Technical Analysis update – August 2017

I tend to produce a technical analysis article every 3 to 6 months to analyse where key markets may move in the short to medium term. The last time I did this was in May 2017. However, the flood of Chatterbox questions this month voicing fears over a stock market correction prompted me to update my analysis sooner than planned. The summer is always a strange period in investing as the majority of market participants jet off on holiday. Lazy days on the markets where not much happens can suddenly give way to spikes in market volatility (see-sawing) exaggerated by the seasonally low trading volumes. Quite simply, if less trades are being made then each one has a more significant impact on the market.

It is always interesting to look back at my previous analysis (in this case in May 2017) and see how it held up. With the benefit of hindsight it's rewarding to see how accurate my analysis was on that occasion. However, technical analysis highlights potential future outcomes so won't always be right. Don't forget that since May we've had a technology sell-off and rebound and there was no foreseeing that.

Each time I write these articles I advise investors not to try and time the market because they will never get it right. However, there's nothing wrong with trying to determine a range of possible future outcomes within investment markets. Think of it like a weather forecast. It’s not 100% accurate but it will give you a better idea of whether a storm is on the horizon. Technical analysis is the nearest thing we have to weather forecasting in the investment world.

What is technical analysis? - A recap

For those who don't already know or have forgotten here is an explanation of what technical analysis is:

Trying to predict the future of the stock market is akin to reading tea leaves. Personal predictions are almost always clouded by prejudices which reaffirm what we ‘want’ to happen rather than what is ‘most likely’ to happen.

That is why one objective method is to use technical analysis to try and judge likely outcomes. So what is technical analysis? One line of thinking is that stock markets are driven largely by human behaviour. At the simplest level you could argue that fear and greed drive a lot of investors’ actions. Let’s say that an opportunity presents itself and some investors jump on it and buy the shares in question. The demand then drives up the price. More investors jump on the bandwagon looking to profit. Then at some point the tide turns (fear sets in) as people think the price for the shares is looking expensive and so people start selling. More and more people start selling to take profits and the price falls. At some point the price falls until others think the shares look cheap and start buying, outnumbering the number of sellers. Again demand outstrips supply and the price goes back up.

This see-sawing explains the movement you see in stock market charts such as those below. The prices at which investors start bailing and selling the shares is called a point of resistance while the point at which they pile in is called a point of support.

As such there is a surprising level of predictability to human behaviour. In terms of the stock market that means when the price goes through historic points of resistance or support it can indicate a new unfolding market rally or collapse. Why does it do this? Part of it will be because traders trading in millions of pounds will use these points of resistance and support to trigger trades. Yet for a lot of investors they might not even be aware of these inflexion points. They simply are reacting to how other people in the market behave. Put it this way, when stock markets fall you feel tempted to sell, right? Also once it starts to rally, you are tempted to jump in? That’s why these patterns have a tendency to repeat.

Some investors and traders swear by it and trade solely using technical analysis. I don’t fall into that camp. I view technical analysis like a road map drawn by someone who has already completed a journey to somewhere near where you are planning to drive to. The road map won’t take you exactly to your intended destination, nor will it be entirely accurate. However, it will give you a better sense of what to expect. Then if you decide you like the look of a particular market you can use 80-20 Investor’s ‘Best funds by Sector‘ data to choose an actual fund to invest in.

Latest technical analysis

There are different types of technical analysis, however, I find the most useful guide is to simply highlight the points of resistance and support, as I've done previously. So below I provide technical analysis, looking at areas of support (the green lines in the charts below) and resistance (the red lines), on the key global equity markets and the pound/dollar exchange rate. Click on the charts to enlarge them.

UK stock market

Back in May I noted that the FTSE 100 would need to break through key resistance levels of 7,255 and more importantly 7,300 if we were to see a strong upside, with the potential for a march towards 7,500 and new all-time highs.

