Technical Analysis update for May 2022

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. It's been a while since I last wrote a technical analysis piece, in fact, the last time I wrote one was in December 2021 before the slump in bond and equity markets. Therefore it's an opportune time to take a look at how key markets have fared so far in 2022 and where they may head next.

Remember, technical analysis is not a crystal ball but instead gives you a range of possible outcomes and levels to watch. In volatile market conditions, 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 that 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 price 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. Click on the charts to enlarge them.

US stock market

The chart below (click to enlarge) shows the movement of the S&P 500 over the last 18 months, on which I've drawn lines of support and resistance.

Back in December 2021 I wrote that “we needed the S&P 500 to finally break 4700 convincingly, and hold above that level if we were to see the next leg higher in US stocks. I also wrote that if the S&P 500 fell sharply below 4500 things could get a bit ugly, as that marked the lows of November/December but also the highs of the autumn. If we broke down through 4500 then an obvious line of support was 4400… and 4300 marked the October low when a spike in natural gas prices shook investment markets. That would equate to a 10% fall below the S&P 500's December all-time high and a break below the 200 day moving average (which would be a bearish sign)”.

Ultimately that is exactly what played out and the S&P 500 responded to each of the support lines as suggested, with the long-term uptrend dating back to November 2020 being broken. After pushing above 4700 on 23rd December, during light trading volumes over the festive holiday period, the S&P 500 broke sharply down through 4500 and its 200-day moving average (the purple line in the above chart) once investors returned to their desks in the new year.

The previously strong support line of 4500 is now a strong resistance line for any recovery. You can also see how each support line on the way down has now become a red line of resistance. Ultimately the rebound failed at the 4600 level and fell to a then new intraday-day low of 4161 in mid-March following Russia’s invasion of Ukraine.

From there the S&P 500 looked to have put in a double-bottom (the w-shaped move as a result of a revisit to the March low) which catapulted the market higher back above 4600. Ultimately the break above 4600 was another failed breakout to match those in February and the market collapsed from there and set a new low - even below that which we saw in March, which was a negative sign. In fact, the intraday low was 4062 which was the support line going back to May last year.

On the downside, if we break below there then the market could go into freefall and crash through 4000. Below there, there are numerous support lines (not shown), mostly every 100 points down to 3750.

Interestingly, had I written this analysis yesterday (before the latest US Federal Reserve decision) when the S&P 500 sat around 4150 I would have explained how the S&P 500 would need to break above 4300 before investors could start getting excited about this market again. From there the index could attempt to build enough momentum to break out of the downtrend channel, with the 4400 level being important. Then from there 4500 and the 200-day moving average would come back into play and moving back above there would be a bullish sign. Ultimately we would want to see 4600 taken out convincingly and with significant trading volume before we can look to the all-time highs once again.

After the Fed decision yesterday to raise interest rates by 0.5% (and not by 0.75% as some had feared) the S&P 500 rallied by 3% in a matter of hours taking the S&P 500 back to 4300 (as shown in the chart above). 4300 remains a key resistance level even now and a move above there would be positive. But bear in mind that in March we had exactly the same explosive market response, following the Fed’s meeting back then, which was also when the market looked like it had formed a double bottom, only for that rally to fade. So keep an eye on how the index behaves at the various lines of resistance and support in the coming months.

UK stock market

Last time the FTSE 100 was sitting just below 7300 and the charts suggested that “if the FTSE 100 convincingly [closed] higher than 7300 then that [opened] up the likelihood of a revisit of the pre-pandemic highs”.

Back then we were still a long way away from the all-time high of 7877 which we saw in 2018. But the FTSE 100 did decisively break above 7300 and attempted to rally towards the all-time. Interestingly, the index retested the support line of 7300 in early January but once again rebounded strongly, to outperform most other global equity markets and remain in the uptrend that can be traced back to January 2021. You can see that uptrend channel sandwiched between the rising red line of resistance and the rising green line of support (which also has often coincided with the 200-day moving average).

Last time I also wrote that the 7150 line remains key, in terms of support, and if we did break below there and the bottom of the rising support channel we were likely to revisit 6900 once again. As it turns out that is exactly what happened and right on cue the FTSE 100 rebounded off 6950 in March. The rebound helped recapture the important 7300 level and the rising uptrend channel before the markets continued on to 7500.

Interestingly you can see from the chart that the moves between 7300 and 7500 tend to be aggressive and quick in either direction. Right now the FTSE 100 sits at 7529. To push to the new all-time high we need to break the 7672 level (the February 2022 high) and finally push above it. In April we revisited the 7672 level but failed to break above it. This has formed a potential double top which is a bearish technical sign, so we need to close above there and hold it in order to negate the double top.

On the downside, 7500, 7380, 7300, 7150, 7000, 6950 and 6900 are all important support lines.  Below 6900 then the long-term support lines of 6800 and 6400 seem like obvious candidates - which I’ve shown in previous technical analysis pieces.

Japanese stock market

Last time I discussed how the Nikkei 225 broke out of the slow-motion car crash that started in January 2021, to begin trading sideways between 30000 and 26800/27000. I wrote at the time that if we broke below 26800, then 24100 was a potential support line and below there then it would be 23000.

As can be seen from the updated technical analysis chart below the Nikkei 225 did ultimately break below 26800. The index plummeted to a March low of 24717, which represented an almost 20% fall from the September 2021 high of 30670. A 20% fall would meet the definition of a bear market.

As can be seen from the chart the Nikkei 225 now has established a new downtrend channel and currently sits on the lower boundary of the previous sideways channel of 26800. If it can break up into this channel it may begin to build a base for a rally higher and there is a potential for an inverse head and shoulders pattern to form which would be bullish. For this to occur we would need to see the Nikkei break above 27500 and ultimately the upper resistance line of the downtrend channel at 28000.

Looking below, 24100 and 23000 remain key support lines if the index breaks down once again.

Pound vs Dollar

There really isn’t anything to like about the strength of the pound versus the US dollar. The chart below shows how the pound has been stuck in a clear downtrend since its high back in January 2021.

Last time I wrote that if we were to “break below $1.32, then $1.30 is a strong line of support that would need to hold to avoid an even greater collapse in the pound”. You can now see clearly that once the $1.30 level gave way then the bottom fell out of the market. The pound currently sits around the $1.25 level but needs to recapture $1.275, but more importantly $1.30 which, right now, feels a long way off. On the downside, $1.25 needs to hold otherwise we could revisit $1.23 pretty quickly.