I hope everyone finds the facts/insights presented in this article valuable.  If you find them interesting please send me a comment @ dan@betterbizbooks.com and forward the article onto as many friends as you want to.  If you want to receive further articles such as this click on the subscribe button on the right to sign up for my Free Monthly Newsletter.  If you want to learn more about technical analysis I suggest beginners read The Visual Investor by John Murphy.  For those interested in learning everything about technical analysis I highly suggest reading Technical Analysis of the Financial Markets by John Murphy.  There is a study guide that can be purchased for those seeking to test their technical analysis capabilities.

This report can be segmented into four different sections and can be downloaded by section if desired.  The entire report is enclosed in this report.  A full length .pdf file, with working links, can be saved by right clicking on the following link and using the "save as" function.

1. Why I wrote this article and what is technical analysis. (Below)

2. My technical analysis of the S&P500 as of 8/1/02.

3. Technical analysis, as of 8/1/02, using Fibonacci numbers, a technical indicator used by many analysts.

4. Technical Analysis, as of 8/1/02, using P&F charts. 

Why I wrote this article:

On June 6^th, 2002, in my Stock Market Returns article, I talked about how the economy was likely going to face years of minimal economic growth and poor investment returns in the near future.  At that time, when the S&P 500 was trading at approximately 1050, I also stated my disdain for Wall Street analysts that were forecasting a huge surge in the S&P 500 for the remainder of the year.  Some were giving target prices of 1300 (over a 20% return in a six month time horizon!), much to my horror.  Since I wrote about the stock market and its woes on June 6^th the stock market is down over 20%.  It has been nothing short of a market meltdown.

I am concerned about economic growth.  Forget GDP growth.  I want to see top line corporate results growth.  Economic data can be fudged every which way known to man.  Top line growth, across a broad spectrum of U.S. corporations, such as those included in the S&P 500, is much more difficult to fudge.  Don’t get me wrong, companies can inflate revenues (Enron & Medco are two recent examples) but a diverse gauge of public companies should provide some indication of true economic growth in the U.S.  As of today I have yet to see any meaningful top-line growth in corporate America.  Top line growth is essential to justify the EPS models that many analysts have forecast for the next 12 – 24 months.

In this particular article I want to spend some time looking at some stock charts using technical analysis, a method of looking at stocks based on market direction and sentiment. 

So what is technical analysis and why is it important?  

Technical analysis is the examination of past price movements to forecast future price movements. Technical analysts are sometimes referred to as chartists because they rely almost exclusively on charts for their analysis.  Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand. Price refers to any combination of the open, high, low or close for a given security over a specific timeframe. The time frame can be based on intraday (tick, 5-minute, 15-minute or hourly), daily, weekly or monthly price data and last a few hours or many years. In addition, some technical analysts include volume or open interest figures with their study of price action.

Technical analysts consider the market to be 80% psychological and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for debate, but there is no questioning the current price of a security. After all, it is available for all to see and nobody doubts its legitimacy. The price set by the market reflects the sum knowledge of all participants, and we are not dealing with lightweights here. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work. By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going?

Before I go further and take a look at some stock charts I want to say “Thank You” to www.RaptorGroupResearch.com for giving me permission to publish a few of their charts.  Check out the website if you are interested in learning more about technical analysis in action.  Raptor publishes their technical analysis of the major indexes, for free, every day at their website

The monthly chart clearly shows what many market technicians call a “head and shoulders pattern.”  The head is the surge in the middle and the shoulders are key points.  Once a stock market establishes such a pattern it typically falls in value.  In this particular graph the stochastic reading, below the stock chart, shows that the monthly trend remains solidly down.  While the stochastic reading indicates an oversold direction (a reading of less than 20) it clearly illustrates that market sentiment doesn’t appear to be shifting upwards at this time.  I would also point out that the stock market clearly broke below September 21^st, 2001 lows.  As a result, the market is looking for an area of “support,” which is an area where buyers previously outnumbered sellers and drove the market higher.  The logic says that this area of “support” is where some buyers shall re-emerge and the market should stabilize in this area. 

