December 6th, 2012

More Reliable: Horizontal vs. Sloped Trendlines?

Over the past several years, charts have become more pervasive than ever in discussions, commentaries and prognostications about individual stocks and the market in general.  Even Cramer, who once considered technicians to be on the same level as astrologers or readers of tea leaves, no regularly refers to the analysis of one chartist or another.

One of my pet peeves, however, is that bloggers and media talking heads will insert trendlines in their discussions almost willy-nilly as they pontificate about the support or resistance they hope the line they drew will presumably offered them. Because the use of trendlines is so prevalent, it’s assumed that everyone understands their meaning and relevance; we rarely hear about the arbitrariness and subjectivity that goes into their selection.

Last week, I offered three examples of head-and-shoulders patterns (GLD, AAPL and FDX), each demarcated by a horizontal trendline, or the pattern’s “neckline”.  [As an interesting aside, I may have been one of the first to publish an alert about the possibility of AAPL forming a head-and-shoulder top which could result in a correction down to approximately 400 in my November 8 post, “AAPL Gets a Cold, the Market Gets …..?”  Now many are commenting about it and Cramer even had a segment tonight dismissing the stocks technical risks.] What makes the head-and-shoulder such a “reliable” (if you allow me to use that term in the context of something so subjective as the reading of stock charts) pattern is that the supporting trendline is horizontal.  I’ve seen sloping necklines but these never turn out to be as recognizable nor as accurate.

As I describe in my book, Run with the Herd,

What makes trendlines so confusing is that many trendlines that seemed so precise at first may lose their potency as new trading is tacked on.  As a matter of fact, as more transaction data over longer and longer periods of time with multiple trading days condensed into individual bars, you’ll usually find yourself drawing a plethora of trendlines.  Some trendlines are short and some long, some connect pivot points that once seemed compelling and inviolate become less significant and even irrelevant when viewed in a longer-term.  The support or resistance expectations implicit in short trendlines at one may become overwhelmed and irrelevant as more recent buying and selling emerges.

Trendlines are nothing more than an arbitrary, imaginary lines that visually connect two or more pivot points. Pivot points are those spaces in time and price where control is transfers between buyers and sellers, when one trend in one direction reverses and begins moving in the opposite direction. In reality, this transfer doesn’t occur in one transaction at one price but instead occur over a period of time, a large number of trades at a range of prices.  There’s no precise way of locating when that transfer is complete and the struggle continue even when a reversal appears to be complete.

Why is it important to locate these pivots? Because we believe that after having occurred several times at approximately the same point, the failure to occur at that same level sometime in the future means that the winner of the last battle has lost control of the trend and it now resides in the other side who will control the trend until the next struggle begins.  That transfer of control is the breakout.

Repetitive struggles at the same price make intuitive sense.  An institutional investor looking to sell its large holding in a stock will continue to do so as long as a stock’s price is above a certain level; when it drops to or below the level they hold their shares back from the market; they will continue to accumulate shares up to a certain price but not above that price.  But what can we say the same thing about pivot points at different levels?  Bottom line, they tell us little about what we can expect about where the next pivot might be and we can say little about whether that recent pivot is the beginning of a reversal or the continuation of a trend.

The above chart for LKQ presents a pretty channel but it offers little information about the risks of the trend failing, how much profit potential remains in the channel trend or when it might collapse.  It is easy to draw the channel trendlines after the fact but drawing those lines in 2010 would have produced the dotted trendlines.  Which more accurately defines the trend, the solid or dotted lines.  Is the stock currently within the trend boundary or is it outside the bounds and bound to correct.  The most common mistake when inserting trendlines is thinking that the recent pivot is critical in establishing a meaningful trendline.  In other words, trendlines are usually discovered within the time frames of the chart, rarely coming in from prior the chart’s beginning.  That’s why I always simultaneously look at a charts in three time horizons.

That error doesn’t occur when you look for breakouts across horizontal trendlines like this one for NEOG.  Is there any doubt that a cross above 48.00 indicates that the bears have lost control to the bulls who have launched a new push to higher stock prices?

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May 24th, 2012

Moving Averages: Trend Inidicator or Resistance/Support Level

There are almost many discussions in technical analysis circles as to whether moving averages are predictive and form resistance and support levels or whether they instead exclusively depict historical information (like, the average price of a stock over the past 200 trading days) and indicate trends (like, the average price over the prior 200 days continues to improve).  I’m not going to take either side other than to say you can’t use one to the exclusion of the other.  What I can say is that the 200- and 300-dma’s have performed extremely well as support over the past week (click on image to enlarge):

It could purely be happenstance or it could be that the close proximity of the two moving averages intensifies their support support capabilities or it might just be that a few more trading days will see the Index cross both moving averages indicating a dramatic deterioration in the market’s health and future prospects but for the time being it does break some temporary comfort and relief to those of us who are of the “technical persuasion”.

Where to from here?  Your guess is as good as mine.  But what I do say is that I’m relieved that I have a discipline that insulates me from all the speculation we’re bombarded with daily in the business media by neutralizing the day-to-day volatility and helps me focus on the longer term picture.  My Market Momentum Meter distills the market’s trend over a number of time horizons and translates the analysis into a single number which, when compared to experience over nearly 50 years of market data, indicates what market tactic (all cash or fully invested) which will like generate the best likely outcome.

My Market Momentum Meter is at the borderline and may soon suggest a more conservative, risk-off approach but for the time being it still indicates that the market’s longer-term trend continues to be “provisionally, moderately bullish”.

 

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January 25th, 2012

“The Great Convergence”

In last week’s Recap Report recently sent to subscribers, I wrote and included the following chart:

“….. at the risk of being labelled melodramatic …. I see “The Great Convergence” coming to a head and finally getting resolved with the 18-month struggle between bulls and bears with (I hope it’s not just wishful thinking but an actuality) the bulls finally gaining the upper hand and finally being able to break into new higher ground.”

After today’s close and after closing higher for 20 of the last 23 trading days, the market is now up 10.01% since December 19.  Even more important is to note that today’s close was at 1326.06, almost exactly the level many chartists have touted as the breakout point that confirms an exit from this summer’s bear market and the continuation of last year’s bull market run off the lows.

It should also be noted that it’s almost exactly where the descending trendline connecting the 2007 and 2011 peaks is today.  However, rather than thinking in terms of points (e.g., 1325 or 1326) we need to think of a zone.  Every single trader doesn’t simultaneously decide to buy or sell which in turn causes a reversal at a single point.  Furthermore, the Index is composed of 500 different stocks in every economic sector and each of these stocks will have their own underlying market dynamics.  Market psychology does change when the market hits various levels but a change of psychology happens over time.

What the above chart indicates is a change in market psychology that’s been on-going since the bottom of the Financial Crisis Crash (see “Revisiting Housing and Banking With a New Ending” of a few days ago).  The ascending trendline since the bottom (higher lows) and the descending trendline from the pre-crash peak (lower highs) results in this “Great Convergence”.  The best momentum indicator (in my book) of moving averages across multiple time horizons are turning constructive adding to the conviction that a clear-cut signal to put, as they say in Wall Street, “risk back on”.

I believe there needs to be a 4-6% consolidation of this 10%, 23-day run and we’re going to look at it as a buying opportunity.  But if the market continues to zoom ahead another 2-3% without that correction, then it’s “damn the torpedoes, full speed ahead.”

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