One of the greatest concerns for some investors is that the world of the chartists, or technical types, is having too big an impact on what stockmarkets do to our wealth. This was seen at its best – or was it worst? – yesterday on Wall Street.
Apart from the key indexes trading through 200-day moving averages, which always spook investors, the charts told a scarier story encapsulated in what the ‘techos’ call a ‘head and shoulders’ pattern.
Put simply, imagine the market rallies then falls (this is the first shoulder). This is followed by a higher rally, then the market retreats again (making a head). However, a third rally comes along that is smaller than the second (creating the second shoulder).
Why is this so scary? Because a head and shoulders pattern is often a forerunner to a sell-off.
Now, the more the market talks about these technical patterns the more a market can be affected by them. It can be a self-fulfilling pattern, at least in the short-run. And if you throw in the computerised trading reaction, you then get market overreaction.
Art Cashin, who’s the director of floor operations for UBS at the New York Stock Exchange (I spoke to him on my Sky News Business program SWITZER last December) told CNBC that this high frequency trade linked to technical developments could explain the overreactions we’re seeing at the moment.
“When the S&P broke through the 1,248-1,250 [level], it violated what is called a ‘neckline’ on a head and shoulder formation,” he explained.
But other things such as the market wiping off the year’s gains, which happened on Wall Street on Tuesday, can also cause investors to jump on the sell-off bandwagon. When technical reasons to sell meet psychological reasons, it is hard for a market to resist gravity.
Sell-offs caused by economic and market worries are intensified by fashionable algorithm trading. Algorithm trading uses advanced mathematical models to make transaction decisions in the financial markets. The model generally aims to buy large blocks of shares by spreading the purchases out into small parcels. The goal is to have a minimum impact on share prices, but when so many are doing it and when the direction of the market is strongly heading one way, the overreaction effect follows.
The model makes perfect sense for short-term traders. But for the long-term player, it’s an occupational hazard of having to play in a stock market to build wealth.
The consensus of US economists has the economy growing between 2-2.5% in the second half of the year and if this is right, then we are seeing an overreaction. If Europe and Italy can stare down the vigilantes attacking Italian bonds and affirm that Italy is not another Greek basket case, then it adds to the overreaction case.
Tomorrow’s jobs report in the United States could add to the overreaction or turn this sell-off around. I liked the VIX, or fear index, dropping from 24 to 23 overnight and the fact that private sector job creation in July was better than expected. And with the debt drama over, positive reactions from business and consumers could show up in the economic readings over the next few months.
Let’s hope the head and shoulders spook factor simply turns out to be a short-term pain in the neck that goes away.
One final thing: all this negativity about the US economy could get US Federal Reserve chairman Ben Bernanke thinking about a third quantitative easing package. It can’t be ruled out and it would help the stock market, but I would prefer to see the US economy pick up its own bed and walk without being on Federal Reserve life support.
Also in the Switzer Super Report:
- The super laws have changed. Do you comply?
- What not to buy – Part 1: size matters
- Buy now while risk is cheap
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