Beware following stockmarket trends

Published by Peter Temple on 11 August 2010.
Last updated on 24 August 2011

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The trend is your friend. So runs an old stockmarket saying. But the word is often used loosely with little thought to its precise meaning or implications.

Most of the basic concepts used for analysing share price movements - such as support and resistance levels, for instance, and the concept of reversals - are based around attempts to measure a trend in order to participate in it at the right time.

For those who prefer a more concrete underlying mathematical basis to their decisions, trends can be measured and calculated statistically by resorting to regression analysis and confidence intervals, which show the implied probability of a share price straying outside of a defined boundary.

Trends are basically a product of the zigzags in the market. The common method, though less precise than the statistical one, is simply to join the successive high points and low points respectively in an uptrend or downtrend to create a trend channel. 

What many observers miss, however, is that trends are also defined by timescale. Short-term and intermediate trends can exist with long term ones. As I've described elsewhere in these articles, long-term stockmarket trends can be as long as fifty years or more.

Working out whether the trend we see now is a long-term secular trend in its own right, or simply a shorter term component in a long term pattern, is crucial to successful investment decision-making for long-term portfolio or assets like self-invested pension funds.

Trends can be up, down or sideways. Spotting when a trend breaks down and changes direction is also important. Nothing is forever in the stockmarket. A change in trend may be down to nothing more than psychology and market sentiment.

A classic scenario might be the publication of one piece of news that lightens the mood only fractionally when things look bleakest: the recent rebound in the price of BP is a good example. 

Changes in trend are often accompanied by changes in trading volume, not necessarily when the trend change first happens, but shortly afterwards, as investors begin to realise that the change in trend has occurred and is likely to be long lasting.

For those of a more statistical bent, the concept of reversion to the mean has considerable attractions. Combine the idea of a linear regression of a share price series with confidence intervals and the idea that, other things being equal, the share price will ultimately find its way back to the central trend line, and you get a powerful tool for timing buying and selling decisions.

The drawback to this notion is that the precise value of the 'mean' to which a share price might revert is also crucially dependent on the timescale taken. If following this approach, it's therefore a good idea to examine a long-term price trend in detail visually first, break it down into its obvious long-term and short-term trend components and then calculate least squares regression measurements, mean trend lines and confidence intervals for each separate component of the cycle.

Most technical analysis software, like Sharescope and Updata Technical Analyst, can perform calculations like this with ease.

Peter says:

What's important to remember is that when it comes to analysing share prices nothing is infallible. External events can exert a powerful influence. All that using techniques like this to determine buying and selling decisions does is to tilt the odds in your favour and give you a deeper insight into what the parameters might be.

Once again BP provides a good example. An observer looking at BP would have looked at the price at the beginning of June when the shares approached 400p and speculated that, since the shares had not dropped below this level for 12 years, the share price would not go down any further. But the external event of the political hysteria in the US and the passing of the dividend saw the shares down to slightly below 300p at their lowest point. 

While they have recovered since then back to the 400p level, they may have a hard time making much significant headway from this point. The previous support level, since decisively broken, has now become a major resistance point. In the absence of better news or a bid, the best that might be expected is that the shares revert to an intermediate or even longer term sideways trend for the time being.

I intend to look, in a later article, at the other broad component of technical analysis: cycles and how to measure them.

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