Somebody suggested that I write “refresher blog” on technical analysis. It’s a big topic, and really can’t be covered in one blog, but I can cover some of the basics here. I hope this blog offers you a few tips on achieving a higher return on investment by using technical analysis in your approach to stock market analysis.
BTW—Canadian MoneySaver printed a 2-part series – one in February of 2015, the other in March 2015 – outlining the ValueTrend methodology incorporating some of our fundamental and technical analysis screens. I recommend you read these articles here if you wish to learn more about creating an investment process of your own.
Remember, technical analysis is about risk vs. reward prognosis. Sometimes people refer to what we technical people do as “market timing” – but in reality, its more about measuring your potential risk vs. reward, and making a decision as to whether those trade-offs are favorable at the time. It’s not about being able to accurately assess peaks and troughs – its more about trading with the odds for you, rather than against you.
5 Important Factors in Technical Analysis of Stocks
Below are the 5 factors within the field of technical analysis that I would like to touch on in this blog. I will not touch on market cycles, sentiment, comparative strength studies or the other refining tools of the trade here. Please refer to my book Sideways for full descriptions of these tools:
- 4 Phases of the market
- Support & resistance, volume
- Patterns
- Breadth
- Momentum
Trends, Patterns and the 4 Market Phases
Support on a chart is defined as an area of consolidation that “supports” – or contains a stocks downside. A stock makes a series of troughs at a similar price level over and over – its where buyers come in and buy the stock at a price level that they perceive to be attractive creating a floor on the stock. Resistance is an area where a stock meets selling pressure. Investors unload the stock and create a celling that becomes difficult to penetrate. Peaks occur over and over at an area of resistance. An uptrend is defined by higher highs (peaks) and lows (troughs) – suggesting that former resistance is no longer a factor. New buyers are buying at higher levels. A downtrend is the opposite—support has been taken out, and buyers are no longer interested in the stock unless it is at a lower price. Peaks and troughs are progressively getting lower.
When volume expands (not shown on the diagram), it can indicate further strength within a trend.
You need to understand what phase the security or sector is in to understand how to trade that security. For example, a stock that is “Phase 1 basing” after a decline is setting up as a potential long candidate – but should not be bought into until it proves a break from that consolidation. A stock that is making higher highs and higher lows in a “Phase 2 uptrend” can be bought within the trend – ideally as it retreats and tests the uptrend line. Finally, a stock that appears to be “Phase 3 topping” should be avoided until proven otherwise – as should a stock making lower highs and lows within a “Phase 4 downtrend”.
Various cute names are assigned to the patterns seen within Phase 1 bases and Phase 3 tops. Double or triple bottoms or double tops, head and shoulder bottoms and tops, and rounded bottoms or tops are commonly described. Consolidation patterns such as triangles or rectangles are often identified by technical analysts. You can read my book Sideways for a list of the most common of these patterns and where you will find them. The most important thing to know is that a stock making higher highs and lows is in an uptrend, and once those highs and lows are no longer taking out the prior highs and lows in that uptrend, you should be suspect of a phase 3 top. The same goes for a downtrend –if a series of lower highs and lows discontinues by a series of flat, or higher peak/trough movements, you should suspect a phase 1 base is forming. Note that a trader should only exercise a buy or short sale after a base or top is taken out, and a new trend develops.
Below are the 4 phases illustrated. Use a 30 week or 40 week simple moving average to help you further define the phase of a market – note the market’s movement through the 30 week MA as it transitions from phase to phase. Volume expansion after a base or top is broken can be considered further evidence of a genuine breakout.
Breadth
Breadth looks at the number of companies advancing relative to the number declining. The most common form of breadth is the Advance Decline line. It’s a cumulative line, continually adding or subtracting the net advancing vs. declining issues on the NYSE to the line. This makes it a slower moving indicator than the New High / Low indicator discussed below. Positive market breadth on the A/D line occurs when more companies are moving higher than are moving lower. More declining securities mean declining breadth—a divergence occurs indicating a declining participation in a bull market. It can signal a pullback is approaching. Below is the A/D line (blue line) courtesy of www.freestockcharts.com plotted against the S&P 500. Note how its divergence (declining line against a rising S&P500 line) accurately predicted the 2008 crash.