Based on the chart below the major support appears to be around 750.  Additionally, it appears as though there is minor support around 850.  The major and minor labels are based on the amount of time in which the stocks traded around those levels.  More time in a price range = more support.  Please note that the 200 month average, regarded as major support to technical analysts, is 655. To get any additional insight into market sentiment we must look at more detailed charts.

Source: www.RaptorGroupResearch.com

The weekly chart below shows the recent trend in more detail.  In particular, take a look at the prior September lows seen around September 21^st, 2001.  There is an old adage amongst technical analysts.  Stocks hitting new highs go higher and stocks that bust previous lows keep going lower (higher highs and lower lows.)  The basic thought behind such logic is that the highs or lows represent investor psychology and sentiment.  Sentiment doesn’t change from negative to positive or positive to negative quickly.  It may shift temporarily but oftentimes the dominant trend reappears.  In this particular case the market broke the prior low, on a closing basis of 965 (established September 21, 2002.).  This is a bearish scenario that is saying “the future isn’t bright.”  The weekly chart shows a very ominous “head and shoulders” pattern that has developed with support at the neckline near 923. Additionally, we have recently busted through lows established in October of 1998 during the Long-term Capital and Asian Financial Crisis.  This is very scary to me.

Source: www.RaptorGroupResearch.com

The daily chart below provides the viewer with a more graphically detailed look at recent investor psychology.  It is quite apparent that the market began crashing in early June.  Since that time the market dropped over 20%, breaking through the previous lows established last September.  In the recent drop some minor support emerged around 940 and 876.  This basically indicates that supply and demand for stock balanced out in this area either due to fewer sellers or more buyers emerging. 

Technical analysts like to say that previous areas of support become areas of resistance in a market downtrend. As a result, we look to these areas as potential problem areas for the market if it tries to go higher.  As of today, August 1, 2002 , the market is trading at approximately 910 so the area of 940 (major resistance) is lurking right above.  This should minimize upside stock movements in the next few weeks.  

Another technical element to notice is that the market was selling off with strong volume.  The opposite can be said of the recent increase from 775 to 910.  This is regarded, from a technical analysis perspective, as a negative and is called a "divergence" between market direction and volume.

ource: www.RaptorGroupResearch.com

The below chart shows even more detail.  From the chart we note several key things:

• This chart is very short-term oriented and provides us with information on recent market sentiment and where buyers and sellers agreed on a certain price level. 
• The triangle break in blue has resulted in a decline of 100 points and is now being followed by what is likely a running correction on the low.
• The S&P 500 closed at 797 on July 23, 2002 and actually hit 776 intraday on the 24^th.  The most important price, according to market technicians, is the closing price because it reflects buying and selling throughout the entire day and more data points are available.  Therefore the 797 area is a key area to hold, on a closing basis, in the future.  Once again, longer-term trends have more relevance than shorter ones.  So, a daily chart has more relevance than an hourly chart.
• As of today the S&P 500 has risen to approximately 910, as shown in the 2nd chart below, indicating that we were able to move above minor resistance areas of 812, 841 and 878.  As a result, it is likely that the previous low of 940 would likely be “back tested.”  It is unlikely that the market would move above 940 using technical analysis.  If the market were to move above 940 I would then look at the 50 day moving average, currently at 979, as a VERY STRONG area of resistance.  The moving average can be seen on the previous graph.

Source: www.RaptorGroupResearch.com

The final stock chart we are going to take a look at is an intraday chart using June 26, 2002 data.  As we can see the S&P 500 Index ran into strong resistance once it moved up to the 855 area.  However, we can see that the stochastic indicator popped up towards the close of the market on Friday.  This is interesting because it indicates that the market is likely to test higher price levels in future days due to a healthier market sentiment.  Therefore, I look at the 876 and 898 price levels for areas of strong resistance on the way up.  We can also notice that the 914-918 price area is where the market has peaked in prior days since the graph only shows 10 days worth of price information.

