Charts can be useful for all investors. Whether you are a technical analyst or a skeptic of technical analysts, charts can be useful because they offer a visual representation of the recent market action. Reviewing charts can simply offer an insight into market action.
To do this, it is important to use simple charts. Some chartists add a dizzying array of indicators to charts. More often than not, this creates confusion and conflicting signals. To avoid this, just one or two indicators should be added to a chart. When two are used, they should measure different factors.
In the charts below, we added only Bollinger bands and a stochastics indicator. Bollinger bands are used to visualize what’s normal in the market. The stochastics is a momentum indicator that offers insight into the strength of the current market action.
We will look at four indexes, the Dow Jones Industrial Average, the S&P 500, the Nasdaq 100 and the Russell 2000. These four charts tell us about the major investment themes that almost all investors care about.
Dow Jones Industrial Average
The Dow Jones Industrial Average, or the Dow, is the stock market to a large number of people. The Dow is shown in news stories about the financial markets and is the only index some individuals may be familiar with. As such, it provides insight into the opinion of the average person.
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The chart below shows the Dow has been trading in a narrowing range and momentum is weakening.
The narrowing range is shown by the Bollinger bands. This indicator is found by taking the average closing price over the past twenty trading days, finding the standard deviation of the moving average and then adding and subtracting two standard deviations from the average. The result is the two lines shown on the chart.
Bollinger bands show what a “normal” market range should look like. As the chart shows, prices tend to move from the lower band to the higher band and vice versa. Bands also visually display the level of volatility.
John Bollinger, the developer of the bands, said “low volatility begets high volatility and vice versa.” Right now, the bands have been contracting. This tells us to expect a more volatile market. Prices are at the upper band. Based on this chart, we should expect a move towards the lower band as volatility expands.
This index is more comprehensive than the Dow but is also a measure of large cap stocks. Charts of the S&P 500 and Dow tend to look similar. To add value to this analysis, below is a weekly chart of the S&P 500. This supplements the daily analysis of the Dow shown above.
Again, we can see the bands have been contracting and warning of a more volatile market to come. At the bottom of the chart, stochastics is overbought and about to break below the overbought line. In the past, this has been bearish.
Notice on the chart that stochastics tend to move into overbought territory and stay there. Overbought means a momentum indicator is a at a high level. For stochastics, overbought is equal to a reading of 80. Analysts generally expect an overbought market to sell off.
For weekly charts, the stochastics indicator tends to become overbought and stay there for months at a time. When it does break down, the market tends to sell off. This is explained more in the next chart.
The Nasdaq 100 includes the largest companies traded on the Nasdaq exchange. These companies include the FAANG stocks – Facebook, Apple, Amazon.com, Netflix and Google. This is a more speculative index. Generally, in a bull market the Nasdaq 100 will lead the way up and then be the first index to reverse when a down trend develops.
The chart below includes Bollinger bands and stochastics. This is again a weekly chart. Vertical lines have been added to show previous instances of the stochastics indicator falling below 80 after spending at least a few weeks in overbought territory.
Asa the chart shows, PowerShares QQQ Trust (Nasdaq: QQQ), an exchange traded fund (ETF) that tracks the Nasdaq 100 index, has sold off after stochastics drops below 80. While the indicator reliably forecasts sell offs, the depth of the decline can not be forecast with this indicator.
This index includes small cap stocks. The iShares Russell 2000 Index Fund (NYSE: IWM) is an ETF that tracks the index. Small cap stocks are important because most of the individual stocks that make up the stock market are small caps. It is difficult for a bull market to continue if the majority stocks are moving lower. The Russell 2000 shows us what a majority of the stocks in the market are doing.
The next chart is a weekly look at IWM. Again, we see the Bollinger bands contracting and the stochastics indicator falling from overbought territory.
In this chart, stochastics also formed a bearish divergence. A bearish divergence occurs when prices reach a new high and the momentum indicator fails to move a new high. Technical analysts believe momentum leads price and in this case, momentum is pointing lower.
Putting It All Together
A look at the charts shows a market that could be near a top. But, a top does not mean a bear market is inevitable. We could see a market correction of 5% to 10%. Corrections of this size are normal in the stock market and it has been some time since we have seen a correction.
All of the major indexes show a similar price pattern. There were a series of steep pull backs in the summer of 2015 and at the beginning of 2016. Stocks that rallied into the summer of 2016 and sold off heading into the election. An explosive rally followed the election.
Since the beginning of 2017, all indexes except the Russell 2000 moved gradually higher. Small caps have struggled as both the price action and momentum show. In the past few weeks, all major indexes have stalled and momentum has turned down on the leading indexes.
From a technical perspective, it appears a down move in stocks is likely. However, there will most likely need to be a catalyst to spark that move lower. Several news events are possible in the coming weeks.
One possible spark for a down trend would be a shift in fundamentals. In July, earnings season starts again. Analysts are optimistic and expect continued growth in earnings. If important companies, like the FAANG stocks, disappoint, a sell off is possible.
Political news could also spark a sell off. Congress is set to go on recess soon and that will leave the White House as the center of news in Washington. The current White House has been a volatile source of news at times and an unexpected announcement from the White House could spark selling on Wall Street.
Geopolitics is always a source of news. Right now, the situation is increasingly risky in a number of hot spots. The Middle East, North Korea, a refugee crisis in Europe, a bank crisis in Europe or multiple other hot spots could flare up at any moment.
What we tend to see is that news leads to trend reversals when chart patterns are in place for a reversal. If fundamentals were strong and momentum was climbing, we could expect the market to shrug off bad news. But, that’s not the case. The market is vulnerable to bad news and we are likely to get bad news. Investors should be ready to act.