Wednesday, October 5, 2022
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Why the S&P futures chart offers some hope for investors

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Regular readers, God bless you, will know that I am not a fan of overly complicated and far-fetched technical analysis. Complex patterns that need a lot of explanation are, in most cases, coincidences rather than reliable signals, and they will always mean absolutely nothing if the fundamental conditions change. However, there are times when reading charts can tell investors something useful, and now is one of them.

What is different right now is that the movement we are seeing is based on a fundamental change in conditions that we already know about. It has been obvious for some time that inflation is with us, and that the Fed would eventually have to realize that and tighten monetary policy in response. The only questions are how bad inflation turns out to be and how drastically the Federal Reserve responds. Daily volatility has been based on those two things, but the general direction has been clear and logical. Still, it will eventually end, and when that is the case, the chart can be helpful in identifying a potential end point for the move.

So what does the chart say for this move down?

When I look at the year-to-date chart for the E-Mini S&P 500 futures contract above, there are a few things that stand out.

First of all, it has been a bumpy downward move, with many daily direction changes, as well as some sustained moves up and down. However, it is the nature of most of these daily changes that interests me most.

Candlestick charts like the one above are the type most often used by traders because they give a clear picture of the price action during each day rather than just the closing price. One horizontal line on each candlestick represents the opening price and another the closing price, with the thin lines, or wicks, protruding above and below those horizontal lines indicating intraday prices outside of the opening and closing prices. The candles are color coded, with red representing low days, when the close was below the open, and green high days, when the opposite occurred.

The interesting thing about this chart is that almost all day down, the red candles have little or no wicks above the top line, indicating that the open was the highest point of the entire day. In many cases, that open was above the previous day’s close, meaning the smaller futures players in the overnight market were bullish, but the big ones who were playing when the US market opened sold heavily and forced the contract down. That’s consistent with a sustained move lower, and that move is unlikely to end until the opposite starts to happen, when initial pessimism is met by optimism and strong buying once the bigs come in. That is what investors looking for a flat should do. searching, early losses become gains, not the other way around.

There are also a couple of things about this chart that suggest we may not be far away from that happening, one technical and one psychological.

The technical indicator is the shape of the candle that formed on Friday. It is what is known as a “doji” to chart readers, a long vertical line with a thin horizontal line forming a clearly defined crosshair. A doji indicates that there was a battle between buyers and sellers that day. Both had the lead at different times, hence the long vertical line, but it ended in a tie, with the open and close close enough to create that thin horizontal line.

To technical analysts, a doji like that indicates the end of a long-term move and a possible change in direction because it suggests that the previously dominant group, in this case the sellers, is running out of steam, and the bottom of that cross is the point where the sellers pulled out. Logically, that becomes a strong support level. So if 3807.5 holds this week, we may have seen the bottom of the move lower, at least for a while.

That is a little more likely because of the psychology of traders, something that decades in trading rooms around the world have taught me is often overlooked but highly influential on the markets. From that perspective, the sale can be seen as a kind of punishment. Stocks had allowed themselves to be overbought despite the obvious risks of inflation and rate hikes, and that needs to be corrected. Still, like all civilized punishment, the goal is to do enough to teach a lesson, but not kill the punished.

So the punishment must have an end point, and the very human pursuit of that end point leads to it usually coming to a logical point, like a round number or maybe a drop of a certain percentage. That makes the fact that the S&P 500 has challenged a level that would represent a 20% drop and a bear market multiple times before reversing seems very significant and lends even more weight to Friday’s low as a support level.

Of course, if economic data and corporate earnings continue to suggest, as they have recently, that inflation is worse than feared and is having a profound effect on corporate profits even before rate hikes begin to affect demand, none of this will matter. In that case, 20 percent isn’t even enough to reflect reality, let alone punish stocks for their previous profligacy, and we’ll continue to go lower. What the chart does do, however, is tell us that short of any more bad news, we may have bottomed out and at least offer some hope to defeated investors.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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