Another breadth indicator is the New High/ New Low indicator. It’s not a cumulative line as is the A/D line discussed above. To make the indicator more useful, I’ve smoothed the New High/Low indicator (blue line on the chart below, courtesy www.freestockcharts.com) with a 40 week (200 day) moving average. More stocks making new highs vs. new lows when a market index like the S&P500 is moving higher is indicative of a low-participation market. This could mean that an uptrend may be ending soon. It’s a “quicker” moving breadth indicator, so it can signal a little earlier than the A/D line. Note the divergence in 2007 that predicted the 2008 crash- similar to the A/D line prediction. The divergence in late 2009 also predicted a market pullback, whereas there was no divergence seen on the A/D line above.
The quicker nature of the New High/Low indicator can also signal falsely. Note the declining New High/Low line in 2013 vs. a rising S&P500.
Currently (May 2015), the New High/Low indicator is diverging strongly against the S&P500 – and has been doing so since mid-2014. However, the slower moving A/D line is not confirming this divergence.
Momentum oscillators
Momentum oscillators identify extremes in the movements of securities. They are shorter termed market timing indicators, and should only be used to refine your trades after identifying the current market phase. If a momentum indicator reads that the market is overbought, this suggests that traders and investors have become overly optimistic about future returns. Momentum oscillators will help us bet against the crowds fear and greed by showing us when traders and investors have gone too far overboard in fearfully selling or overzealously buying. Extremes shown by a momentum indicator show us that the market may be about to take a turn in direction.
When a momentum oscillator illustrates a directional trend that is not the same as the security it is tracking (i.e. one is going up, the other is going down), this, as with breadth indicators for the broad market, is called a “divergence”. Momentum divergences are important indications of an impending change in direction for a security. If a momentum indicator is trending in the opposite direction of the security you are watching, expect the security to change direction soon.
The chart of the Dow Jones Industrial Average (DJIA) below shows 3 commonly used momentum indicators. The fastest indicator to react to market changes is stochastics, shown in the top pane below the chart. When the black “slow” line hooks down and breaks through the red “signal” line – you have a stochastics sell signal. If the hook is to the upside, you have a buy signal. Notice how this indicator accurately calls the short termed peaks and troughs, but isn’t much good for longer termed investors.
The middle pane shows Wilders’ RSI oscillator. This oscillator shows us overbought and oversold levels on a longer termed basis. If the line is near or above 70, it’s a sell signal. If it’s at or below 30, it’s a buy signal. In an uptrend, the line won’t likely get too close to 30. In a downtrend, it won’t get too close to 70. You may want to adjust the “look back” period from the default 14-bars to more or less bars, depending on how sensitive you want the indicator to be. Also note the divergence in 2013 between RSI, which made lower highs – and the S&P500, which made higher highs. The RSI divergence signal predicted the pullback that August. It’s interesting to note the current divergence (May 2015) of RSI against the S&P500.
The bottom pane is the Moving Average Convergence Divergence (MACD) indicator. It’s the slowest of the oscillators discussed here, and my least favorite oscillator. Like stochastics, MACD can cross the red signal line to provide entry and exit signals. The histogram bars below the indicator provide an easier to read signal—if the histogram goes above the horizontal line, it’s a buy, and vice versa. MACD shows false divergences to the S&P500 frequently. I’m hesitant to rely too much on these signals.
As an aside—note the 200 day (40 week) Moving Average line on the DJIA chart below was confirming the uptrend as of May 2015.
Like fundamental analysis, technical analysis does not provide absolute accuracy in predictions about the future of a stock or the broad markets. Instead, technical analysis increases your odds of success by analyzing crowd behavior. For a more detailed discussion on using the tools of technical analysis, I would recommend reading my book Sideways: Using the power of technical analysis to profit in uncertain times
