It is time for a piece of chocolate cake
Early in the day on Feb. 11, 2016, the Dow plunged 350 points, on track to its lowest point in two years. The S&P 500 dropped almost 2%. This was the longest losing streak since last August. January saw the worst decline on record for the month with an 8% loss in the S&P in the first 15 days of January.
The 8% loss in early January reminded me of what my husband said after his recent bilateral knee replacement. He had been on some pretty strong pain killers, didn’t have much appetite and hadn’t had a drink of alcohol for about a month. He lost about 15 pounds – close to 8% of his original body weight. “If I keep losing weight,” he said, “at this rate I will shrivel away into nothing.”
Well, just like my husband, we know that the S&P is not going to continue to lose 8% every 15 days and shrivel away into nothing. What controls how low the S&P will go? Why did it lose 8% and not 50%? We will hear in the media such fundamental explanations regarding the Chinese economy, the price of oil and on and on. That explains a drop, but what explains how great the drop will be?
When we lose weight, our metabolism slows and our body starts to conserve calories. Similarly, there are forces at work that prevent a precipitous drop in the stock market. Technical analysis can help us understand the emotional controls that are important limiting mechanisms when it comes to stock market volatility. Behind the talk of interest rates, fed policy and unemployment data lies technical analysis that can gauge the emotions of the market. Perhaps this can be best explained by some of the terms used in technical analysis.
RESISTANCE – A chart point or range that caps an increase in the level of a stock price over a period of time. At a certain point a stock will have trouble going higher – usually because it has stopped at this level before – at a level where the stock has sold off before. Investors are concerned that the price will start going down, like it did previously, so they don’t want to buy and might be tempted to sell. Good earnings expectations or a great new product might allow the stock to “break through” this resistance. Or, if a stock stays at this resistance level for a while it is sometimes said that it is “digesting” this level. The longer it stays here the more likely that it will continue higher eventually, as a comfort level occurs indicating that if it can remain at this level this long there is a good likelihood that it can move higher. Or, the stock could go down for a while possibly to a previous support level. And, it could continue for a time moving back and forth between support and resistance – moving sideways.
SUPPORT – Once a stock has established itself above a resistance level, that resistance level can become support. Just as the stock had trouble getting up through the resistance it will have trouble going down through support. If a stock moves down to support for some reason (usually fundamental) people will feel a comfort level here at support where they can get a few more shares or get in on the stock because it is expected that whatever just brought it down to this level is temporary and, after all, there were some fairly compelling reasons for it to get through this level initially. Stocks tend to have momentum and continue to go in the same direction unless there is a strong force applied to change that direction. Most stocks tend to move in a particular direction for a period of time – either moving up, down or sideways. This is called a trend.
VIOLENT MOVES – A violent move is generally a counter-trend move. Looking at Apple stock you can easily see on a monthly chart that it had strong drops in 2008, 2012 and 2015. These drops occurred over a period of weeks or days. On a monthly chart the drop looks almost vertical. This is followed by a slow steady rise up and through the point where the downward move began. So the trend for Apple has been up even though it has been broken on occasion by a violent move down. These violent moves are counter to the overriding upward trend.
Trends can be broken. If an upward trending stock moves down, hits a support level and goes strongly down through it, this could indicate a reversal of a trend. It could continue down, it could start moving sideways between a support and resistance level or there could be some impetus that enables it to move back through the support (or resistance) level that was broken. Apple is an example; now at a resistance level that was formed in 2012, which it broke through in 2014, resting now at the support level of 94. If Apple breaks strongly down through 94 the next support level is around 75 or 80 with strongest support around 55. It will be interesting to see what happens here.
Why didn’t the market drop 50%? If we look at a chart of the S&P 500 we can see that on Friday, Jan. 15th the index closed at 1880 with an intra day low of 1860. These are the same levels that were reached in September of 2015 when there was a violent move down. This level, also reached in October of 2014 after a market decline was an area of resistance in early 2014. These previous support and resistance levels indicate strong support at this level. So from a technical standpoint this is where one might expect support to occur.
Our body hunkers down during times of stress to conserve energy. Similarly the emotional component of the market helps to control the volatility of the market. In the stock market as well as our body weight there is a very unlikely chance of a 50% loss and such a loss would be an indicator of much more serious problems. So perhaps it is time for the market to take a cue from my husband and relax for a while with a glass of scotch or a piece of chocolate cake – no need for a violent move up – just a little sideways consolidation would be fine right now.
Written By: Jane Evelyn