Combining Seasonal Investing With Technical Analysis

 

Why use technical analysis in conjunction with seasonal investing? Seasonality analysis is a useful tool when looking at a general time to enter and exit equity markets and sectors. However, seasonality analysis is not precise. It only gives an approximate time when trades can be made. Equity markets and sectors rarely reach important lows and highs on the dates identified by seasonality studies. The solution is to use technical analysis to optimize seasonal entry and exit points. Normally, technical analysis will provide optimal entry and exit points within one month (plus or minus) of an identified period of seasonal strength. Net result: investment performance usually is enhanced significantly.

 

Using Short Term Momentum Indicators To Optimize Seasonal Entry and Exit Points

 

Several well known momentum indicators are preferred for optimizing seasonal entry and exit points. They can be used separately or jointly. Choice of indicators is determined by experience and comfort of the investor. Short term momentum indicators based on daily data are preferred when seeking entry and exit points for seasonal strategies. Indicators using weekly data are useful as a supplement to indictors using daily data, but, by definition tend to be less precise for entry and exit.

 

Three momentum indicators are preferred:

  • Moving Average Convergence Divergence (MACD)
  • Relative Strength Index (RSI)
  • Stochastics

All use moving averages in one form or another when calculated. By definition, all will provide entry and exit signals shortly after a short term low or high has been reached.

 

MACD is the best known and most widely used momentum indicator. Entry and exit points are determined by a cross over of two moving averages. A buy signal is given when the indicator is oversold (i.e. below -1.0) and a positive cross over occurs. Please refer to the enclosed chart for demonstration of a buy signal. Conversely, a sell signal occurs when the indicator is overbought (i.e. above 1.0) and a negative cross over occurs.

 

MACD buy and sell signals are more relevant when divergence between the indicator and price of the security occurs on an intermediate basis. The enclosed chart gives a trend line showing divergence between the MACD indicator and the price of crude oil.

 

MACD is the slowest and latest of the three momentum indicators. RSI and Stochastics are faster, but are more prone to false signals.

 

RSI is slightly faster. When the indicator declines to 30% or lower, the security is oversold. The investor looks for a recovery above 30% for a recovery entry point. Conversely, when the indicator is above 70%, the security is overbought. The investor looks for weakness below 70% for confirmation of an exit point.

Chart courtesy of StockCharts.com                   www.stockcharts.com

Stochastics is the fastest momentum indicator. A drop below 20% indicates that the security is oversold in the short term. A recovery above 20% indicates a short term entry point. Conversely, a move above 80% indicates that the security is overbought in the short term. Weakness below 80% indicates a short term exit point.

 

 

Bullish Percent Index

Bullish Percent Index is a useful indicator when used in conjunction with short term momentum indicators. Its strength is its unique method of calculation. Data for Bullish Percent Index does not include moving averages applied by other indicators.

 

The root of the Bullish Percent Index is Point and Figure charts showing the trend of a security. A chart with a “bullish” trend has a current column of “x”s moving higher than the previous column of “x”s. Following is an example:

 


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IBM is one stock out of 500 stocks in the S&P 500 Index that is considered to have an uptrend or “bullish” trend based on point and figure analysis. StockCharts.com adds up the total number of stocks in the 500 that have an uptrend and publishes the data as a Bullish Percent Index for the S&P 500 Index. Bullish Percent Index for the S&P 500 is updated daily and published at www.stockcharts.com at $BPSPX.

 

Bullish Percent Indices are available for well known broadly based equity indices and U.S. sectors including the S&P 500 Index, The S&P 100 Index, the Dow Jones Industrial Average, the NASDAQ Composite Index, the NYSE Index, the NASDAQ 100 Index, the Dow Jones Transportation Average, the Dow Jones Utilities Average, the TSX Composite Index and the ten S&P sector indices.

 

Bullish Percent Index works best for an index with a large number of holdings. For example, it works better for the 500 S&P 500 Index stocks than for the 30 Dow Jones Industrial Average stocks. The Bullish Percent Index based on a small number of securities tends to be more volatile (i.e. choppy) and prone to false signals.

