ChartWatchers

This is the sixth part of a series of articles about Technical Analysis from a new course we're developing. If you are new to charting, these articles will give you the "big picture" behind the charts on our site. if you are an "old hand", these articles will help ensure you haven't "strayed too far" from the basics. Enjoy! 

(Click here to see the beginning of this series.)

Chart Scaling

Charts are created with one of two different kinds of vertical price scales.  An arithmetic scale evenly spaces price along the right side of the chart.  Arithmetic chart spacing between $10 and $20 is half as tall as the spacing between $20 and $40.  A log scale evenly spaces price in percentage terms.  Chart spacing between $10 and $20 has the exact same chart spacing as between $20 and $40 since they represent the same percentage increase. 

  

The SharpCharts above illustrate the differences between the two scaling methods.  On the arithmetic scale, three different trend lines were required to keep pace with the price advance.  On the log scale, the trend line fits the price trend during the entire rally.  Log scaling should be the first scaling choice when using trend lines, especially over long time frames.
 
 

Volume

StockCharts.com provides several ways to plot volume data on a chart.  The following price and volume SharpChart of AAPL illustrates how volume is typically plotted.

Volume can be plotted in an ‘indicator panel’ above or below the ‘price plot area’ or in the price plot area as an ‘overlay’.

 

   
When the ‘Color Volume’ option is used, the volume bars are shown as black for up days and red for down days.  Color volume bars allow the chartist to quickly see where heavy or weak buying and selling activity is happening.

 

CandleVolume Charts

CandleVolume charts are similar to candlestick charts except that each candle's width is proportional to its corresponding volume value.  This charting style allows one to visualize the volume activity ‘in’ rather than ‘below’ price moves.  Depending on the style of analysis, volume bars could be omitted to simplify the chart.

The time axis for these charts is not uniformly spaced since the candlestick bar widths vary with volume values.  As a result, trendline analysis using CandleVolume charts should always be confirmed with a standard candlestick or OHLC chart.  The SharpChart above of AAPL shows how volume bars correlate to the candlestick widths.

That wraps up our look at how charts are constructed.  Next time, we're going to start to talk about how charts are analyzed - starting with Support and Resistance analysis.

One of the problems with doing an analysis of the "stock market" is choosing which market index to represent it. Like most analysts, I rely on the S&P 500 which is generally viewed as the market benchmark. As we've pointed out several times, however, some parts of the market have been rallying much stronger than others. One of those groups is technology which is heavily represented in the Nasdaq market. Generally speaking, relative strength by technology and the Nasdaq are good signs for the rest of market. And the fact that the Nasdaq Composite has already exceeded its January high is a definite sign of leadership. However, the Nasdaq is undergoing another test of its uptrend. Chart 5 shows the Nasdaq Composite Index testing its 200-day moving average near 1750. It's a good idea to keep an eye on that test. It's also a good idea to watch the rising 20-day average (green line). The Nasdaq needs to stay above that rising support line to keep its uptrend intact.

The PerfChart below shows the percentage change for the S&P 500 and the nine sector SPDRs. The S&P 500 acts as the benchmark for relative performance. Sectors with greater percentage gains are outperforming the S&P 500. Sectors smaller percentage gains are underperforming. Defining the leaders and the laggards can tell us a lot regarding the quality of the rally. Relative to the S&P 500, the Financials SPDR (XLF) is the leader of leaders since early March. Other leaders include the Consumer Discretionary SPDR (XLY), Industrials SPDR (XLI) and Materials SPDR (XLB). Surprisingly, the Technology SPDR (XLK) is simply performing in line with the S&P 500. Leadership from the consumer discretionary sector is probably the most important aspect of this rally. This is the most economically sensitive sector and leadership here bodes well for an economic rebound.
 

I have been referring to the slow, steady advance of the last few weeks as a "correction". To be more specific, it is a "running correction", which means that prices have moved higher as indicators have chopped sideways and lower. This is evident on the chart below which shows the CVI and STVO (two short-term volume indicators). The CVI has been oscillating above the zero line in an ever-narrowing range for almost two months. The STVO is almost become a flat line. This kind of indicator activity is very unusual, and the impression I get when I look at the charts is that it is not likely to last much longer.

