Tuesday, March 20, 2007

Technical Tuesdays: Using Technical Analysis for Profit (and Fun)

As a big believer in the additive value of technical analysis (TA), I have found that many (not all) tools of TA have a useful predictive value. One such tool combines momentum, moving averages, and the concept of divergences.

As the chart on the left shows, momentum and MACD plunged in the early phases of the current correction. Now, here’s where the fun begins.

To begin, take a look at last spring’s correction and first focus on momentum (first chart lines beneath price chart) . Big plunge, rally to neutral, followed by a secondary drop. During that second drop, note how the market made a new low BUT momentum did not. Divergence #1.

Now, look at MACD (second chart lines beneath price chart). It, too, plunged, rallied to neutral, then dipped again. Also, not making a new reaction low. BUT, and this is most important, it wasn’t until the moving averages of MACD (the moving averages of the moving averages, if you will) crossed and trended upward that the market began to stabilize, build a base, then make a run to new highs.

Investment Strategy Implications

Thus far, the current correction has followed the above script fairly closely. The argument I have made, from a TA perspective, is that the extent of the damage done by the first wave is followed by a second wave during which divergences hopefully develop (between price and momentum and MACD) which sets the stage for the rally to new highs.

If the current correction does not unfold according to TA Hoyle, then the most dangerous words in the investment language are in effect – “This time is different.”

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