 

A 15 day moving average has been proven through experience to be a reliable “cross over” measure to confirm a change in trend on Bullish Percent Index charts.

 

Like any indicator, Bullish Percent Index is not perfect. However, when used in conjunction with momentum indicator and seasonality, it eliminates much of the “noise” that occurs during an intermediate cycle. It also can be used in conjunction with momentum indicators only (i.e. excluding seasonal influences) to identify additional intermediate trading opportunities. Following is a Bullish Percent Index on the TSX Composite Index showing entry and exit points that combine Seasonality, MACD and the Bullish Percent Index. Arrows indicate entry and exit points using seasonality (i.e. Buy when it snows, sell when it goes” from the end of September to the end of April). Zeros represent other entry and exit points based on MACD and Bullish Percent Index only:

 

Charts courtesy of StockCharts.com                               www.stockcharts.com

 

Chart courtesy of StockCharts.com                         www.stockcharts.com

 

Tech Talk’s Up/Down Ratios

 

Tech Talk has developed a reliable intermediate technical indicator for the TSX Composite Index and the S&P 500 Index that is similar to the Bullish Percent Index indicator. The indicator is called the “Up/Down ratio”. It is based on a ratio of stocks in an index that have established uptrends versus downtrends. The up/down ratio is published each Monday. However, it could be calculated daily based on data offered in daily Tech Talk reports.

 

The Up/Down ratio is determined by examining each day every stock that is part of the TSX Composite Index and S&P 500 Index. Each stock is in an uptrend, neutral trend or downtrend using a mechanical model. Stocks breaking resistance and support levels based on the mechanical model determine if a trend change occurs.

 

The Up/ Down ratio is the basis for determining the eight phases of the stock market cycle. A description of the Up/Down ratio and its determination of stock market phases originally was published in the International Federation of Technical Analyst Journal in November 1991. Tech Talk was the author. Following are excerpts from the original report plus updates in 2004 giving information on past intermediate cycles.

 

 

Understanding the Eight Phases Of the Stock Market Cycle

 

The stock market normally progresses through eight phases during an intermediate cycle lasting (on average) a year. The range of time for a full cycle is 5 –15 months. Total number of cycles during the past 23 years:23. Identifying which phase the market stands will help the investor to determine risk/reward parameters.

 

The eight phases are intuitive, but they can be measured and determined with a mechanical model. The eight phases are:

  1. Bottoming
  2. Base Building
  3. Breakout
  4. Mark Up
  5. Peaking
  6. Distribution
  7. Breakdown
  8. Markdown

 

The mechanical model primarily looks at the ratio of stocks in a broadly base index  (e.g. S&P 500, TSX Composite) that are in an uptrend versus a downtrend (i.e. the up/down ratio).

 

The Bottoming phase frequently occurs when the up/down ratio is between 1/3 and 1/2 (i.e. between 0.33 and 0.50). Occasionally, extremes are reached when the ratio falls below 0.33. The Bottoming phase is a point in time that is determined in retrospect (Usually in 5-10 trading days after the fact). The Bottoming phase occurs when most (but not all) stocks in the market have reached their lows for the cycle. The Index potentially could move to new lows if big cap, heavily weighted equities in the Index continue to move lower, but usually the Index bottoms at the same time as the up/down ratio.

 

The Bottoming phase and the Peaking phase are points in time. All other phases are periods of time.

 

The Base Building phase is a period of time following the Bottoming phase when stock prices develop a sideways trading range. Buying is recommended during this phase (particularly if a period of seasonal strength in a stock, sector or market is starting).

 

The Break Out phase is a period of time following the Base Building phase when equity prices move above their trading ranges. The Break Out phase is the most exciting stage in the market when stock prices move rapidly on the upside. Buying is recommended during this phase.

 

The Break Out phase moves to the Mark Up phase when the up/down ratio rises above 1.00.

 

 

 

The Peaking phase frequently occurs when the up/down ratio is between 2/1 and 3/1 (i.e. between 2.00 and 3.00). Occasionally, extremes are reached when the ratio exceeds 3/1. The Peaking phase also is a point in time that is determined in retrospect. The Peaking phase occurs when most (but not all) stocks in the market have reached their highs for the cycle. The Index potentially could move higher if big cap, heavily weighted equities continue to move higher, but usually the Index peaks at the same time as the up/down ratio.

