Technical Analysis update – May 2017

Periodically I produce an article with my technical analysis of where key markets may move in the coming months. The last time I did this was back in December 2016 and it is always fun to look back at how my analysis fared.

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 December when I wrote my last technical analysis piece the FTSE 100 was sitting near 7,000 and I tipped that if it broke 7,020 it could go on to set a new record high, which it ultimately did. But it took its time to break out of the tight trading range between 7,150 and 6,900.

Four months on we’ve pulled back from the new all-time high after a rally in the pound, sparked by the surprise UK election, sent the FTSE 100 into a dive. Interestingly we are now stuck in a new range. At the time of writing the FTSE 100 sits at 7,228 having pulled back from 7,250 the day before. As shown in the chart below the FTSE 100 needs to break through key resistance levels of 7,255 and more importantly 7,300 if we are to see a strong upside. If we do there is a potential to march towards 7,500 and new all-time highs.

On the downside 7,200 and 7,192 are support levels to key an eye on which have proved resilient. So until we break above or below this 100 point trading sandwich we won’t know which way the market is going to go. If we break below 7,192 then we could well head towards 7,100. The strength of the pound versus the dollar is going to have a major impact on the path of the FTSE 100 in the coming months and I look at the GBP/USD exchange rate later.

US stock market

The US stock market has struggled to make new headway since it hit a closing high of 2,395.96 on 1st March 2017. We’ve seen some pullbacks which have been readily bought by bullish, albeit nervous, investors. The S&P 500 even dipped below its 50-day moving average (a usual sign of weakness) before buyers stepped in and drove the market back above this watershed.

At present the S&P 500 is at 2,391 just shy of its all-time high. The longer it stays near this record the greater the chance it will eventually breach it. 2,395 is massively resistant as is 2,400 so the market needs to close above these before it can march higher. If it does then the new target and resistance levels will be 2,425, 2,450 and 2,500! On the downside 2,375 has proved hugely supportive as has 2,350.

In the short term the market is in neutral but long term the uptrend is still intact, just about. If we can get over 2,400 then the bullish mood will be reinforced.

Japanese stock market

Japanese equities struggled in March as unexpected dollar weakness saw the yen appreciate, which is bad for Japanese exporters and their share prices. Overall the market fell by more than 6%. It has since rebounded mostly back to where it was. Unfortunately for UK investors sterling's recent volatility has meant that they remain down around 4.5%. Japanese funds which hedged out their currency exposure obviously benefited.

I wrote last time (in December) that 20,000 was a key resistance line for the Nikkei 225 that needs to be breached if the market was to go higher. Ultimately that proved elusive and the index is largely back where it was in December (19,445 currently). The key resistance levels that need breaching before we can think about 20,000 are 19,600 and 19,470.

Short term the risk/reward is skewed to the downside with 18,800 and 18,600 being key support levels before we hit fresh air. Medium term there’s not a lot to get excited about until we see the aforementioned resistance levels breached, which are around 2.8% higher than we are now. Long term the outlook is a little more positive as the Japanese stock market still represents good value.

Pound vs Dollar

For UK investors the strength of the pound remains one the biggest influences on their returns in 2017, as it was 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. Obviously the converse is also true.

$1.25 has been a crucial threshold for some time. All the while we were below that the outlook for the pound was poor. However, the pound has gained strength, largely the result of the surprise UK election, breaching $1.25 and surpassing the further resistance points of $1.275 and $1.285.

We are now sitting at $1.292 which is above the crucial $1.29 level. $1.29 was a huge line of resistance and has now switched into a line of support. $1.29 is now the new level to watch.

Forecasting the outlook from here is tricky because the strength of the pound is a quasi-risk measure for the UK economy and investor risk appetite. Therefore it will respond positively or negatively to any headlines around the UK election or Brexit negotiations. On the upside there is a weak resistance level at $1.30 which should break if the pound strengthens. After that the next resistance point is around $1.3112, which was the low point immediately after the Brexit vote.

The key resistance level that will keep a lid on the rise of the pound is around $1.33-$1.34, which has been a resistance point that's held since the Autumn and the likely high point in the near term.

On the downside if $1.29 is breached a key support level is $1.275 before we start pondering $1.25 again. Overall the outlook for the pound is certainly more bullish than it has been but the number of bearish investors still just about outweighs the number of bullish investors. The upward shift in momentum we’ve experienced has favoured those who hedged out any sterling exposure in their global holdings, and it explains why a number of such funds have made it into May’s Best of the Best selection.