As regular 80-20 Investor members know, periodically I like to look at what technical analysis suggests about where key markets might be headed next. The last time I did this was a year ago, back in May 2020, as markets were trying to recover from the coronavirus induced market sell-off. Given that most equity markets are near all-time highs (or at least multi-year highs) I think now is a good opportunity to look at what technical analysis is telling us about the current market environment.
Technical analysis is not a crystal ball but instead gives you a range of possible outcomes and levels to watch. In volatile market conditions, such as those we are experiencing now, technical analysis tends to prove particularly useful and traders and professional investors start to pay greater attention to it.
As ever, I like to recap what technical analysis is and how it works. I always 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. Occasionally I also look at moving average lines (the black line). Click on the charts to enlarge them.
US stock market
The chart below shows the movement of the S&P 500 over the last 12 months. Usually, a technical analysis chart emphasises the struggles an index has at key levels of support or resistance with plenty of see-sawing. But, as you can the S&P 500 has been steadily climbing in an upward channel over the last year (as marked by the red and green parallel lines), especially since the US election. Pullbacks and periods of consolidation, such as the one we saw in February, have occurred when the index has hit the rising red resistance line. However, each time the uptrend has resumed when the index sank towards the rising green support line, which also currently happens to be tracking the 50 day moving average for the S&P 500.
Whichever way you look at it, this is a strong uptrend that remains intact despite the consolidation we've seen recently at the 4200 level. Oddly, large round numbers are psychologically significant hurdles for the market to overcome, which 4200 is proving to be. The same was true of 4000, which is currently providing support and is also where the rising support line and the 50 day moving average converge. Should the market break lower this is a natural place for it to initially find support, which is around 4% lower than we are now.
The chart below shows the longer-term performance of the S&P 500. You can see how the S&P 500 was in a narrowing uptrend channel stemming from its September high. Often with this type of pattern, an index is eventually forced into a corner, resulting in a break higher or lower, often in an aggressive way. In this instance we saw the market break aggressively higher.
If the S&P 500 can break above the 4200 level then it can continue to push higher. On the downside, there is plenty of support through 4000 and all the way down to 3,750, which represents a 10% fall from current levels or in other words a technical correction. This uptrend has been driven by easy monetary policy from the US Federal Reserve as well as promised spending from the US government. As long as these persist supportive investors' "buy the dip" mentality is likely to remain and is proving profitable.
UK stock market
The FTSE 100 has not enjoyed the same kind of rebound that the US stock market has, still being some way from its all-time high of 7877 achieved back 2018. However, as the chart below shows it broke its short-term downtrend (the downward sloping red line) in November when news emerged of the first Covid-19 vaccine. The initial parabolic move higher eventually consolidated into a sideways move between 6400 and 6800. After being backed into a corner by the rising green support line and 6800 (then a resistance line) the market broke higher and headed towards 7000. The 7000 level is a psychologically tough barrier for investors, now acting as a line of resistance. The FTSE 100 has tested this line and right now the index seems to be being backed into another corner by the rising uptrend line around 6900. If the market breaks lower then 6800 would be a natural first support line, which also happens to be where the 50 day moving average currently sits. But break below there and we could be back into the 400 point sideways channel.
But If we zoom out further you can see that the FTSE 100 has a bigger test of its narrowing uptrend move at 7100. A long term support line that is now resistance (see below). If the market can break above there and hold then things could become much more interesting for investors. As I write the FTSE 100 currently sits at 6997.
Japanese stock market
If you look at the Japanese stock market over the short term it resembles the S&P 500 more than the FTSE 100.
After a quick initial recovery from the Covid-19 lows the Nikkei 225 bounced around 23030 for the second half of 2020 before its parabolic move higher after the Pfizer vaccine was announcement in November. The market then continued on its uptrend but now sits at a critical juncture. With the Nikkei 225 at 28812 it is testing the support line at 28860 that's held so far this year but also the rising support line. On top of that, there are early signs of lower highs (as shown by the downward sloping red line) which is ominous and something to watch. With the Nikkei 225 being forced into a corner is it about to break lower or rebound and push to new multi-year highs?
If the market does fall then should 26800 not hold as a support (which is around 7% lower than current levels) then there is potential for the market to head back towards 24100 as shown in the longer-term chart below. On the upside, we really want to see the index break above its recent high of 30468.
Pound vs Dollar
The downtrend that had plagued the pound versus the dollar was finally broken in the autumn as shown in the chart below.
Optimism surrounding the Covid-19 vaccine rollout and a Brexit deal eventually saw the pound break above $1.372 earlier this year. Since then $1.372 has acted as a support line even after the pound went on to touch $1.41 (a three year high). Right now the pound is trading in a sideways range of between $1.372 and $1.397, providing a much less volatile period for the currency than we've experienced over recent years. Much to the relief of investors with overseas holdings. The currency is currently valued at $1.39 but $1.425 remains an elusive but important barrier if the pound is to continue higher against the dollar. If the pound was to break lower aggressively then $1.34 should prove supportive.
