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Are shares at risk of a pullback?

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By Michael McCarthy

The Australian share market could be facing a significant pull back. While fundamental economic conditions continue to improve, there is growing evidence that market pricing has run ahead, and will need to correct itself. How do I know? The chart.

It seems amazing that market participants still fall into the “fundamental analysis versus technical analysis” trap. After all, they are not mutually exclusive. When trying to solve a puzzle as complex as the market, why wouldn’t an investor use all the tools available? 

Charts can give hints and warnings of possible price moves as, or even before, the fundamental factors become apparent. Possible is a key word here. No indicator (or fundamental factor) has a 100% record in forecasting market moves. If an investor accepts the idea that the price of any share is simply a mass expression of opinion, it’s easy to understand the difficulty in forecasting. Crowd behaviour can be as beautiful as a ballet, as brutal as a riot. And crowds and markets can flit from one to the other very quickly.

At the moment, the chart of the Australia 200 index is flashing a warning:

An experienced investor or trader may pick up this chart and shout “sell” immediately”. Let’s work through the process.

Starting at the beginning, this is a daily candlestick chart. Each of the (pink or blue) candles represents one day’s trading. A blue candle means the day closed higher than the opening. A pink candle is a down day. For most of 2016, and into this year, the index is in an uptrend – signified by the purple line that touches the ongoing series of higher daily lows. 

The green line at 5580 is a point where the index has found support and resistance previously – and is therefore more likely to do so again. The break through that level signalled potential for further gains. So far, so good.

However, the problem occurs when I run CMC’s pattern recognition scanner for “double tops”. The thinking was to identify market indices in the US that were clearly signalling a pullback. Instead, the Australia 200 index showed the orange double top signifier – the extended “M” shape you can see on several peaks in the chart.

Because no signal is fool proof, traders often look for confirmation. Often, this is another unrelated indicator that is pointing in the same direction. At the bottom of the chart is the MACD (moving average convergence divergence) which is a multi-use indicator. There are two lines to the MACD. The black line leads, and the red lags. Signals occur when they cross – sell when black crosses from above, buy when black crosses from below. 

However, there is more to the MACD. Where the cross occurs relative to the middle “zero line” is important. A sell signal above the line is considered more powerful, as is a cross upward below the zero line.

Now back to the chart. The MACD is threatening to cross upward, usually good news. However, the lines are above the zero line, and a touch and fall away is as good as a cross from above. In other words, a couple of negative days trading and it’s likely the short term traders will start heavily selling the index.

Keeping perspective, a 5% pullback to around 5500 would leave the longer term uptrend intact. A normal and healthy pull back that creates a base for further gains. On the other hand, chart signals can be as wrong as any expert. In trading above the recent high at 5832 would negate the double top and shift the balance of probabilities to more immediate gains for the market

Published: Tuesday, March 14, 2017


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