Using technical analysis to understand stock market cycle patterns

Then technical analysts started charting the price action of the indexes and did discover trends. Unfortunately, early technical analysts attempted to use charts as a means of “predicting” or “timing” the market in their quest for acceptance.

Neither of those broad theories has worked consistently over time. The retail and professional communities have now come to accept that the market is neither random nor predictable in the manner set forth in their respective theories. Theories, which are usually formulated by economists and mathematicians, require testing in the real market to prove or disprove them.

What is more important is to understand what is going on by using all of the available tools, data, and information. When the cycle patterns of the market are better understood, then ambiguity, confusion, fear, and even greed are contained and decisions can become logical instead.

The following chart of the S&P 500 Index, if analyzed properly, should help independent investors and retail traders understand what is going on in the current stock market cycle pattern—beyond the British Brexit vote scare, the collapse of the United Kingdom’s solidarity, and the anxiety in world markets right now. (Editor’s note: This instructional technical analysis by Ms. Stokes was prepared on July 7, 2016.)

This chart shows a trading-range market condition for the S&P 500, which is the most used index for mutual funds, pension funds, sovereign funds, and hedging funds. The trading-range pattern is easy to see with a line chart set on a monthly view scale.

Adding the detrended price oscillator (DPO) indicator to the analysis helps to clarify where the market is in its normal cycle. The DPO has hit the center line, while the S&P 500 values have held within a trading-range pattern. Trading ranges are actually a form of market correction for indexes. The DPO indicator expresses this market correction in a cyclical pattern.

See Related Article: Identifying the buying/selling patterns of large institutions and why it matters

The volume indicator is also important, and volume started to increase in 2015 on a month-over-month basis. Previously, it had been declining since 2009, going back to the period of the V-shaped bottom of that year. This “V” is rare and created an abnormal cycle deviation that took several years to pattern out. Increased volume signifies that more investors and traders are buying S&P 500 Index funds or individual components of this popular index.

For now, the Brexit vote has not altered the monthly trend, which is still sideways in a trading range. Seeing this event from the perspective of longer-term cycle trends provides a better understanding of what is actually occurring in the market. Many investors tend to rely on daily view charts, which contain too much “white noise” for proper long-term analysis.

The contrarian pattern between DPO and volume is, however, a positive divergence. This means that volume increasing as the DPO continues to decline is a confirmation that the trading range is nearing the end of its corrective cycle. Barring any unforeseen and unknown event, the trend after a trading range is usually a continuation—in this example an upward trend. As always, technical analysis is not a predictive tool, but a means of understanding what is going on in the market and its cycle patterns. More volume means more activity, which should equate into stronger stock price trends.

Disclosure: All statements are the opinions of TechniTrader, its instructors, or employees, and are not to be construed as anything more than opinions. Examples presented are for educational purposes only.