 Source: www.RaptorGroupResearch.com  

In this particular section I want to spend some time looking at Fibonacci analysis, a tool that some technical  analysts swear by.  Fibonacci numbers are commonly used in conjunction with other techniques to trade and I have used this methodology in the past with much success and a few failures (when I first didn't know enough about the tool.)  Allow me to first explain what Fibonacci theory is before illustrating the theory in some charts of the S&P 500.

Leonardo Fibonacci, a mathematician in the 1200’s created a numerical sequence of numbers.
From left to right after the first two numbers, the values increase successively. Each number, in turn, is determined by the sum of the previous two numbers.

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377,.......to get the next value of Fibonacci series after 377 add 233 to 377 and arrive at 610.

The other interesting relationship of this number sequence is that if we take the ratio of two successive numbers in the Fibonacci series (that is, we divide each number by the number after it in the sequence) we will move towards a particular constant value. That value is 0.6180345 which has been referred to as “the golden ratio”. If you also calculate the ratios using alternate numbers in the Fibonacci series (that is, do the same calculation but skip over a number) the resulting ratios approach e 0.38196

Many technicians use Fibonacci numbers in their Technical Analysis when trying to determine support and resistance, and commonly use 38.2%, 50%, 61.8% retracements. Commonly thought, a .382 retracement from a trend move will tend to imply a continuation of the trend.  A .618 retracement implies that a trend change may be in the making.  Many such rules have been adopted by technicians.

The first thing we have to understand is that Fibonacci basically is about human behavior.  The basic thought is that humans can only endure so much pain or pleasure before some people rebel and do the opposite.  It is quite similar to Elliot Wave Theory, another technical analysis tool.  At the end of the day technical analysts believe that the dominant trend will normally dominate.  

Technical analysts that utilize Fibonacci theory look at the top and bottom of a recent market move (on a closing basis) to determine what level the market will move back to, based on the previously mentioned ratios of .382, .5 and .618.  

So lets look at an example:

Notice how the chart below shows lows and highs based on market moves?  In May the market moved by 60 points to the upside.  In June the same 60 point swing from bottom to top was experienced also.  Then, in July it was repeated again.  In this example, if we have correctly picked the appropriate market top, the retracement levels would be shown below.  

Why did I pick 993 rather than 926 as the market top?  

The reason for this is due to market movements.  The 926 level had a prior low of 876 but it was a one day blip on the radar and appears to be more of a speed bump on the way down.  Additionally, the market only traded their for a few minutes whereas the 934 price area was tested for 2-3 days, signalling that there were buyers and sellers that agreed it was an appropriate level.  

Remember what I said in section two.  Longer-term trends matter more than shorter-term trends.

So what is the conclusion from the chart above? 

If I picked the appropriate top I don't anticipate the market moving above (and then closing above) the 918 price level during this rally.  

Given that we lots of "overhead supply" - people that want to sell to break-even, weak corporate EPS growth, weak economic growth and high levels of indebtedness amongst consumers, corporations and the government I believe it is highly likely that the market will roll over and retest prior lows.  

The below chart is what is called a P&F chart (point and figure chart.)

P&F charts typically display what is regarded as the most significant price movements in a recent market move.  The charts tend to accurately identify support levels and market trend lines enabling traders and investors to find out where to buy and sell securities.  If the market breaks a trend line it might suggest a reversal in market sentiment and could be a key area to make serious $$$.  

In the P&F chart below, an analysis of the S&P 500, it appears as though the market will have a difficult time breaking above 960.  One key element of the charts is time.  As the weeks pass by the red lines will continue to slant down and to the right, reaching lower levels.  Eventually the trend line will be broken but the trends shown below have been occurring since early 2000.  I am guessing that some kind of trend line will be broken when the S&P 500 gets to around 750 - 800 some time in the Fall of 2002.

                        Source: Stockcharts.com

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