The Independent Market Observer

2/28/13 - The Rally Continues

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Feb 28, 2013 4:09:15 PM

and tagged Market Updates, Economics Lessons

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The interesting story today is the stock market, as it manages to shrug off the worries from Europe, the sequester, and a power higher. The Dow Jones Industrial Average is closing in on its all-time high, set in October 2007. The S&P 500 Index is not quite—but almost—as close to the high that was set around the same time. Are happy days here again?

The numbers I mention above are a bit misleading, in ways both positive and negative. For both indices, if you include dividends paid over the time since the previous highs, we have already passed them. This would be positive. If you look at the indices adjusted for inflation, however, we are further away, which is negative. The key is that, surpassing the previous levels would just be numbers, with more psychological than economic significance.

Psychology has a lot of force in the market, though. Technical indicators do appear to have some predictive power, and one of the more important ones is the notion of support and resistance levels. The basic idea is that there are price levels where prices tend to stop moving, and the more times prices stop there, the more powerful the resistance or support. Round numbers tend to make good resistance or support levels, as do previous highs and lows.

The idea behind this is that investors tend to make their decisions based on their purchase prices. So, for example, suppose you buy a stock at $100 and it goes down. A lot. Assuming that you don’t sell, there will be a tremendous urge to sell when you get your money back (i.e., when it recovers to $100). With lots of people doing the same thing, selling will increase whenever the price approaches $100—which will push the price down again, creating resistance. Once buying pushes the price through that $100 level, though, the sellers will be exhausted and the $100 price will become a support level.

Support works the same way but in reverse. This time, buyers will tend to appear as the stock becomes “cheap” (i.e., as prices go down). If you bought it at $100, you will be tempted to buy more as the price drops to that level again, and, if many people do that, the price will be pushed up, creating support.

Previous highs, which we are now approaching, can easily act as a resistance level, as sellers are motivated by the doubt that prices can continue to increase. Conversely, when the selling is exhausted, many times, a break in a resistance level will result in continued gains.

We can’t tell which way it will go, but, as we approach the previous highs, we can expect interesting activity as sellers and buyers fight it out. Because this resistance level has stood for more than five years, it should be a very interesting time.

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