Why use technical analysis in conjunction with seasonal investing? Seasonality analysis is a useful tool when determining a general time to enter and exit equity markets and sectors. However, seasonality analysis seldom is precise. It gives an average date in history when seasonal trades are optimal. Equity markets and sectors rarely reach important lows and highs exactly on their historic optimal dates. The dates for lows and highs will vary slightly each year from their average optimal entry and exit dates. The solution is to use technical analysis to pinpoint seasonal entry and exit points as seasonal average optimal dates approaches. Normally, technical analysis will pinpoint entry and exit points within one month (plus or minus) of an average optimal date. Net result: investment performance on a seasonal trade usually is enhanced.
Using Short Term Momentum Indicators To Pinpoint Seasonal Entry and Exit Points
Several well known momentum indicators are preferred for optimizing seasonal entry and exit points. They can be used separately or jointly. Choice of indicators is determined by experience and comfort of the investor. Short term momentum indicators based on daily data are preferred. Indicators using weekly data also are useful, but are less precise.
Three momentum indicators are preferred:
- Moving Average Convergence Divergence (MACD)
- Relative Strength Index (RSI)
- Stochastics
All use moving averages in one form or another when calculated. By definition, all will provide entry and exit signals shortly after a short term low or high has been reached.
MACD is the best known and most widely used momentum indicator. Entry and exit points are determined by a cross over of two moving averages. A buy signal is given when the indicator is oversold (i.e. below -1.0) and a positive cross of the two moving averages occurs. Conversely, a sell signal occurs when the indicator is overbought (i.e. above 1.0) and a negative cross over occurs.
MACD is the slowest of the three momentum indicators. RSI and Stochastics are faster, but are more prone to false signals.
RSI is slightly faster. When the indicator declines to 30% or lower, the chart is oversold. The investor looks for an improvement above 30% for an entry point. Conversely, when the indicator is above 70%, the security is overbought. The investor looks for weakness below 70% for confirmation of an exit point.
Chart courtesy of StockCharts.com www.stockcharts.com
Stochastics is the fastest momentum indicator. A drop below 20% indicates that the security is oversold in the short term. A recovery above 20% indicates a short term entry point. Conversely, a move above 80% indicates that the chart is overbought in the short term. Weakness below 80% indicates a short term exit point.
Bullish Percent indices
Bullish Percent indices are a useful indicator when used in conjunction with short term momentum indicators. Their strength is their unique method of calculation. Data for Bullish Percent indices does not include moving averages applied by momentum indicators. The root of the Bullish Percent Index is Point and Figure charts
Bullish Percent Indices are available for well known broadly based equity indices and U.S. sectors including the S&P 500 Index, The S&P 100 Index, the Dow Jones Industrial Average, the NASDAQ Composite Index, the NYSE Index, the NASDAQ 100 Index, the Dow Jones Transportation Average, the Dow Jones Utilities Average, the TSX Composite Index and the ten S&P sector indices.
Bullish Percent Index works best for an index with a large number of holdings. For example, it works better for the 500 S&P 500 Index stocks than for the 30 Dow Jones Industrial Average stocks. The Bullish Percent Index based on a small number of securities tends to be more volatile (i.e. choppy) and prone to false signals.
A 15 day moving average on Bullish Percent indices has been proven through experience to be a reliable “cross over†measure to confirm a change in trend.
The Bullish Percent Index indicator is not perfect. However, it is helpful for pinpointing seasonal entry and exit points when used in conjunction with momentum indicators. Following are charts showing entry and exit points on the TSX Composite Index using a combination of seasonality, MACD and the Bullish Percent Index.
Charts courtesy of StockCharts.com www.stockcharts.com
Other Useful Technical Indicators
Trend Lines
Trend lines are useful for confirming the direction that a chart is moving during a period of seasonal strength. They can provide early warning signs when direction is changing. However, they should not be used a “stand alone†buy or sell technical signal.
By definition, a trend line needs three or more points to connect. For an uptrend, the three or more points are located below indicated prices. For a downtrend, the three points are more are located above indicated prices. Confirmed support and resistance levels often are useful for establishing trend lines. Following is an example.
Chart courtesy of StockCharts.com www.stockcharts.com
Moving Averages
Moving averages can be considered as another form of trend line. They indicate a chart’s direction, but with more flexibility.
The moving average most frequently used for longer term direction is the 200 day or 40 week moving average. Both averages are virtually the same. The 200 day moving average frequently acts as a support or resistance level.
The second moving average frequently used for medium term direction is the 50 day moving average. A break above the 50 day moving average is an “alert†signal to explore a possible seasonal buying opportunity. Conversely, a break below the 50 day moving average is an alert signal to explore a possible seasonal selling opportunity.
Target Prices
Target prices are interesting with qualification. They frequently are useful as a guideline for potential return when entering a seasonal trade, fully realizing that targets will vary over time as technical and fundamental parameters change. .
Targets are calculated in two ways:
- A point gain (or loss) recorded in a previous trading range that is translated into a potential point gain (or loss) when support or resistance levels for the current trading range is broken.
- The percentage gain (or loss) recorded in a previous trading range that is translated into the potential percentage gain (or loss) when support or resistance levels for the current trading range is broken.
Pattern Recognition
Lots of strange names: Head and Shoulders, double tops, double bottoms, rising wedges, saucers, rounding tops, V formations and spikes! All are major reversal patterns. They frequently appear at the beginning and end of a period of seasonal strength. Other names include triangles, diamonds, flags, pennants, wedges and rectangles. All are continuation patterns. They frequently appear during a period of seasonal strength
All of these terms are jargon used by technical analysts. All of these patterns are based on three factors:
- Support
- Resistance
- Trend
Naming the patterns is an interesting exercise (particularly when talking with another technical analyst), but is not necessary when determining an entry or exit point for a seasonal trade.
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Tags - Previous posts for stock ticker: momentum indicators, seasonal investing, Technical Analysis
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