INTERVIEWER: Chart analysis is often regarded as something of a self-fulfilling prophecy, and there may be some truth in this, as many eyes can be fixed on the same formation, waiting for the breakout or the break down before putting on the same trade all at the same time. If you look at Twitter, it's full of this. And it's these types of human behavior that show up in the price time and time again.
Markets are said to be ruled by fear and greed, human emotions. And we're all susceptible to things like fear of missing out, loss aversion, optimism bias, and trying to call the tops and the bottoms in price. And these are all forms of behavioral bias, which affect our decision making through flawed patterns of responses to judgment and decision problems. Psychologist Daniel Kahneman has written extensively about the subject and how it relates to investor behavior in financial markets, and I strongly recommend watching his interview on the platform, which is linked in the additional resources in module one. And this shows up in charts all the time.
We've seen countless examples where people have tried to sell the top or buy the bottom, only to be too early or wrong on their view. So now, let's turn our attention to examples where investors try to catch a falling knife, as the expression goes. And there is this tendency to buy following a big sell-off, and this is due in part to the anchoring effect, which makes the lower price seem cheap in comparison to where it was trading before, regardless of the fundamentals, which will likely have been discounted in the new price.
Home exercise equipment manufacturer Peloton had been a very popular momentum trade during the pandemic era. It reached a peak of $170 in January 2021. But a number of factors led to the stock being rerated, and the share price halved within a matter of months. Having attempted a retracement, prices had soon faded back towards that previous low, around $80 ahead of earnings. And clearly, some investors saw this as an opportunity to buy. In the days leading up to the results, the stock had got back to $100. But another disappointing set of numbers saw the stock gap below the previous support at $80 and now make a new low.
The stock was now heavily oversold, according to the relative strength index, which is well below 30, but it would have been a mistake to consider buying here, at least in hindsight. The stock lost nearly 2/3, never mind the pain that would have been felt by those earlier investors. But remember, some of the biggest sell-offs occur from oversold conditions. People think something is cheap compared to the high, but it keeps falling. And in the case of Peloton, we saw a major capitulation following those earnings.
Now, we're also going to introduce another simple term to proceedings, and that's volume. Capitulation usually occurs on heavy volume. Looking at the chart of Bitcoin, can see how price continued to fall, even whilst the RSI, the relative strength indicator, was oversold until a cathartic move lower on very heavy volume. This was ultimately the point at which the buyers had capitulated. Then lo and behold, the selling was over, and the market rallied.
So by combining price and volume in our analysis, charts can show us where inflection points might be or where a downtrend has reached its exhaustion point. A pick-up in volume can also help confirm that a breakout in price is being driven by renewed momentum. So we can, of course, use all of this to our advantage.
With charts, the combination of price and volume is really trying to help us gauge the market sentiment. There are a number of tools which specifically try to identify that market sentiment. There are price-based indicators, such as the aforementioned relative strength index, and also Bollinger Bands that can help to identify when things may be at a short-term extreme, indicative of effectively a consensus view. Whilst the consensus isn't always wrong, it sometimes does pay to be contrarian.
In this example of gold, you can see the RSI study in the lower panel. It moves on a scale between zero and 100. It has two horizontal lines drawn at 30 and 70. And as I referred to earlier, 30 is seen as the threshold for oversold, where the market may be about to stage a bounce, and 70 is considered overbought, where a correction might be imminent. You can also look for so-called divergence, where the RSI registers a higher low, as price makes a lower low, which is considered bullish, or the opposite, where the RSI posts a lower high as price makes a higher high. And other price-based oscillators do essentially the same thing in attempting to identify potential mean-reversion opportunities when sentiment has driven price to an extreme.
But a word of warning, these tend to work better within range-bound conditions, as trending markets can remain overbought or oversold for an extended period of time. And we also have to accept that on occasions, we will buy and sell the range based on these indicators, just as the market breaks out of the range and creates a loss for us. And that is why we also have risk management, which we'll come onto in a later module.