We broke those key resistance levels and we now find ourselves once again above 7,500. On the downside 7,500 forms a line of resistance which has been tested during the escalation of the US/North Korea tensions after Trump's 'fire and fury' comments. All the time we remain above 7,500 investors are likely to keep buying dips in the short term. Should we fall through 7,500 then keep an eye on 7,480 and then 7,450 support levels. Further below, the 7,300 level remains an important support level if we do eventually see a bigger pullback. If we break down through this level then the outlook becomes far more bearish with further downside likely as we head back towards the trading range I discussed back in May and possibly 7,100.

On the upside we need to see the FTSE 100 move convincingly above 7,500. If the FTSE 100 can break the resistance level of 7,525 and then push on through the tough 7,550 level the index will set new all-time highs. From there 7,600 is the psychologically important barrier, which is around 1% higher than we are today. Longer term if we see the pound fall significantly back below $1.30 then some analysts think we could head towards 8,000 over the long term, which feels optimistic.

US stock market

The US stock market has continued to hit new all-time highs driven mostly by the runaway tech sector. At the time of writing the S&P 500 sits at 2,469 after Trump's aggressive posturing towards North Korea caused the market to have a minor wobble, and when I say minor we are talking around -0.3%. However, the increase in US/North Korea tensions has spooked international equity markets and it's too early to say if this is the beginning of a reversal.

For the sentiment surrounding the US stock market to start becoming negative we would need the S&P 500 to break down through 2,450 and 2,440, so keep a close eye on that level. However it's only if the market breaks down below the psychologically important support level of 2,400 would I start to question whether the current uptrend has finally turned.

On the way down from there we would then be looking out for support levels at 2,375 and then 2,340 - 2,350 to hold. How the market behaves around this level, if it gets there will be crucial because if things were to turn nasty then 2,200 is possible in a larger correction (which also happens to be around 10% below where we are now). On the upside if we can stay above 2,450-2,460 then the uptrend for the S&P 500 could be reinforced and push us through 2,500 but it probably won't be straightforward and will likely take time. Click the image to enlarge

 

Japanese stock market

Japanese equities broke through the key resistance levels of 19,470 and 19,600 which propelled the index above 20,000. However for much of the last 6 weeks the market has been trading into a sideways triangle as shown below. The next move up (a breakout) or down was always going to be crucial. At the time of writing the index has just broken below 20,000 after the index lost 1.25% thanks to Trump's tirade. That leaves it at 19,738 which is below the 19880 support level.

Short term we need the market to bounce off the 19,600 line if it is to regain its positive stance. If it doesn't then the omens are not good. Ultimately the market needs to move back above 20,000 before the market sentiment is overtly positive. If we break down through 19,600 then we are looking at 19,470 with 18,800 and 18,600 once again being support levels before which we hit fresh air and all bets are off. That is around 6% below where we are currently. Click to enlarge image.

Pound vs Dollar

For UK investors the strength of the pound remains one the biggest influences on their returns in 2017. When the pound is in freefall any funds or assets held overseas are immediately worth more (ignoring any change in their underlying value) because of the currency exchange rate. Obviously the converse is also true.

Where much of the focus for the sterling/dollar exchange rate has centred around the impact of Brexit, it's being countered somewhat by a weakening dollar. Trump's inability to pass new legislation or make headway with new tax reforms, while the European economy has shown signs of life, has seen the dollar tumble in value. Coupled with the fact that the Fed seems to have stepped back from aggressively raising interest rates while the Bank of England has begun musing over the possibility of raising them in the UK, the pound has risen against the dollar. We've seen a pullback from the recent high of around $1.31 and it now sits at just over $1.30. The mood in the very short term is slightly bearish because of the political angst in the UK and recent disappointing economic growth figures.

Where the market will go is tricky to say because we are once again at that $1.30 cross road. The resistance and support levels I discussed last time remain in play. $1.31 and then $1.33-$1.34 are resistance levels keeping the pound subdued, with $1.36-$1.37 the medium term high point.  If we head down from here then $1.29 is the focal point. If we continue through that level then its $1.285 and then below. Keep an eye on all these key levels as they may give you a steer as to which direction the market is going to move once we see some form of conviction.