Looking at the medium-term breadth and volume indicators below, I am concerned that the overbought conditions are so extreme and the indicators have just barely topped. This condition must be cleared, but it doesn't necessarily need to be cleared by a big price decline. Looking to the left side of the chart, you can see two instances where overbought conditions were cleared as the market moved higher. I believe we will see a similar resolution this time.

Bottom Line: We are in a long-term bear market, but we also have a medium-term buy signal, which means that bull market rules apply at the present time. Market action has been persistently positive since the March price low, and overbought conditions are most likely to clear in a non-destructive way.

Ok, I understand the logic - partially.  In order of S&P 500 calendar month performance since 1950, May ranks 8th out of 12 and June ranks 10th out of 12.  However, both have produced positive annualized returns and in this period of very low interest rates, does it really make sense to pull that portion of your investments devoted to equities?  What's not mentioned by most who follow this theory, though, is that there are VERY bullish periods that fall within both of these calendar months.  Simply avoiding the market during May and June makes little sense given that the first handful of days in May and the last handful of days in May have produced annualized returns of 37.72% since 1950.  Compare that to the average annual return on the S&P 500 since 1950 of 8.46%.  By sitting on the sidelines, your money has no chance of working for you during periods where annualized returns are more than four times the average.  Does that make any sense?  The middle of May does tend to have neutral to bearish implications, but only on the S&P 500 does our historical meter, The Bowley Trend, actually turn bearish.

The part I find most disturbing regarding this theory is the perception that all equity investments suffer after the beginning of May.  Do these folks realize that since 1971 the NASDAQ has produced annualized returns of 13.85% and that NASDAQ prices have moved higher 23 of the 38 years over this period?  Does pulling your equity investments really make sense given the NASDAQ's relative outperformance during May?  By the way, June's annualized return since 1971 on the NASDAQ is 10.67%.

Now for the really good part.  Let's talk about the small caps, the Russell 2000.  In terms of the Russell 2000 monthly performance, only December has been a better month than May over the past 22 years.  The annualized return during May on the Russell 2000 since 1987?  How about 24.40%?  Do you still feel like May is an atrocious month for equities?  While I'll admit that May isn't the best month overall for equities, not even close to it, the facts suggest you might do more harm to your portfolio by "going away" than by staying.  There's some food for thought.

As for the current state of the market, it continues to perform as I suspected it would.  You cannot stand in the way of a significant market trend.  The bias remains on the bullish side.  The VIX, after breaking down from a triangle pattern, moved back higher to retest the breakdown as prices consolidated, then has moved lower.  A declining VIX is somewhat synonomous with higher equity prices and that's what I continue to look for and trade based upon.

Happy trading!

Tom

The past several trading sessions have shown an increased propensity for traders to "allocate or rotate" funds into commodity and natural resource stocks. Those gains were no starker than during Friday's trading session, when the S&P Energy Sector (XLE) was higher by +3.23% versus the S&P 500's (SPY) +.54% gain. This circumstance however, hasn't been the norm in recent months, but perhaps it is the beginning of a larger rotation move out of those sectors that have done relative well off the S&P 500 March 9th low such as the S&P Technology Sector (XLK). Time will tell as they say, but the technicals behind the XLE/SPY ratio are setting up reasonably well for a larger XLE move higher against SPY.

The daily XLE/SPY chart is clearly in an uptrend, with the 600-day moving avearge being the fulcrum point of this rally. Once again this level is being tested and arguably given yesterday's sharp move in XLE vs. SPY...it has begun to show its technical merit. The question is whether there is sufficient buying pressure to push the ratio above its 200-day moving aveage that would "seal the deal" for perhaps another run at the highs near .70. In our opinion, there is sufficient cause to believe this will be the case given the 40-day stochastic is plumbing down to near-oversold levels, which in the past has been a bullish harbinger of rallies.

Given these circumstances, and given the XLE is now clearly breaking out above its 100-day moving average - we would think that if long positions were to be added at this juncture, then Energy names would be at the forefront of any list.

Good luck and good trading,
Richard