Technical Analysis update – December 2016

In this month’s Chatterbox I was asked whether I thought now was a good time or not to invest new money. The question arose as a result of my latest update to my £50,000 portfolio in which I explained why I refrained from making too many changes during a period where we’d seen a spike in volatility. That’s very different to suggesting that now is a good or bad time to invest.

As you well know I regularly advise investors not to try and time the market because they will never get it right. In the worst case scenario they will lose money which they will struggle to recoup. 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?

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

As the chart below shows the FTSE 100 enjoyed a strong rally after the EU referendum but has largely traded sideways for the last 4 months. During that period we’ve experienced a few dips and rallies, largely driven by the relative strength or weakness of the pound at the time. Don’t forget a weak pound is seen as positive for the many FTSE 100 companies with overseas earnings as well as those who export.

In the last two weeks we’ve seen the market rally form 6,680 and it now sits at the psychologically important 7,000 level but has struggled to make more headway. Interestingly things have pretty much played out exactly as I suggested in my last Technical analysis update.

In the short term the market can push higher if the pound continues to weaken (see later) . If the FTSE 100 can just creep and hold above 7,020 then we could push on towards 7,150 and an all-time high. It won’t be easy as there will be resistance around 7,070 and 7,080.

There’s been a lot of support when the FTSE 100 has sold off at 6,950 and 6,900. If the market is to go lower then we need to break 6,860. So we are in a short term range of -2% and +2% for the FTSE 100 unless we get a strong rally or sell-off to break support and resistance lines.

US stock market

Since the US election the S&P 500 has exploded upwards breaking that critical 2,200 resistance level and setting numerous new all-time high records along the way. Understandably there’s been a lot of concern that the Trump trade will run out of steam.

Certainly the market rally is vulnerable to a sell-off. The key support level in the short term is 2,250 and the index needs to break down through that if a larger sell-off is at all likely. From there the 2,200 should act as a support level (i.e. over 2% below where we are now) and then 2,190 in particular as shown in the chart.

On the upside 2,275 is a psychological resistance level (which would surpass the current all-time high of 2,271 set last week) and if we manage to break through that then 2,300 is possible. You can see that the Trump rally brought the S&P 500 back above the uptrend line from January’s low and if it remains above that line the signs are positive. Many will be hoping that the Santa rally arrives/continues (as my analysis from last year shows it does over 70% of the time) to push on to new highs. Interestingly the S&P 500’s 14-day relative strength index, which is a momentum gauge, rose above to 77.6 last week. Anything above 70 is considered a sign that the market is overbought and a little stretched. Yet it has since fallen back to 67.5 which is a sign that the market has become less stretched, which is positive.

Japanese stock market

The Nikkei 225 finally broke the key 17,000 level mentioned last time with the catalyst being the rally in the dollar following Donald Trump’s US election win. Back then I suggested that if we breached that level there was great deal of upside and wow did we get that. As the chart below shows the Nikkei 225 struggled to break upwards convincingly and it wasn’t until Trump’s victory that it managed to smash through the 17,000 resistance level.

The index now sits at 19,494 which is over 14% above 17,000 and it has achieved that in just six weeks. This rally has been a result of the dollar strengthening versus the yen. If you recall when the yen weakens the Japanese stock market rallies as exporters benefit from the competitive advantage the currency exchange rate offers over other Asian exporters.

Looking at the chart , on the downside 18,600 remains a pivotal point as there’s a lot of fresh air below here if the market broke down. The market remains in a definite bullish uptrend as shown by the sloping green line on the right of the chart. If it pulls down through that line then you know that momentum has changed. Where the green uptrend line meets a resistance line is 20,000. This is 2.5% above where we are now (this 2+% short term upside is a recurring theme in this article) and the market must break that convincingly to go higher. The second chart puts the current rally in context of the market’s all-time high. Interestingly the charts are in local currency terms (i.e. the Yen) and Japanese equities have enjoyed a rally of over 19% since the pre US election low. If we allow for the currency moves between the pound and the yen UK investors with unhedged exposure would be up a more modest 7%.

Pound vs Dollar

For UK investors the strength of the pound has been one of the biggest influences on their returns in 2016. When the pound is in free fall any funds or assets held overseas are immediately worth more (ignoring any change in their underlying value) because of the currency exchange rate.  $100 of shares are now worth around 16% more in sterling terms than they were before the Brexit vote. I recently wrote an article at the request of an 80-20 Investor member on how to remove the exposure to the strength of the pound going forward, ahead of a potential rebound, after enjoying the profits made from its recent fall.

For weeks I’ve been talking about the importance of the $1.25 level as support for the pound. If we broke through that we could head much lower. We did just that and tumbled to nearly $1.23 at the time of writing. Hard-Brexit angst has returned to the market and if the downtrend doesn’t reverse and we go through $1.23 then we could see $1.20. On the upside $1.25 remains the pivotal threshold as a break above that could see the pound rally before meeting resistance between $1.275 and $1.285.