Charting Stock Market Cycles

December 5, 2008

Just as charts can reflect the activity of a stock—its volatility and price movements—they are also useful tools for tracking the effects of economic instability on the stock market. The major indexes, the Dow, the S&P 500, and the NASDAQ, reflect activity in various market sectors and segments of our economy. When there is turmoil, it is evident in the daily index charts.

Just as charts can reflect the activity of a stock—its volatility and price movements—they are also useful tools for tracking the effects of economic instability on the stock market. The major indexes, the Dow, the S&P 500, and the NASDAQ, reflect activity in various market sectors and segments of our economy. When there is turmoil, it is evident in the daily index charts.

In the last year there have been both historic highs and record lows in trading in the market. Charts of the stock market indexes show where overall market performance was at the top levels, with the resistance zones marked where activity went no higher. Then, after disturbing economic news, it is easy to see where performance dropped, plunging through previous levels of support, reaching new lows. There have been days when panic selling has taken control of the market, contributing to historic volatility. This is reflected in the Chicago Board of Exchange Volatility Index, the VIX, which has hit record highs.

Charting or technical analysis is the study of the past performance of a stock, currency, commodity, or financial tool such as a market index. The chart shows where price or volume has been and gives an idea of where it will go. Certain patterns in stock charts tend to be repeated year after year and, although it may sound complicated, it’s pretty straightforward.

Support is the price level at which demand is strong enough to prevent the price from dropping further. As price declines towards the support level, usually demand surges and stops it from falling lower. This support trend line is the area of greatest volume or activity in the buying and selling of a stock. The opposite of support is resistance, which is a higher level where price advances are turned back, establishing a trend line that identifies the resistance level.

Recently, the market indexes have plunged through support levels, resulting in wide trading ranges. The number of stocks being sold daily reflects investors’ enthusiasm, or lack thereof, for both the market and the economy. When this happens, the large-scale selling of stocks causes a sharp decline in price. Investors are not thinking about their selling price, they are simply rushing to get out of the market. Jesse Livermore, early twentieth century stock market wizard once said of investors, “The market does not beat them. They beat themselves because though they have brains, they cannot sit tight.” This aptly describes many of today’s investors.

Examine a major index such as the S&P 500, which has recently fallen below its lowest point in 2002. The Dow Jones Industrial Average has seen its support level that was established by the market lows of 2004 and 2005 decisively penetrated. That level was near 10,000 points. The Dow Jones Industrial Average recent low is 47% below its high of 14,198 in October 2007. There have been two super low points since 1900: in 1932, there was a loss of 89% from the top; and in 1974, there was a loss of 45% from its top. In light of the perfect storm of adverse economic conditions, it remains to be seen if a stock bear market low has been reached. Usually an important low will need to be tested, which will determine if a true “stopping point” has been reached.

Just as a patient’s vital signs graph contains important information, charts record market activity and may hold indications of the future. Speaking of the current uncertainty and the sickening churn in the markets, psychiatry professor Henry Nasrallah of the University of Cincinnati, reassures, “Know that this too shall pass and good days will come back.”

Michael Doran is Managing Director of the long/short equity fund, Emerald Bay Partners LP.

Mr. Doran can be reached at (530) 677-1635 or sierracap@directcon.net.

CAN SLIM® and variations are marks of Investor’s Business Daily, Inc. and affiliates (‘IBD’). The CAN SLIM® Certified mark is licensed by IBD only to signify successful completion of IBD’s CAN SLIM® Training program. IBD does not license, review or approve of, and is not responsible or liable for any investment advice or other ser