A slightly different price-based sentiment indicator is market breadth. In this example, we're looking at the percentage of stocks, in this case, on the S&P, which are trading above their 200-day moving average, in other words, are higher than they were the best part of one year ago. Unlike the RSI, you ideally want to see this number remain as high as possible. If the number is low, then fewer companies are supporting the performance of the index. And such narrow leadership is what led to some of the problems during the dot-com bubble. And more recently, the same criticism has been aimed at the dominance of FANG names in driving particularly the NASDAQ market higher.
So whilst a reading below 50% would suggest that breadth is pretty poor and generally considered bearish for the market, if things get to such an extreme, such as a level of 20 or even possibly 10, then it actually becomes a contrarian indicator. In other words, consensus sentiment must be extremely negative. And therefore, it might actually be bullish as an indicator because things literally can't get any worse.
And let's talk a little bit about this point. Markets operate on a rate-of-change basis. And once something is at a negative extreme of the pendulum, there is only one direction from there. If something goes from super negative to just somewhat negative, that is actually a positive rate of change. And PMI indices, like the ISM, which we discussed in the last module, are a great example of that.
During a recession, the PMI can reach strong contractionary territory, something like the mid-30s, and it might take the index many months to move back into expansionary territory, which is normally above 50. But the rate of change will be strongly positive on the way there, meaning that the pace of the slowdown of the economy is actually slowing itself as the economy's internals are beginning to improve.
And there's also a few other sentiment surveys that aren't necessarily based on price. Raoul often talks about the Citi Economic Surprise Index, the CESI, or C-E-S-I, which compares whether realized economic data is coming in above or below the estimates. If the number is below zero, then either the data is weakening or the consensus is overly optimistic. And vice versa, above zero, the data is beating estimates, but that's not to say that the data is stronger. It could just be that the analysts have become too pessimistic. Either way, the CESI provides a snapshot of how the macroeconomy is performing relative to sentiment and expectations and provides yet another angle to our charting.
And similarly, positioning can also give clues as to whether a position is crowded or not. A crowded position is one where it feels like everybody has it on in the same way. And one example of that was the dollar at the beginning of 2021. Now, back then, pretty much every FX strategist believed that the dollar would go down and the euro would go up, based on fundamentals. But when we looked at CFTC positioning on the futures market for the euro in the US, which is only tiny compared to the overall volumes of currency trading in the overall OTC market over the counter market, but we could see that the longs in the euro were at a record high. So people already had the long euro and short dollar trade on.
Now, that doesn't mean that the dollar couldn't go lower. But it did mean that if everybody was being bearish on the dollar and bullish on the euro, when the market was already suggesting that everybody was already bullish on the euro, then it meant you had to be maybe a little bit skeptical about that macro call. So that positioning would have helped us inform our view of where that bullish euro call was getting ahead of itself.
Now, ahead of the next module where we will be exploring how asset classes interact in more detail, I wanted to share a few examples of how charting can be used to visualize relationships between fundamental data and the related assets. Things like ratio charts and overlays also help build on concepts around market drivers that we discussed in an earlier module. Let's begin with a chart of gold versus real interest rates.
So as you can see, the two trends are almost identical. As real yields fall, and this is on an inverted scale, the price of gold has tended to rise and vice versa. Overlay charts can also help you understand when a number of assets which may feel unrelated are actually following almost the same trend.
So for instance, emerging market equities, the Australian dollar, and copper have all been following pretty much the same pattern over the last 10, 15, maybe 20 years. That might seem obvious in many ways because many emerging markets are exporters of commodities. Copper is a commodity. And the Aussie dollar is a commodity currency, and a lot of copper comes out of Australia. But what we can see here is that if you had these three in your portfolio, the correlation is fairly high. And therefore, we can mitigate risks when we spot trends of a number of different assets that almost have the same pattern.
A ratio chart gives us the relative performance between two variables. If the ratio is rising then the first asset is outperforming the second asset and it's the opposite that's true when the ratio is falling, we can then add a comparison to our chart to see how the ratio performs vis-a-vis the comparison. And a classic example of that is the dollar index versus the ratio of the S&P versus the emerging markets.
