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  • Stocks are unpredictable, but technical analysis offers clues into price direction.
  • The 40-week exponential moving average can alert you to rising risk.
  • The advance/decline line, on-balance volume, and moving average convergence divergence may help you sidestep a sell-off.

Nobody knows if the stock market rally that began in mid-June will continue. It could be that stocks backfill recent gains before rallying again like in the summer of 2020 or that stocks lose steam, rollover, and make another leg lower like in May 2008. Unfortunately, crystal balls are hazy this year.

Michael Burry of Big Short fame recently pointed out the 23% rally in the NASDAQ isn’t unique. On Twitter, he wrote, “Across 26 bear market rallies from 1929-1932 and 2000-2002, the average [bear market rally] is 23%. After 2000, there were two 40%+ bear market rallies and one 50%+ rally before the market bottomed."

So, a big rally alone doesn’t necessarily mean stocks are out of the woods.

Plenty can go wrong for stocks. 

The economy is shrinking, not growing, and rising interest rates causing the decline are still heading higher. Real wages continue to decline because, although inflation is decelerating, it remains higher than wage growth. As a result, personal savings rates are the lowest since the Great Recession.

The pressure on consumers is forcing them to shift away from discretionary spending and pushback on price increases that are necessary for companies to pass along higher costs. As a result, corporate margins are thinning, and profit growth is slowing. According to Factset, excluding energy, S&P 500 earnings fell 3.7% in the second quarter, resulting in analysts reducing full-year earnings growth estimates to 8.9%, down from 9.9% in July.

Because these headwinds could make for a choppy path for stocks, technical strategies may help you figure out when it makes sense to sell.

Spotting warning signs

In “Having Trouble Spotting When to Sell? The Technicals Can Help,” Real Money technical analyst Bruce Kamich explains some tools he uses to determine if it’s time to ride the pine. He writes:

“There are scores of books on how and when to buy stocks, but very few discuss the same for selling stocks. Despite the mantra of financial advisers, investors do have the tools (when properly applied) that can help in side-stepping declines.”

One of those tools is the 40-week exponential moving average or EMA. EMA is similar to a simple moving average, or SMA (the average closing price over a period); however, it weighs recent price action heaviest. As a result, it’s more sensitive to recent price action than the SMA.

Back to Kamich:

“For example, if you sold the S&P 500 when it crossed below its 40-week exponentially smoothed moving average line, you would dramatically outperform a buy-and-hold strategy. In this 10-year chart below, you can quickly get a sense of how this simple tool can get you out before serious declines. (When to buy is a topic for another day.).”

CHART_081522

Kamich prefers the EMA, but you can similarly use the SMA to spot selling points. The adage, “nothing good happens below the 200-day moving average,” applies either way.

Another option is tracking the last hour of the trading day. Stocks often react to news early in the day, but the initial action can wane as the day progresses. So if the final hour of trading is poor, it may signal that stocks are due for a breather.

Kamich writes:

“If we see a pattern where the Dow continues to rise, but it keeps losing points in the last hour of trading, it is an early warning signal for the Dow. A peak in the last-hour indicator often precedes a downturn in stock prices.”

The advance/decline line is also helpful. This line is the running total of advancing stocks to declining stocks. The A/D line is a breadth indicator, so it shows if a move in the market is supported by widespread or narrow participation.

Kamich writes: 

“The level of the A/D line is not important, but its trend is [emphasis mine]. It is understandable that at a market bottom, investors tend to buy the better-known companies, but as a stock market advance continues and the economy improves, more companies participate in the rally, the advance broadens out, and the A/D line rises. The more stocks that participate in an advance, the stronger it is; while the lower the number of stocks moving up in an advance, the greater the probability of a reversal. The A/D line is a leading indicator and will peak before the final price high.”

Kamich shares the following NASDAQ chart along with its A/D line to illustrate his point. Notice how the A/D line peaked in early 2021, months before the NASDAQ peaked.

CHART2_081522

Kamich believes on balance volume (OBV) -- a running total of up and down day volume -- can spot weakness early, too. In his daily articles, he uses it and moving average convergence/divergence (MACD) to explain why stocks may be a buy, hold, or sell. 

Similar to the A/D line, OBV’s trend is what matters. If it’s declining while stocks are making highs, it can signal sellers are about to swamp buyers.

MACD is an oscillator that subtracts the 26-period moving average from the 12-period moving average. Readings above or below zero are bullish and bearish, respectively. A 9-period moving average is used as a signal line. A cross above or below the signal line is bullish or bearish. 

Kamich writes:

“The MACD oscillator narrowing is another tool at your disposal. Before the MACD oscillator crosses to the downside, it will narrow. This is your heads up to become more cautious of the advance.”

The Smart Play

If your head’s spinning, don’t worry. These indicators may sound complicated to calculate, but most chart services do the work for you. You simply need to select these choices, usually from a drop-down menu labeled something like “indicators,” to apply them to your chart. Then, practice looking at them so you get comfortable using them.

These tools can help spot turning points, but they're by no means perfect. If they were, everybody would use them and be rich. Instead of following them blindly, use them as inputs into your process. Kamich writes, “Applying these tools (above) should not be according to a formula, in my opinion. The stock market is always changing and evolving so a flexible approach is needed. When the weight of the evidence tells you to sell, you should take action. If you are proven wrong, you can always get back in.”

Tools like these can serve as an early-warning system. If they alert you to potential weakness, you can trim some of your position, tighten up your stop losses, or, if you’re a long-term investor, look for lower support lines at which you can consider buying. 

Of course, you shouldn’t change your long-term investment strategy based on these indicators willy-nilly. Nevertheless, you may want to add them to your regular homework. At a minimum, knowing if these indicators are working against you may keep you from being surprised, making it less likely you react emotionally to market pops or drops.

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