There were some classic signposts, but also some head-fakes, along the way. The question is how to read the new signals
So much for fundamental research. The Standard & Poor's (MHP) 500-stock index is down 46% from the all-time high of 1576 it hit back in October 2007. At every step of its seemingly endless decline, investors have been told one thing: Based on the fundamentals, stocks are cheap. Yet shares continue to fall.
There's another way to analyze the market that can offer insight into such turbulent conditions. Technical analysts look at trends in stock prices and trading volume to discern whether investors are likely to continue selling or may be ready to reverse course and spark a rally. On Nov. 20, when the S&P 500 plummeted through its 2002 trough to close at an 11-year low of 752, they didn't like what they saw. Says analyst Todd Salamone of Schaeffer's Investment Research: "We've entered a black hole."
Despite warnings from investment gurus such as Burton Malkiel, author of A Random Walk Down Wall Street, against reading too much into technical analysis, academic studies have shown that it's not just mumbo-jumbo. Massachusetts Institute of Technology Professor Andrew Lo and two colleagues reviewed 31 years of market data in a March 2000 paper and concluded that patterns cited by technical analysts were useful in providing signals of future market moves.
The foundation of technical analysis starts with a chart of a stock's or a stock market's price. Analysts typically look at a bar chart, which simply shows a stock price's trading range for each day, or a candlestick chart, which shows where a stock opened, closed, and registered its daily high and low. They use the charts to determine whether a stock will become stuck in a trading range or break out of it to move significantly higher or lower. "Understanding the trend is the most important thing for successful investing," says Bart DiLiddo, chairman of investor software company VectorVest.
That's why such analysts, also called chartists, were alarmed on Nov. 20, when the S&P 500 dropped 54 points, the equivalent of over 500 points on the Dow Jones industrial average. It wasn't the size of the move—the S&P has dropped over 50 points 17 times this year. It was what the drop meant in the context of the charts.
A bit more background on technical patterns explains why analysts viewed Nov. 20's move with such concern. Technicians look for a level of "support," or a "bottom"—a price that a falling stock does not trade below. They also identify a level of "resistance," or a "top"—a price that rising shares won't trade above. And they look for recurrences of these levels. For instance, when a stock trades at a new 52-week high and then dips, analysts watch to see whether there are signs of further demand from investors to push the price higher—powering through the resistance—or whether the sellers will rule. If the sellers win, the market is said to have formed a "double top," a bearish signal. The reverse— a "double bottom"—is considered bullish when it holds. But on Nov. 20, a double bottom based on five years of data blew to pieces.
Most chartists layer a range of indicators over their charts. Some look at moving averages—the average price of a stock over a set number of days, recalculated each day by dropping the oldest day's price and adding the closing price from the most recent day. Others key in on divergences, behavior that doesn't fit the overall picture. Low volume in an upmarket, for instance, could indicate that the buyers are losing steam. Some technicians also perform fundamental research: They analyze a company's or stock market's earnings, revenues, and other business-related measures, and then use the technical factors to decide when to buy or sell.
It's a technique that helped many avoid the carnage of the last 12 months. What did they see that others didn't? The end of the bull market last year was a classic example of a double top. On July 13, 2007, the market peaked for the first time at 1,553 and started to fall before reversing itself in August. For the next two months, the market went up. But FusionIQ's Kevin Lane noticed that even as the overall market rose, prices of a majority of individual stocks were falling, a sign the rally was tapering off. The S&P closed at 1,565 on Oct. 9, 2007, an all-time high—though just barely. On Oct. 19, the S&P fell more than 60 points and the bear market began, according to technical analysts.
Like all investors, fans of technical analysis are seeking the bottom. Many thought the market had found one on Oct. 9, 2008. By then the S&P had fallen 75 points, completing a 22% drop that began on Oct. 1. For the next month the index bounced in a range, never trading much above 1,000 or below 820. While stuck in that band, the index had huge single-day moves of 5% or more.
As the market gyrated, chartists searched for signs that it was poised to head up or down. S&P technical analyst Mark Arbeter saw that 88% of New York Stock Exchange (NYX) securities had reached new 52-week lows on Oct. 10—a sign, perhaps, that the market was oversold. But he spotted a red flag. Each time the market dropped back, it would reverse and bounce a bit higher, but the bounces became smaller—a sign that selling pressure was starting to outweigh buyer interest.
On Nov. 19, the S&P 500 broke through the bottom at 820, closing at 792. Then the dam broke. The next day, the S&P 500 smashed through its next level of support—the October 2002 low—like "a knife cutting through butter," says Schaeffer Investment Research's Salamone. The best-case scenario for investors now would be a quick bounce and a drop that holds at 820. But few investors are betting on it.
StockCharts.com has a wealth of educational features that it takes a step further, featuring interactive tools so do-it-yourself investors can add technical analysis to their portfolio management
Investopedia.com offers a technical analysis primer that explains the basics—support, resistance and trends—as well as more esoteric techniques such as moving averages and Bollinger Bands