of the trend. For now, the trend is up but a break below the highest recent low, shown as the red line. For now, that means a break below $218 is a potential sign of a trend reversal.
In the next chart, we apply a simple technique to spot a potential turning point. We have applied a technique called a measured move to the chart to obtain an up side target for the current bull market.
All chart pattern analysis is based on the idea that there is a relationship between past market action and the future market action. Traditional patterns apply a rule of symmetry. For example, in a head and shoulders pattern, traders measure the distance from the neckline to the top of the head and expect to fall by an amount equal to that distance. They are looking for a symmetrical down move to occur after the trend reverses.
A similar technique is used for rectangles or other patterns. The distance from the top of the pattern to the bottom, in other words the width of the pattern, is used to find a price target. As an example, consider a stock trading in price range between $20 and $30. The distance between the bottom of the range and the top is $10. If prices break out to the up side, we would have a price target of $40, the $10 depth of the range added to the top of the pattern at $30. A down side break would provide a target of $10, the $10 depth subtracted from the $20 low.
This technique assumes prices will move at least as much of the width of the pattern and establishes a minimum price objective. Price can and do move past the target price and there are times when they fail to reach the target before reversing. But, price targets are useful to help us evaluate the potential rewards and risks of a trade.
The measured move extends that principle of symmetry to generate price targets. To apply this technique, we look for price move that ended in a consolidation. We assume the consolidation marks the halfway point of the move. We then measure the distance prices moved to form the consolidation, in the case above we measure from the low to the consolidation. We then draw a line of the same size from the breakout point to the price target.
For SPY, the measured move provides a price target of $257.40.
For those expecting an imminent top, the price target provides a way to measure how large the potential gains could be. Moving to cash now means possibly another 9% or so of upside. Bears may argue this doesn’t matter because the risks are too high. However, over the long run the stock market has delivered an average gain of about 8% a year. Few investors are wealthy enough that they can afford to give up more than a years’ worth of potential up side.
This type of analysis illustrates the value of using charts. We now know the possible up side is significant. We can also develop an action plan for the down side.
In the first chart, we drew red lines under important lows as prices worked their way higher. A break below one of those red lines would be a signal that the trend is in danger.
Conservative traders may want to begin implementing their bear market plan on a break below the most recent lows near $218. Less conservative traders might want to wait until the second low is broken, waiting for a close below $206 before implementing a bearish strategy. The most aggressive investors might want to consider deferring action until the price of SPY falls below $195.
These price levels are dynamic and new levels will form on the chart as the market action evolves. If there’s another push up, the stop levels could move sharply higher. The advantage of this approach is that it participates in the up side while limiting the likely risks on the down side. A market crash is always possible, but unlikely and preparing for a crash can be a costly mistake for investors.
For the most conservative investor, those ready to turn bearish at $218 on SPY, this represents down side risk of about 7%. The lowest sell point, $195 on SPY, is more than 18% below the recent price. With up side potential of just 9%, the risks might seem high.
Of course, the possibility of even larger gains are also real. Instead of stopping at $257, SPY could continue to soar. Or, prices could consolidate and set up for another push higher. It’s even possible a bubble could form and take prices to new highs.
As always, the future is uncertain. Chart analysis offers us a way to take action based on what actually happens in the markets. As long as the trend remains up, it most likely pays to remain long with as much exposure to stocks as possible, consistent with your risk tolerance. When the trend reverses, there will be time to act as prices fall below important levels. These levels will move higher as long as the prices continue moving higher and the dynamic stop levels they provide will ensure we know the trend reverses.
It could be best to let the market action dictate decisions. Moving to cash too soon carries a high cost in missed opportunities. Moving to a bearish strategy too late carries a high cost in potential loss of capital. Using a chart can provide an amount of protection that is just right while allowing profits to run as long as possible.