Saturday, October 31, 2009

Barron's: A Scare that Can Last Beyond Halloween (Technical Analysis)

Since technical analysis is more art than science, I rarely will post someone else's technical analysis but this Barron's piece follows in my footsteps - KISS technical analysis so I thought it was worthy to share.  Further, it corresponds with my thoughts that the markets could be in trouble in the intermediate term and now is a time for supreme caution.  We see some compelling trends - the NASDAQ breaking its trend line drawn from all the lows since March 2009; the "leading indicator" transport index forming a "double top" etc. 


On a related note - I've received a few emails asking about how to learn about technical analysis or what books to read.  I am sure there are some excellent references but essentially everything I've learned has been picked up in drips and drabs over the years from this place or that on the internet.  Certainly if you google technical analysis you can begin discovering many resources and my best advice to learn is just to read blogs and websites that utilize it.  Blogs were not around when I started investing (we had to walk to the computer uphill, both ways, in the snow, barefoot....) so it's a great avenue to learn that has not always been available.

I spent the first 5 or so years in equities completely oblivious to "TA" and when I look back now at how I used to invest it scares me to death.  "If only I knew what I did not know".  Then again we were all geniuses in 1999 so why did I need to bother to learn about "tea leaves".  I will also emphasize in college course terms I use Technical Analysis 101... there are countless "indicators" and many investors have incredibly sophisticated systems.  (TA 301, TA 401 courses)  That doesn't mean TA 301, or 401 is better - it just means there are many far more extensive methods than what I use.  There is also an entire class of traders out there (some institutional) who could care less what a company does, if it makes money, or any of those type of factors - all they use is the stock symbol and their charts.  We are a hybrid of fundamentals and technicals; there is a reason we buy these companies but if the charts go against us, we are not going to lose massive amounts of our capital to prove a fundamental point.  I read a lot of mutual fund manager interviews to see what the "competition" does, and I am aghast to see almost no one use technical analysis... frankly in a computer dominated market, I think its importance is growing by the week.  [Aug 24, 2009: John Hancock Technical Opportunities Fund Becomes 2nd Technical Analysis Based Mutual Fund to Launch]   The more tools on your tool belt... the better.

Technical analysts seek to identify price patterns and trends in financial markets and attempt to exploit those patterns. While technicians use various methods and tools, the study of price charts is primary.

Technicians especially search for archetypal patterns, such as the well-known head and shoulders or double top reversal patterns, study indicators such as moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants or balance days.


On to the Barron's viewpoint:

(I) On Tuesday, the Nasdaq made two bearish moves. The first was a drop under last week's small trading range (see Chart 1). The more important was the drop under the rising trendline drawn from the March low. Indeed, it's time to look for a real correction once again.

To be sure, when a major trendline breaks, it does not always signal an imminent decline. Many times, the ensuing phase can be sideways as excesses built up during the rally are worked off. Therefore, we have to reign in the doom and gloom until a true declining trend emerges.

For now, however, the deterioration in market breadth is unmistakable. While the traditional measure of breadth, the advance -- decline line, has not yet broken down, many sectors are starting to turn south.

(II) Many consider the recent drop in the Dow Jones Transportation Average to be one of the more significant sector declines.  The transports index is now down over 8% from its peak set just last week (see Chart 2). But even more than the raw decline, chart watchers will notice a potential double top brewing.

A double top, sometimes called an "M" pattern due to its shape, suggests that the force of the rising trend has abated. If the index falls below support at the trough between the two highs, the pattern is completed and a sell signal is given.

For the Dow transports, that level is 3656. However, after the steep decline already in place, it would be no surprise to see a bounce before that happens. After all, one of the tenets of technical analysis is that support is presumed to hold unless proven otherwise.

But this is short-term thinking. The long-term chart shows that the twin peaks of the past few weeks occurred at a rather powerful resistance level near 4060. This price level supported major pullbacks in July 2006 and January 2008 and resisted the bounce of November 2008, so it has been important for several years.

(III) For the benchmark Standard & Poor's 500, another technical negative is visible (see Chart 3). Drawn from the important interim low set in July, a set of three trendlines called "fan lines" is evident. (Mark's note: "fan lines" is not something I use)  Evoking images of a folded paper fan, this pattern occurs when a trend is starting to gradually roll over.

The theory behind the pattern is that an early-rising trend is very steep and therefore unsustainable. The market dips below it, but rallies to a new high at a slower pace. This second line is then broken on the ensuing correction, but the market turns higher once again to set yet another new high.

Note that each rally halts at the previously broken trendline. When the third line in the set is broken to the downside the bulls finally give up and the market falls.

Similar to the transports, the S&P 500 is now sitting on support from its 50-day moving average. Short-term oversold conditions may prompt some opportunistic buying at these levels, if only to cover short positions.

But with the failure for the Nasdaq to advance in light of giant jumps higher in some of its major components, and with the deterioration in overall market breadth and the "fan lines" breakdown in the S&P 500, it does look as if the market is ready to pull back.

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