 

The Distribution phase is a period of time after the Peaking phase. Equity prices develop a sideways trading range (plateau). Profit taking is recommended during this phase (particularly if a period of seasonal strength is ending).

 

The Break Down phase is a period of time following the Distribution phase when equity prices move below their trading ranges. The Break Down phase is the dreaded period when stock prices move rapidly on the downside. Profit taking is recommended during this phase.

 

The Break Down phase moves to the Mark Down phase when the up/down ratio falls below 1.00.

 

How does the mechanical model determine trends used to calculate the up/down ratio?

·        Stocks in an uptrend have higher highs and higher lows.

·        Stocks in a downtrend have lower highs and lower lows.

·        Remaining stocks are in neutral trend. 

 

The key to trend identification is determining the highs (i.e. resistance levels) and the lows (i.e. support levels). Highs require stock prices to trade below their high price for 15 days or more. Lows require stock prices to trade above their low price for 15 trading days or more. 

 

 

 

How does the mechanical model determine trends?

·        Stocks in an uptrend have higher highs and higher lows.

·        Stocks in a downtrend have lower highs and lower lows.

·        Remaining stocks are in neutral trend. 

 

The key to trend identification is determining the highs based on confirmed resistance levels and the lows based on confirmed support levels. Highs require stock prices to trade below their high price for 15 days or more. Lows require stock prices to trade above their low price for 15 trading days or more. 

 

Following are examples of equities in upward, downward and neutral trends:

 

A chart showing higher lows and higher highs based on confirmed support and resistance levels is in an uptrend. Support is confirmed when the chart trades above a low for 15 trading days or more. Resistance is confirmed when the chart trades below a high for 15 trading days or more. The following chart is in an uptrend based on confirmed support and resistance levels.

Chart courtesy of StockCharts.com                           www.stockcharts.com

 

A chart showing lower highs and lower lows based on confirmed support and resistance levels is in downtrend. Once again, the minimum 15 day rule is used. Notice that only the initial levels for support and resistance are counted. The 15 day rule does not apply after initial support or resistance is confirmed.

Chart courtesy of StockCharts.com                                  www.stockcharts.com

 

Charts that are not in an uptrend or downtrend based on confirmed support and resistance levels are classified as Neutral. The following chart previously was in an uptrend (higher highs and higher lows), but subsequently broke support to establish a neutral trend. An uptrend is re-established when resistance is broken above 340. A downtrend is established when support at 295 is broken.

 

Chart courtesy of StockCharts.com                               www.stockcharts.com

 

The following chart previously was in a downtrend (lower highs and lower lows), but subsequently broke resistance to establish a neutral trend. An uptrend is established when resistance is broken above $38.00. A downtrend is re-established when support is broken at $31.25.

 

 

Chart courtesy of StockCharts.com                       www.stockcharts.com

 

When an individual stock that is part of the S&P 500 Index or TSX Composite Index breaks a confirmed support or resistance level, Tech Talk generates a report the following day indicating the stock’s previous trend and its new trend. The report looks like the following:

 

 

 

S&P 500 stocks breaking resistance

 

Stock                           Symbol            Previous          New

                                                            Trend              Trend

Pfizer                            PFE                 Down               Up

IBM                             IBM                 Neutral             Up

Google                         GOOG             Up                   Up

 

 

Other Useful Technical Indicators

 

Trend Lines

 

Trend lines are useful for confirming the direction that a chart is moving. They can provide early warning signs when direction is changing. However, they should not be used a “stand alone” buy or sell technical signal.

 

By definition, a trend line needs three or more points to connect. For an uptrend, the three or more points are located below indicated prices. For a downtrend, the three points are more are located above indicated prices. Confirmed support and resistance levels often are useful for establishing trend lines. Following are examples.

 

Chart courtesy of StockCharts.com                         www.stockcharts.com

Chart courtesy of StockCharts.com                         www.stockcharts.com

 

Moving Averages

 

Moving averages can be considered as another form of trend line. They indicate a chart’s direction, but with more flexibility.

