Technical Analysis update for May 2019

My last technical analysis piece was written just as equity markets started to rally after the December lows. I always find it a useful exercise to go back and read what I wrote with the benefit of hindsight. 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 such, now represents an opportune time to look at what the technical charts are telling us about where markets are likely to head next.

As ever with these pieces 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. Click on the charts to enlarge them.

US stock market

My last technical analysis article, back in January, now makes for interesting reading. At the time the market had been building up momentum to try and push higher but hadn't fully negated the downtrend that started in October 2018.

As you can see from the chart below (click to enlarge) the S&P 500 eventually broke higher, following a dovish u-turn by the US Federal Reserve. The S&P 500 (the purple) line broke the downtrend and rallied incredibly strongly, eventually hitting a new all-time high on 30th April 2019 at 2,945.83. In doing so the index smashed through a series of resistance levels to produce a V-shaped recovery. However unlikely such a recovery may seem, as often there is a retest of the recent lows following a severe sell-off, it was always a possibility once the rally was under way. However, on the 5th May, Donald Trump reignited US-China trade tensions which caused the index to pull back from its all-time high.

We are now in a situation where the market could be forming a classic double top formation. This is where the market ultimately falls after retesting a recent high. It is a bearish technical pattern and if it does continue to unfold then the market would likely head lower. Ominously the recent pullback has broken through the two diagonal support lines (marked in green) and now sits just above the psychologically significant 2800 level.

As you can see 2800 is a key support level, even more so now that the 200-day moving average sits just beneath it. If the market breaks down and closes below both levels then we've got to seriously consider the possibility that the recent uptrend is over. There are a host of negative headwinds out there for the US stock market including a strengthening dollar, the US-China trade war, continued economic weakness and an inverted Treasury yield curve. If the market does break lower then ultimately a retest of the December 24th low is possible, at 2351. That would require the S&P 500 to fall by almost 17% from where it is at the time of writing. However, there are a host of support lines on the way down which could arrest any selling, most notably 2641 which I've shown in the chart above and is 6.5% below where we are right now.

Having said this, the 2019 rally has been incredibly dogged with investors rushing to buy any dips. This latest pullback may not necessarily end up any different, especially if we get some form of trade war truce. If you look at the far right-hand side of the chart above the S&P 500 is now trading in a narrow 100 point window between 2800 and 2900 while Trump antagonises China. Keep an eye on 2900 because if the market breaks above there then it is possible that we could push on to new all-time highs. Ultimately this is what we need in order to confirm the uptrend is intact. There is an argument that the market has been in a sideways trading pattern since mid-March once it broke above 2800 and it is still looking for a sense of direction, up or down. However, it looks like we should find out either way soon as the green uptrend line and the new downtrend line (the diagonal red line) is forcing the market into a corner.

UK stock market

While the implications of the US-China trade war are being felt globally in stock markets, in the UK the key driver remains Brexit and the value of the pound. The chart below shows the key resistance levels in red, support levels in green and the 200-day moving average in black. The picture is not dissimilar to the S&P 500 but with the key difference being that the FTSE 100 has not set a new high since the 7877 set back on 22nd May 2018.

Last time I wrote that the "FTSE 100 seems to be stuck in a 200 point range below 6950 and we need to break above 7000 and then 7050 if we can make an attempt at 7250. In recent history breaking above that level sees us quickly regain 7500." 

True to form when the FTSE 100 eventually broke above 7250 it promptly moved above 7500 where it eventually lost momentum. As you can see a failure at 7500 often sees the market fall back just as quickly towards 7250. If the key 7237 support level (shown) gives out then it opens the door for the market to move lower. That's where we find ourselves now, with the falling pound helping the FTSE 100 keep its head above water at 7277. On the upside, we need to hold above 7500 if we are going to have a chance of consolidating before pushing on towards new all-time highs, but it will be a big ask.

If instead, we break below 7237 then 7200 is the next level to watch and then the 200 day moving average close by at 7174. Falling below there would be a bearish sign and could trigger more selling. If we head lower then 7090 and 7000 remain crucial support levels. Below there then we'd need to consider whether a retest of the December low (6584) is on the cards. Ultimately, Brexit and the value of the pound are going to play a major influence on where the FTSE 100 goes from here.

Japanese stock market

My last technical analysis article showed how the Nikkei had broken down out of an uptrend that dated back as far as 2016. The Nikkei 225 then became boxed in by lines of support and resistance suggesting that a break out either way was on the cards. As the chart below shows the Nikkei 225 eventually broke higher, alongside other global equity markets.

However, the Nikkei 225 remained a long way from its autumn high. Last time I suggested that if the market broke higher then it would likely trade within a 1000 point range as it did for most of 2018 unless it broke above 23000, which was ambitious. The market did push over 22000, towards 23000, but fell short and has now pulled back below 22000 to sit fractionally above the important 21150 support level shown. The Nikkei 225 is currently at 21260 and a fall below 21150 would open the door to a potential retest of the recent low, which is exactly 10% below current levels.

Pound vs Dollar

As you can see from the chart below the short term outlook for the pound doesn't look great. The recent move higher for the pound caught a lot of investors off guard. However, a strengthening of the dollar combined with the political turmoil in the UK and an impending no-deal Brexit sent the pound into something of a tailspin.

The pound crashed through the important $1.30 support line and through its 200 day moving average to paint a bearish picture. There is not a lot to get excited about with the pound right now and a retest of $1.25 is a real possibility. If that doesn't hold then $1.22 could be on the cards.

To move higher the pound has to recapture $1.27 and move back above $1.30. While that may seem unlikely, if a deal is suddenly struck between the EU and the new Prime Minister (whoever that is) or we revoke Article 50 then the pound could shoot higher. Just as we saw recently, such a scenario would see those shorting (betting against) the pound having to scramble to cover their losses again and buy the pound. That is what sent the pound towards $1.32 last time and it could happen again. Already some value hunters are becoming interested in the long term outlook for the pound, betting on more upside, but betting on currencies is a dangerous game.