Now, historically, when the dollar is falling, emerging markets have outperformed the S&P. Dollar index down and the ratio is falling. When the dollar index is rising, that's normally been bad for emerging markets, relative to the S&P, and the S&P is outperforming, which is the rising line. And you can see over the last 20 years that this ratio has pretty much held on a long-term basis. If you zoom in onto some very short time frames, clearly, this will break down.
But as a general rule of thumb, we know that a strong dollar environment is generally bad for emerging markets. And if we therefore have a view on the dollar, up or down, we can position accordingly in our relative performance of emerging markets versus the S&P or generally developed markets. And it's also pretty much true to say that strength in the dollar is usually associated with weakness in things like commodities, and that actually also fits into that whole story of emerging market relative performance to the S&P and the dollar index.
And we'll just finish off this section with another favorite, which is the ratio of industrials to consumer staples sectors relative to the level of ISM. There is a clear rotation towards industrials as the ISM rises, as investors anticipate stronger economic growth. But as the ISM falls, and especially if it goes below that 50 threshold, investors will rush to more defensive sectors, like consumer staples. And there are other plays on this, including consumer discretionary to consumer staples or financials to utilities. In fact, they're all ultimately a play on growth expectations and yields, and charting these relationships can be really insightful.
So hopefully you quite literally get the picture here. Charts are a great visualization of what's happening in the market. They are a price history, but they're also a great starting point. Charts don't tell you where a price is going, but it can help identify potential inflection points or relationships with other assets. And they can be extremely useful if you have confidence in one view, for instance, the direction of yields or a currency, because it can help you determine the expected direction of a related asset. And perhaps most important of all, they can help instill discipline into your trading and investing regime by helping you to identify entry and exit points or price levels where you will place a stop loss, all of which we'll build on in the risk management module.
So why don't you try this for yourself? Open up a chart of a stock, an index, a cryptocurrency, or anything else, and play around with the chart. You can use any of the free charting software out there. Most of them are fairly standard. Zoom out, and see the evolution of the price. Establish the secular trend, and then go deeper to understand if there is any cyclicality in the price action and then even deeper to look for more recent price action.
Look for a historical chart pattern on your preferred time frame. Have a think about what the price is currently doing. Would you take a position? And if so, what would that be? And then overlay the chart with another asset to look for relationships. And if you want, you can post your analysis and see what the community thinks about it. So until next time, thanks very much.
ROGER HIRST:
This is the Real Vision workshop on charts.
Now, we could have followed on from the module of the market drivers that underpin the performance of the broad market with this section on what drives the performance of individual asset classes.
But we're already getting pretty chart-heavy, so we wanted to first look at the key role that charts play before we look at the drivers of individual assets.
Charts are an essential part of an investor's toolbox. And yet, there are many cynics out there who scoff at the use of charts to help spot trends, as well as timing entry and exit points.
But James, Jamie, and I think they're super useful.
When the three of us were discussing the subject of charting, we all agreed that charts are a great way to understand the history of a given market in a single snapshot. A chart can very quickly help you to identify the important regimes and inflection points that were behind the price.
You don't need to be an expert in any particular market to pull up a chart and get a feel for what's been going on.
And this becomes all the more useful when scanning markets to generate ideas using the chart as a starting point for fundamental research where you can ask yourself, why is that breaking out?
So in this workshop, we'll focus on the value of charts in everyone's investment process. And to do that, we will go through the basics of identifying a trend, as well as key support, and resistance levels.
Basics of Charts
The Role of Technical Analysis
Technical analysis is essential for identifying:
Despite skepticism from some investors, technical analysis provides tools for better market timing and decision-making.
Common Chart Patterns
Conclusion
Charts are an indispensable part of any investor’s toolkit, providing a visual snapshot of market trends and potential turning points. In this workshop, we’ll delve into some commonly used patterns and techniques to better understand market movements.