Stocks May Be Ready For A Breakout, According To These Three Indicators

Stocks May Be Ready For A Breakout, According To These Three Indicators
Russell Burns

about 1 year ago5 mins

  • The S&P 500 is facing tough resistance from the downtrend line from January 2022, a break above could lead to a more sustained move higher.

  • The S&P 500 has broken just above its 200-day moving average and that seems positive – but it could be another false dawn

  • Investor sentiment is improving but remains below historic norms. But cash levels remain high, which suggests a positive outlook for the S&P 500.

The S&P 500 is facing tough resistance from the downtrend line from January 2022, a break above could lead to a more sustained move higher.

The S&P 500 has broken just above its 200-day moving average and that seems positive – but it could be another false dawn

Investor sentiment is improving but remains below historic norms. But cash levels remain high, which suggests a positive outlook for the S&P 500.

Mentioned in story

We’re only a couple of weeks into 2023, but the S&P 500 is already dropping hints that this year could be an interesting one. If you’re obsessed with charts (like some of us), you may have already noticed this. If not, let me show you three major technical indicators and what they say about the potential for a stock market rally...

1. Trend lines

You can look at a ton of different technical indicators, but trend lines will always be one of the most important ones. And right now, they show the S&P 500 at a key level, bumping up against major trend line resistance. In other words, that recent surge in demand has lifted prices to a level where there’s a strong desire to sell. What happens over the next week could determine the next major move in the S&P 500.

S&P 500 Index. Source: Bloomberg.
S&P 500 Index. Source: Bloomberg.

Trend lines are used to analyze prices on both short- and long-term time horizons. A trend line connects at least two points on a chart and is usually then extended to see where pricing may encounter upside resistance (a kind of ceiling) and downside support (a kind of floor) in the future. The trend line (in white) starts from the high in January 2022, and connects with the lower highs in March and in December, extending to just above the most recent closing level of 3,999, at around 4,020.

This tells you something important: if the S&P 500 manages to break a bit higher and close above this trend line resistance, that move could act as a trigger for a more substantial nudge higher. That’s because a lot of quantitative-driven hedge funds will see that break as a major buy signal.

2. Moving averages

Of course, you don’t want to miss out on moving averages when you’re checking out technical indicators. They can serve as important support (a floor) or resistance (a ceiling) for an asset because so many investors use these levels to determine when to buy and when to sell. This technical indicator takes the closing prices across a number of previous days (50, for example, or 200) and comes up with a continuously updating, or moving, average.

If you look at the S&P 500 (blue line) now, you’ll find that at 3,999, it’s trading slightly above its 200-day moving average (red line) at 3,958.

The S&P 500’s price (blue line), its 50-day moving average (green dotted line) and its 200-day moving average (red line). Source: Yardeni Research.
The S&P 500’s price (blue line), its 50-day moving average (green dotted line) and its 200-day moving average (red line). Source: Yardeni Research.

This could be an encouraging sign for the S&P 500, but it’s a bit too early to tell. See, a similar situation happened twice in December: the index traded marginally above its 200-day moving average but then failed to break the trend line resistance. As many chartists would tell you, a single moving average isn’t all that useful on its own: you need at least two to help create a “crossover”. A crossover occurs when a faster moving average (i.e. one that covers a shorter period) crosses a slower one. In the chart above, the index’s 50-day moving average is sitting around 3,923, which is below the 200-day moving average. You’d want to see the 50-day moving average cross over the 200-day moving average before you could consider this a buy signal.

3. Sentiment levels

A few weeks back, Luke took a look at the latest Bank of America Global Fund Manager Survey and noted that cash holdings as a percentage of assets were at 5.9%, which hints at a more positive outlook. When cash levels are above 5%, it suggests that it could be a good time to buy, and when they’re below 4%, a good time to sell.

While the Bank of America survey is published monthly, the one from the American Association of Individual Investors (AAII survey) is published weekly. And it’s a valuable contrarian indicator. Above-average market returns have often followed unusually low levels of optimism, while below-average market returns have often followed unusually high levels of optimism.

AAII sentiment bull-bear spread. Source: AAII.
AAII sentiment bull-bear spread. Source: AAII.

As you can see, the survey shows that sentiment has moved into neutral territory. Here’s a closer look at how the AAII respondents have been feeling.

AAII sentiment votes, over time. Source: AAII.
AAII sentiment votes, over time. Source: AAII.

Pessimism (i.e. bearishness) among individual investors about the short-term direction of the stock market slipped last week to its lowest level in 10 weeks. Neutral sentiment also pulled back, while optimism (bullishness) has rebounded. Expectations that stock prices will rise over the next six months climbed to 24%, from just 20.5% the week before. But don’t get too excited about that level of optimism: it’s been below its historical average of 37.5% for 54 straight weeks and has been at unusually low levels for seven consecutive weeks. So although sentiment has improved, optimism remains subdued among individual and professional investors alike. That, at least, means on a break higher, there is room for sentiment to improve and give this rally more momentum.

What’s the opportunity here?

Trading is as much an art as a science, but following a rules-based system can help limit your losses and maximize returns. If you’re feeling bullish after the breach of that trend line, you could consider going long, or buying index exposure to the index, with an ETF like the SPDR S&P 500 ETF (ticker: SPY US; expense ratio 0.1%). And if the index sees a moving average crossover (between the 50-day and 200-day), you could buy more, adding to your position. If the index falls below the trend line, on the other hand, you could sell out of any long position to limit your losses.

But if you’re not the optimistic type, and you’re feeling bearish now, you could go short on the SPY: for example, by buying the Proshares Short S&P 500 ETF (SH; 0.89%). And you could sell out of the ETF if the index breaks above the current trend line. The key is to stay in the game and keep your losses small, so that whatever decision you make, you live to fight another day.

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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