My last technical analysis piece was written at the start of June. It is always useful to go back and look at what the technical analysis suggested at the time and how things panned out. The summer months turned out to be unseasonably kind if you invested in developed world equities (and in particular in US equities). However, October has been extremely volatile and equity and bond markets have fallen. Interestingly this latest sell-off has been compounded by technical factors as much as it has been by newsflow and macro themes. So I think it is an opportune time to review where we are and 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
Just like during February's sell-off US stocks, and in particular technology stocks, were at the centre of October's market weakness. A repricing of US interest rate expectations was enough to send bond yields spiking and money out of US tech stocks and equities in general. Looking at the broad S&P 500 it is currently 5.5% below its recent high and at the low-point of last week's sell-off it was down almost 7%.
It's worth noting that US equities have not yet suffered a 'technical correction' in October. A correction is defined as when the index has fallen 10% below its recent high point. However, on the way down the index broke through a number of technical support lines which have now turned into lines of resistance. In the chart below I show how back in May the S&P 500 finally bounced to new highs after breaking upwards from the narrowing triangle on the left. You can also see that the start of that rally commenced after the market reconfirmed the low achieved in February, (i.e achieved it again and then bounced higher). That nice W-shape is a technical analyst's dream and confirmed the floor of the market sell-off. The market was then free to move to new all-time highs. However, this month's sudden sell-off broke below the upward trend channel you see on the right. The 2862 level currently represents the lower range of that upward channel and if the market wants to get back into a bullish mode it needs to head back above it.
But as you can see this will be tricky. I've highlighted just one line of resistance (2786) but there are many more on the way up including 2800.
The market appears to be currently floating in no-mans land but the chart below gives this context. The faint green line is the straight line of support that the market has been bouncing along since 2016. The dark green line is the S&P 500's 200-day moving average. Some people pay attention to the moving average others don't. But as a rule of thumb if the market is above the 200-day moving average line it is bullish for the index. If the index is below the 200-day moving average it is bearish. What is important is that both of these lines now meet, as they did in February this year. The market tested these lines in February but remained above them which helped the market to ultimately recover and the bull run to push on to new all-time highs.
As you can see we are now at a critical juncture once again. On the downside, if the market breaks decisively below its current 200 day moving average (2768) it could herald the end of the bull run we've enjoyed since 2016. If the index breaks lower than 2700 (a key level of support on the S&P 500) then it would bring February's low point into play (see chart above) which is 2580 and then 2500 below that. If the market were to head below 2500 then the gains made since the November 2016 US election would be in jeopardy and we'd be looking at the real prospect of an unfolding bear market.
On a positive note if the S&P 500 can continue to hold above the 2016 uptrend and the 200-day moving average (2768 currently) then it is possible that the bull market can resume. We would need to see the market push through 2800 (which would be a positive sign) and then up towards 2862 before heading on to 2900. The coming weeks will be pivotal in deciding where the market ultimately heads.
UK stock market
At the time of writing my last technical analysis piece, the FTSE 100 had just set a new all-time high and was in the beginnings of a pullback after an extraordinary rally. As you can see from the chart below the market fell and bounced off the key 7500 support level. As I've highlighted previously 7,500 is a significant support level and when the market has broken below 7,500 it has tended to be a negative sign with the market quickly heading towards 7,250. This is exactly what we saw play out again. These support lives have all turned into resistance lines for a subsequent rebound. The same is true of the key levels of 7200 and 7100 (this latter line is shown in the second chart below). The market is now sitting at 7049, above the psychologically important 7000 support line.
Looking at the longer term chart below, the FTSE 100 is currently in a downtrend shown by the sloping green line and we would need the market to get back above 7250 to see that trend reverse. If it does then 7500 becomes important if the FTSE 1000 is to avoid range trading between 7250 and 7500 as it did for a lot of 2017. The February low of 6888 is important because if the market were to fall below this then there is not a lot of support on the way to 6400 which we last saw before the Brexit referendum.
Japanese stock market
Japanese equities took off during September, exploding upwards as the yen weakened. However, as you can see from the chart below that while the Nikkei 225 broke below the first (and steeper) uptrend that stems from the summer of 2016 it has settled into a new one. Over the medium term it would suggest that the Japanese stock market is still in an uptrend. However, the Nikkei 225 is currently at a crossroad itself sitting at 22532 and testing the uptrend line of support. On the upside look for the Nikkei to head over 23000 if we are to go back in search of the highs of 24270 but there will be resistance if we get there, as shown by the red line in the chart below. On the downside 22220 is the bottom of the current uptrend channel. Obviously much depends on the outlook for the yen as a weak yen helps Japanese stocks. But much like the S&P 500 the market is testing the floor of the current uptrend.
Pound vs Dollar
For UK investors the strength of the pound has a big influence on their returns. Back in June when I looked at this pairing the green uptrend line (shown below) had just been broken and the pound began to fall against the dollar. As you can see the pound continued its downtrend until it hit support at $1.27 at which point it began to strengthen. Right now the pound has taken a breather and sits at $1.306, bouncing along the strong $1.30 support line. The outlook for the pound has much to do with the outcome of ongoing Brexit negotiations. A positive outcome could send the pound higher and on its way to $1.37 which is fair value for the currency. Conversely, bad news could see the $1.30 level breached and a retest of the recent lows.
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