 

The moving average most frequently used for longer term direction is the 200 day or 40 week moving average. Both averages are virtually the same. The 200 day moving average frequently acts as a support or resistance level.

 

The 200 day moving average also is an attractive indictor for measuring risk and potential return. Assuming charts eventually revert to a neutral level determined by the 200 day moving average, the percent gain above or below the 200 day moving average can indicate amount of risk/potential return.

 

The second moving average frequently used for medium term direction is the 50 day moving average. A break above the 50 day moving average is an “alert” signal to explore a possible buying opportunity. Conversely, a break below the 50 day moving average is an alert signal to explore a possible selling opportunity.

 

Target Prices

 

Target prices are interesting, but not very useful. They frequently are provided by technical analysts as a guideline for potential return from an investment, fully realizing that targets should not be used as “hard numbers” for completing a transaction.

 

Targets are calculated in two ways:

  • A point gain (or loss) recorded in a previous trading range that is translated into a potential point gain (or loss) when support or resistance levels for the current trading range is broken.
  • The percentage gain (or loss) recorded in a previous trading range that is translated into the potential percentage gain (or loss) when support or resistance levels for the current trading range is broken.

 

Here is an example using an upside breakout above an established trading range:

 

The Philadelphia Semiconductor Index broke above confirmed resistance at 380.13. Previous trading range was 380.13 to 332.11.

·        Upside technical target price based on the point gain method is 380.13-332.11= 48.02 + 380.13= 428.15

·        Upside technical target based on the percentage gain method is 380.13/332.11x380.13= 435.09

The later method is preferred.

Chart courtesy of StockCharts.com                           www.stockcharts.com

 

Here is an example showing a downside breakdown below an established trading range:

 

Whole Foods broke below confirmed support at $29.81. Previous trading range was $29.81 and $36.03.

 

  • Downside risk based on the point loss method is $36.03-$29.81= $6.22. Downside technical target is $29.81-$6.22= $23.59

 

  • Downside technical target price based on the percentage loss method is $29.81/$36.03x$29.81= $24.66

Chart courtesy of StockCharts.com                            www.stockcharts.com

 

 

 

Pattern Recognition

 

Lots of strange names: Head and Shoulders, double tops, double bottoms, rising wedges, saucers, rounding tops, V formations and spikes! All are major reversal patterns. Other names include triangles, diamonds, flags, pennants, wedges and rectangles. All are continuation patterns.

 

All of these terms are jargon used by technical analysts. All of these patterns are based on three factors:

  • Support
  • Resistance
  • Trend

Naming the patterns is an interesting exercise (particularly when talking with another technical analyst), but is not really necessary when determining an entry or exit point on a chart.

 

Percent Retracements

 

When owning a trending investment, what size of a correction is reasonable before concerns about a change in trend are raised?  Up-trending charts usually experience brief periods of weakness over time. Seasonal investors frequently will calculate their “tolerance” level where they will take protective measures when the investment weakens. Their tolerance level frequently is called “the box”. The seasonal investor will maintain the position unless the security drops out of the box. The box is established by calculating a retracement level based on the investment’s previous trading range. A retracement box is calculated on a percentage basis and usually is a range between 33% and 66%. (Investors focusing on a Fibinacci retracement will use 37.5% and 62.5%).

 

Here is an example. General Dynamics has been trending higher for an extended period of time. The trader wants to protect himself. He decides he will maintain the position during a short period of weakness as long as the stock remains above his “tolerance” level. The stock’s recent trading range has been between $69 and $81. Retracement “Box” for the stock is between $73 and $77. If the trader has a tight tolerance he may decide to place a stop loss order near the top of the box at $77. Another trader with a higher risk tolerance may be willing to place a stop loss order at the bottom of the box.at $73. Both traders are out of the trade if the stock moves below $73. 

Chart courtesy of StockCharts.com                       www.stockcharts.com

 

Volume

 

Volume is a useful tool when stocks are breaking confirmed support and resistance levels. A spike in volume on break outs and break downs usually confirms their significance. Chances of follow through in the short term are higher. Break outs and breakdowns on volume, when significant news is released, are particularly relevant.

