Can charts help you navigate markets?
By
Deputy Editor
Tim Bennett Jul 31, 2009
Print this article
Few things divide investor opinion more than charting – the use of past trends and patterns to decide when to trade shares. John Mauldin of Millenium Wave Securities is sceptical: "It means nothing until it means something, and we don't know what that something is for some time." But former star fund manager Anthony Bolton finds charts "very useful... especially for timing". He reckons that if "the technicals [charts] support the fundamentals [key ratios such as price/earnings]", investors should act. So, what do the charts say about stocks right now?
How charting works
Charting jargon – 'head and shoulders', 'Fibonacci sequences', 'flags and pennants' – can be daunting. But as Josephine Moulds notes in The Daily Telegraph, beginners can ignore most of this. "The simplest rules in charting tend to be the most reliable." Chartists believe the past is the best guide to a share's future behaviour. To them, share prices reflect everything known about a stock, so there is no point trying to find value in the form of mispriced firms. Instead, you should look for repeating patterns that suggest big buyers and sellers are about to take a share up, down or sideways, then follow the trend.
A chart usually plots closing prices against time. But a chart line built on 'spot' data has one big drawback – a one-off price spike or dip can hide the underlying trend. So a common substitute is the moving average. Say a share closes at these daily prices: £3, £3.50, £4.50, £3.40, £3.10. The five-day average 'mean' is £3.50 (add the values and divide by five). If on day six the closing price is £3.50, the new five-day average becomes £3.60. This reduces the impact of a spike (which in this case was to £4.50) and reveals a flat underlying trend. Armed with these basics, here are three chart signals that can help you make money.
1 Resistance levels
Chartists try to spot when a share or index is struggling to rise above a 'ceiling' price or is being propped up by a 'floor' price. In the absence of new information these 'resistance' and 'support' points tend to hold; so a chartist would sell as the market rises close to a resistance point and buy when it hits a floor.
As the chart above shows, while strong corporate earnings have helped push the FTSE 100 up by about a third since March, the index has struggled to break decisively through 4,600 to beat its high for the year that was set in January. Some say it's a matter of time – a majority of investors think the market is set to rise further, with bulls outnumbering bears by 8%, according to the Investment Management Association. But Model Investor's James Ferguson warns that a further uplift won't last – this sort of rise isn't unusual in a long-term bear market. There were nine rallies in Japan of at least 20% magnitude during the first decade of the bear market and a dozen in the US between 1929 and 1940.
2 The Golden, or Black, Cross
Another signal is when a short-term moving average, such as the 50-day, crosses a longer-term line, such as the 200-day. A cut through from below is bullish – the 'golden' cross – while from above it is the opposite, a 'black', or even 'death' cross. The S&P 500, the Nasdaq, and the FTSE 100 have all seen recent Golden Crosses. But what does it mean? Michael Stokes on Istockanalyst.com points out that since 1957 the pattern has signalled a subsequent bull run 75% of the time. Michael Kahn in Barron's adds that "there have been no failures since 1998". Time to pile in? Maybe not.
The Golden Cross backfired five out of six times between 1928 and 1941, which given the scale of the current economic slump is the most comparable historic period. Robin Griffiths at Cazenove also warns the FT that "if the slope of the 200-day moving average is itself rising, then it is unequivocally clear that it is a bull market". But as the chart shows, this isn't yet the case for the FTSE.
3 The Relative Strength Index (RSI)
This captures if a rally is running out of steam ('overbought') or a fall has gone too far ('oversold'). In its simplest form, it takes a fixed period and divides the total points gained on up days (say 150) by the total points lost and gained (say 400), and multiplies this by 100 (37.5%). A reading above 70% is unusual, indicating the market has risen fast and may now turn. The FTSE 100 and S&P 500 are hovering close to that level. On the other hand, a reading below 30% suggests it's time to buy – this was the case back in February, just before March's big bull run.
So if the FTSE 100 breaks above 4,600 sharply, the bull run could keep going – even to 5,100, Ferguson suggests. But with the rally based on thin summer volumes, and the threat of more bad news to come, the scene, he says, remains set for "an autumn sell-off".
Published in
How to invest
| More
articles
by
Tim Bennett
Related articles
-
By Jody Clarke, Nov 20, 2009
-
By Merryn Somerset Webb, Nov 17, 2009
FREE - MoneyWeek's daily investment email
Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.
