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Caution still warranted

Lesley Beath  |  12 May 2014Text size  Decrease  Increase  |  

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Disclaimer: To the extent that any content in this report constitutes advice, it is general advice that has been prepared by Lesley Beath without taking into account the particular investment objectives, financial situation and particular needs of any individual investors. If necessary, you should consult with a licensed investment adviser or dealer in securities such as a stockbroker before making an investment decision. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.


Overview

The US S&P 500 continues to push against resistance. Last week it did so on three occasions but failed to break topside. Similar resistance is impacting the Dow Industrials.

Without going into too much detail, support and resistance levels are not just lines that technical analysts like to draw on a page. They actually represent levels of supply and demand, and are a reflection of investor psychology.

So when support or resistance levels fail, it represents a change in investor sentiment. That is why old resistance levels can often become support, and old support levels become resistance.

That is a relatively simple explanation and as we know support and resistance levels are often broken only to be followed by a quick reversal, creating what is known as a "false break".

As I have noted in recent reports, there has been a false break in the All Ords in every April/May period since 2010. This preceded each corrective phase.

In the current instance, as I pointed out last week, the All Ords has made a few attempts to break topside (in February/March and on two occasions in April) but these failed breakouts have not led to declines of any significance, so to-date the market has actually held up far better than on those other occasions.

And if we take a close look at the US market, we can see that after the false breakout in early April and the daily key reversal that followed on the 4th, the S&P 500 picked up support in mid-April and pushed quickly up to resistance again.

It has been battering against this resistance since 22 April and has not yet given up.

Sometimes it is the way prices act as they near these resistance levels that will give some guidance as to the future movements.

If we think about the psychology of this, I would think that in the current instance, in the US, there is an even tug-of-war between the bulls and the bears, with neither side prepared to give in just yet.

Obviously, there are some problems outside these major indices and there are some warning signals, but this resilience as resistance is tested time and time again suggests that if it is finally convincingly broken, it could unleash a quick and sharp move to the upside.

I don't think there is evidence to suggest that scenario at this stage, but it is always wise to look for evidence to suggest that your view is coming under threat, rather than simply looking for actions to support your existing view.

This helps reduce what behavioural psychologists call confirmation bias. Wikipedia describes confirmation bias as: "The tendency of people to favour information that confirms their beliefs or hypotheses."

"People display this bias when they gather or remember information selectively, or when they interpret it in a biased way ... people also tend to interpret ambiguous evidence as supporting their existing position."

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