 

Cardinal Health is a good example. The company broke above a base building pattern on higher than average volume after reporting better than expected quarterly results.

 

Chart courtesy of StockCharts.com                                    www.stockcharts.com

 

 

On Balance Volume As A Price Predictor

 

On Balance Volume is an interesting indicator that frequently is useful for identifying stocks that are under accumulation for a possible take out. The method for calculating On Balance Volume is relatively simple. Volume is added when price of the stock moves higher and volume is subtracted when price of the stock moves lower. The reason for the phenomenon is a tendency for acquirers of large stock positions to “sit in the weeds” with a “bid” just below the market and to take out the “ask” price only when a sizeable block of stock is offered. Net result: the On Balance Volume indicator moves higher during a time when price of the stock remains relatively flat.

 

The On Balance Volume indicator is particularly useful when the indicator has moved to a new high just prior to a test of a key resistance level. The implication is that the acquirer may be ready to take the stock to the next higher price plateau. 

 

The indicator is less useful today than it was 20 years ago.  Equity activity related to listed options transactions has skewed the data for actively traded stocks and ETFs.

 

Denison Mines is an example of a stock with a positive On Balance Volume profile. Rumors of an eventual takeover of the company persist. On Balance Volume data indicates that the stock is under steady accumulation by a large buyer.

Chart courtesy of StockCharts.com                     www.stockcharts.com

 

 

 

Elliott Wave Theory

 

Interesting, but not high on the seasonal investor’s radar screen”! Most people find Elliott Wave analysis difficult to grasp and somewhat intimidating. The principles behind the theory are relatively simple. They focus on patterns, ratios and time. However, interpreting Elliott frequently is more of an art than a science. If you put four Elliotticians in a room with one chart, chances are that at least three interpretations will be offered. To be fair, some Elliotticians have shown considerable skill over the years. The best example is Bob Prechter, the ultimate guru of Elliott Wave. More information is available through Bob’s company, Elliott Wave International. His website location is www.elliottwave.com.

 

The Four Year Cycle

 

The four year stock market cycle usually is called the Four Year Presidential Cycle or the Four Year Economic Cycle. Historically, the four year cyclical low for the U.S. stock market has occurred within three months prior to the U.S. midterm election held during the second year after a president has been elected. On average, U.S. equity market advance thereafter for the next 22 months. The best period for performance by the S&P 500 Index during the four year cycle has been the nine month period following the four year low.

 

The series of recurring events trigger the four year low in the U.S. Presidential cycle:

  • The President uses his “political capital” to complete difficult items on his agenda during the first year of his mandate. His standings in the “popularity” polls diminish.
  • The opposition party in Congress starts to raise concerns about the President’s actions early in the second year of his mandate. Plans to gain more seats in Congress during the mid term elections are prepared.
  • Political rhetoric builds during late spring and summer. Congress is spending more time debating each other than considering legislation.
  • Rhetoric raises concerns about economic activity.
  • Growth in the U.S. economy starts to slow. Corporate revenues and profit margins come under pressure into the second and third quarters.
  • The mid-term election is held on the first Tuesday in November
  • The political agenda shifts, the president looks for ways to improve the economy prior to the end of his four year term, economic growth accelerates, corporate revenues and earnings improve and stock prices go higher.

 

Less well known is the tendency by all major developed nations to complete a four year economic cycle that corresponds to the U.S. Presidential Cycle. Four year economic cycles and their corresponding four stock market cycles also occur in Canada, the United Kingdom, developed European countries and Japan.

 

The four year stock market cycle has been exceptionally reliable for many decades. The U.S. stock market has recorded a four year low on 26 of the past 29 occasions since 1890. The only three occasions when the four year low was not identified just prior to the U.S. mid-term election were 1936, 1986 and 2006. On each occasion, the U.S. equity market continued to move higher without a correction of 5% or more. The miss in 1936 was followed by a substantial correction in 1937. The miss in 1986 was followed by a substantial correction in October 1987. The miss in 2006 was followed by a significant correction in late 2007/ early 2008.