After a prolonged period of steadily ratcheting prices, all stock indices sold off abruptly over the last week. The breakdown in discussions on trade between the US and China has been blamed for the swoon. In fact, this was the case since nothing else has really changed in the past few months. While the selloff was quite dramatic, the market action underscores what the basis of technical work is all about.
The majority of technical indicators have been constructive including the very important ‘internals’ that tech geeks refer to. These are statistics on advances versus declines, up volume versus down volume, new highs, new lows and so on. Most importantly, price trends in general, as indicated by moving averages, have been constructive. Well if that’s the case, why did the market sell off?
The entire premise of technical analysis is about gauging the activites of the vast crowd of investors, informed and uniformed. The tools measure strength and direction of price movements but implicitly, measures expectations including fear and greed. There’s no question that the investment environment has been very supportive of higher prices. Thanks to continued low interest rates, decreasing business regulations and benign foreign trade pacts, confidence in the future was reflected in higher stock prices across all stock classes, particularly consumer issues. In other words, markets were moving on all known information.
The surprise impact of an impasse with China was unexpected by markets and consequently participants scrambled to adjust to this information and the possible new reality. Has it changed? We don’t know of course but price activity in the coming months will reveal what investors collectively think. The fact is, no analytical tool can divine specific policy changes, they can only indicate what investors expect the policies may be. Technical analysis is about gauging expectations.
At times when stock markets react violently to news, it’s very useful to step back and assess the strength of existing trends. Unless there has been increasing evidence of a deteriorating trend, the assumption has to be that the underlying trend will prevail once the shock of a news event has passed. We’ve seen this phenomenon in effect consistently over the years. When trends are strong, that is an implicit vote by investors to buy at increasingly higher prices. When this happens, prices stay consistently above their long term moving averages. But markets ebb and flow based on the aforementioned fear and greed dynamic and when a price shock brings prices back to a longer term moving average, those are often opportunities to act.
As we survey the positions of the major stock indices on a weekly basis, it’s clear that the longer term trends are advancing. What it also shows is that prices have plenty of room to possibly retrace even more and still not be bearish. We always assume longer term trends will be slow to turn and not be capricious as in shorter term price swings. Once we have that confidence, we dial the time frame down to a shorter duration such as dailies or hourlies to find bottoming patterns for entry. The holy grail of price entry is when prices converge on a number of time frames at a critical support or resistance level.
In additon, it bears paying close attention to stocks or industry groups that declined the least during a market swoon and to therefore search among these strong relative strength issues for the expected resumption of trend. As an illustration, the following chart shows the relative performance of the major stock indices plotted versus various Dow components. We can see that despite the sell off, consumer and pharma stocks show considerable relative strength. We would look to some of these issues and their industry groups for buying opportunities.
Another tactic will be to monitor those issues that have strongly up trending moving averages but were pushed back by market activity. As an example, one such stock may be ETSY shown below. We note that the weekly trend has been very strong and the recent price pullback is to the previous level of resistance. Momentum gauges have yet to turn back up but accordingly, we would look for a favorable candle such as a daily doji or other reversal pattern for entry since the risk if we’re wrong is very defined here. A failure here will project a drop down to the mid 40’s.