January 24th, 2009

Trendlines and chart patterns don’t predict anything

If the market is in a bottom process, as I think it is, this is a most treacherous time for stock picking. Here’s a radical statement: “Trendlines and chart patterns don’t predict anything.” They surely don’t predict what a stock will do (either cross or reflect off a trendline). They are only tools to alert you of the prices, based on past experience, at which there is an opportunity to take some specific action (buy or sell) with the likelihood of a positive return with associated low risk based on the core belief that stocks or indexes tend to trend. Once begun in a direction they will continue to move in that direction for some unspecified time, a belief rationalized by the principles of basic supply and demand.

A price crossing above a trendline price represents a fairly reliable signal that the price will continue to move up for some time; a cross below a trendline offers a high probability that the price will continue to fall for some time. Prices reflecting off a resistance trendline will continue to drop for a while; prices reflecting off a support trendline will continue to move up for a while.

It’s easy to understand our fear of approaching trendlines as the herd (it’s the herd that’s important since we individual investors contribute less than 25% to total volume trading) transitions from bear to bull, from distribution to accumulation, forming bottom or top reversal patterns through their trading action. Will the coming signal be to sell and capture trading profits or jump aboard in anticipation of a breakout?

Benjamin F. King’s rule echos back: “50% of a stock’s price movement can be attributed to the overall movement in the market, 30% to the movement in its sector and only 20% on its own.” In other words, pivot points and trendlines on stock charts are usually nothing more than a shadow of similar trendlines in industry group and stock market charts. The factors causing pivot points at the market or industry level also create pivot points on a stock’s chart. While trendlines in individual stocks, industry groups and the market may coincide, the specific chart patterns they form may be different.

That’s why I spend so much time trying to figure out the market’s (the S&P 500) direction. If you don’t get the market right, there’s a high probability you’re not going to get the individual stock correct. There’s a low probability that, based on its chart, a stock will move contrary to the market or industry chart. If the market crosses above (or below) a key trendline, there’s a good chance a stock will also sooner or later break above (or little risk of crossing below) a key trendline.

Individual stocks may be more volatile or less. They may have crossed one or more of their moving averages or not. They may be forming distinctive and clearly discernible patterns or their price movement may still appear erratic. But what’s most important is that most stocks track the market. Click on the symbols below to see the uncanny similarity, on a relative basis, of just a few of stocks and the S&P 500 (shown as a blue line):

I could go on an on but you get the picture. There are those who point to specific stocks with specific patterns such as a “rising wedge” or stocks approaching 50-day or 200-day moving averages or stocks hitting resistance levels as justification for selling short, buying puts or taking some other action in anticipation of price declines.

I’m here to say that, at the moment, all this talk of individual stock patterns is meaningless. With the market having dropped as far as it has, pretty much everything will move in tandem (slower or faster, lesser or greater, but together). It’s not chart patterns that predict what an individual stock will do, it’s the market. If the market is in a bottoming process, as I think it is, this is the best – and most dangerous – time for individual stock picking.

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