Getting Technical
MONDAY, DECEMBER 30, 2013
The 2014 Stock Market: What the Charts Say
By MICHAEL KAHN
The market's momentum should carry into early next year. But will the inevitable correction be shallow or deep?
The simple strategy of identifying the major trend and then holding on through the bumps paid off handsomely in 2013. With just one day of trading left, the broad market is sitting on a total return north of 30%. But all good things do eventually come to an end. By the look of the trend it is hard to think that end is immediately upon us. Later in 2014, however, may be a different story.
Indeed, even several technical issues – lagging small stocks and deteriorating market breadth, for instance – have been resolved. The Russell 2000 index of small company stocks may not be leading the market, but it is at least keeping up with it again. And the NYSE advance-decline indicator, which keeps tabs on the number of stocks going up and down each day, has moved to fresh 52-week highs.
For me, the big problem is sentiment. I've written here about very high levels of bullishness among investors and traders and very low levels of bearishness.
What constitutes too much bullishness and too little bearishness is up for debate, but at some point the giddiness will reach the critical level where theoretically everyone interested in buying stocks has already done so. Without fresh demand, it will be difficult for prices to advance any farther. Extremely bullish sentiment also leaves the market vulnerable to a shock that could cause people to try to sell into this vacuum of demand, leading to a steep and swift decline.
Last week, bearish sentiment according to the Investors Intelligence survey of financial advisors dipped to 14.1%. This is the lowest level in more than two decades in terms of the dearth of bears and in the ratio of bears to bulls. This does not mean the market is about to tank but it should keep us alert for the first true sign of trouble. The long-awaited market correction can easily catch everyone napping under such extremes of sentiment.
Let's move to the big picture to see where the market is now and what that might mean going forward.
The Dow Jones Industrial Average broke out from seven-month trading range in mid-November and based on the size of the range the implied upside target is roughly 16,750 (see Chart 1), up from around 16,490 Monday. This is simply the height of the range projected up from the breakout point.
![[image]](http://barrons.wsj.net/public/resources/images/ON-BD234_bGTCht_NS_20131230151609.jpg)
In early December, prices backed down to once again touch the top of the former trading range in what technicians call a "test" of the breakout. If demand for stocks swells, which it did, the breakout holds and prices move back up. The odds that the upside target will be achieved increase.
The target is also in line with the top of the rising trend channel that has defined the market since the major low in October 2011. A rising trend channel is just a trendline drawn through significant lows and a parallel line drawn through significant highs.
For the Standard & Poor's 500, pundits have seen many bearish patterns on long-term charts from triple tops to expanding triangles (see Chart 2). None seem valid given the size of the current bull market from the 2009 low because it has stretched those patterns beyond what seems reasonable. In other words, the current rally invalidated them and that is good news for long-term bulls.
![[image]](http://barrons.wsj.net/public/resources/images/ON-BD235_bGTCht_NS_20131230151625.jpg)
But it would also be premature to call the action in 2013 a breakout from a 20-year trading range. One of the events I have noticed over my career is that breakouts that occur after strong moves are prone to failure. These momentum-based breakouts, where trends are already in effect before resistance is broken to the upside, are often just temporary overshoots of that resistance.
What can cause such a self-propagating trend? Extreme bullish sentiment. Nobody wants to be left behind, and so investors buy at any price, even if indicators flash warnings. Sooner or later, however, the market will correct.
As the Dow did with its shorter-term pattern, the S&P 500 can suffer a sharp decline, perhaps down to 1,550, in round numbers, to test its breakout above its 2000 and 2007 highs. If that happens, we'll have to see if demand swells again and prices hold that level.
If so, it could be the great buying opportunity for which many savvy investors are waiting. It would also be the confirmation of the start of a secular bull market that can last for several years. The problem is that this scenario calls for a good deal of pain beforehand.
To sum up, the Dow has some unfinished upside business in the short-term and that is good for stocks in general as 2014 begins. However, in an environment of extreme bullish sentiment, the S&P's long-term breakout seems to be in need of rest, if not outright correction. If it successfully holds 1550, give or take a few dozen points, then stocks will be in good shape for a very long time.
Indeed, even several technical issues – lagging small stocks and deteriorating market breadth, for instance – have been resolved. The Russell 2000 index of small company stocks may not be leading the market, but it is at least keeping up with it again. And the NYSE advance-decline indicator, which keeps tabs on the number of stocks going up and down each day, has moved to fresh 52-week highs.
For me, the big problem is sentiment. I've written here about very high levels of bullishness among investors and traders and very low levels of bearishness.
What constitutes too much bullishness and too little bearishness is up for debate, but at some point the giddiness will reach the critical level where theoretically everyone interested in buying stocks has already done so. Without fresh demand, it will be difficult for prices to advance any farther. Extremely bullish sentiment also leaves the market vulnerable to a shock that could cause people to try to sell into this vacuum of demand, leading to a steep and swift decline.
Last week, bearish sentiment according to the Investors Intelligence survey of financial advisors dipped to 14.1%. This is the lowest level in more than two decades in terms of the dearth of bears and in the ratio of bears to bulls. This does not mean the market is about to tank but it should keep us alert for the first true sign of trouble. The long-awaited market correction can easily catch everyone napping under such extremes of sentiment.
Let's move to the big picture to see where the market is now and what that might mean going forward.
The Dow Jones Industrial Average broke out from seven-month trading range in mid-November and based on the size of the range the implied upside target is roughly 16,750 (see Chart 1), up from around 16,490 Monday. This is simply the height of the range projected up from the breakout point.
Chart 1
Dow Jones Industrial Average In early December, prices backed down to once again touch the top of the former trading range in what technicians call a "test" of the breakout. If demand for stocks swells, which it did, the breakout holds and prices move back up. The odds that the upside target will be achieved increase.
The target is also in line with the top of the rising trend channel that has defined the market since the major low in October 2011. A rising trend channel is just a trendline drawn through significant lows and a parallel line drawn through significant highs.
For the Standard & Poor's 500, pundits have seen many bearish patterns on long-term charts from triple tops to expanding triangles (see Chart 2). None seem valid given the size of the current bull market from the 2009 low because it has stretched those patterns beyond what seems reasonable. In other words, the current rally invalidated them and that is good news for long-term bulls.
Chart 2
Standard & Poor's 500 But it would also be premature to call the action in 2013 a breakout from a 20-year trading range. One of the events I have noticed over my career is that breakouts that occur after strong moves are prone to failure. These momentum-based breakouts, where trends are already in effect before resistance is broken to the upside, are often just temporary overshoots of that resistance.
What can cause such a self-propagating trend? Extreme bullish sentiment. Nobody wants to be left behind, and so investors buy at any price, even if indicators flash warnings. Sooner or later, however, the market will correct.
As the Dow did with its shorter-term pattern, the S&P 500 can suffer a sharp decline, perhaps down to 1,550, in round numbers, to test its breakout above its 2000 and 2007 highs. If that happens, we'll have to see if demand swells again and prices hold that level.
If so, it could be the great buying opportunity for which many savvy investors are waiting. It would also be the confirmation of the start of a secular bull market that can last for several years. The problem is that this scenario calls for a good deal of pain beforehand.
To sum up, the Dow has some unfinished upside business in the short-term and that is good for stocks in general as 2014 begins. However, in an environment of extreme bullish sentiment, the S&P's long-term breakout seems to be in need of rest, if not outright correction. If it successfully holds 1550, give or take a few dozen points, then stocks will be in good shape for a very long time.
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