Chart: How High Could Stocks Go From Here?

Chart: How High Could Stocks Go From Here?

Amid a swirl of news, including controversies that make Fed Chair Janet Yellen's testimony before Congress seem dull by comparison, stocks made a series of record highs this week. To see how high (or low) they could go from here, let's ignore the news and look at the charts. 

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Scroll down for the large version | Vikram

Traders continued their broad-based buying of stocks and selling of bonds this week, a pattern going back to the start of the year and before. The trading appears to be driven by pure market forces—supply and demand—despite a flurry of news from Washington and abroad, including the resignation of National Security Advisor Michael Flynn, the withdrawal of Labor Secretary nominee Andrew Puzder, and investigations into Russian involvement in the US election. 

The news with the most direct effect on markets was Janet Yellen's testimony before the banking committees of the Senate on Tuesday and House on Wednesday. Yellen made some specific clarifications which might, on another day, have elicited strong reactions. The markets' response seemed to be "Keep calm and carry on" with the buy and sell programs that came in orderly waves to make up an overall uptrend. 

Yellen said that the Fed would use interest rate increases to keep the economy on its current trajectory of steady job creation and gradual inflation growth. She also made clear that the Fed would not make adjustments to its $4.5 trillion balance sheet any time soon. That means that the Fed would not be converting US debt instruments like bonds and notes into cash or vice versa. These sales and buybacks of maturing bonds are one of the Fed's key tools for controlling the money supply. 

One reason her statement is significant is that other major holders of US currency and debt have been adjusting their balance sheets in a big way. China, the biggest holder of US debt, revealed on Wednesday that its holdings of US Treasuries dropped by a record amount in 2016. The Chinese government regularly dips into its foreign-exchange reserves (its stockpile of US dollars) to buy yuan and boost its exchange rate value. It's a tactic that China has used to prop up its currency for years now. 

With all that to digest plus earnings reports, including an insanely great one from Apple, traders who speculate on the news had a lot to work with—maybe too much. For that reason, let's step back and do some very basic, straightforward technical analysis. This is nothing fancy and you'll notice there are no moving averages or oscillators on this long-term chart of the S&P 500 futures, just trendlines and a Fibonacci retracement. 

 

As you can see, the uptrend is a steady series of waves stretching back left of the chart, really back to 2015 or so. If you draw simple lines connecting the tops and bottoms of the waves, the crests and dips, you see that the market has overall been very well-behaved. Even the dramatic dip on Election Day, November 8, actually corresponds to a Fibonacci retracement to roughly the 61.8% level. 

Overall, the market has clung to those trendlines and returned to them whenever it veered away. Technical traders watch for this phenomenon, when the lines act almost like magnets, with price bars clinging to them and being pulled between them as they move in channels. It may be a self-fulfilling phenomenon: traders expect the markets to return to certain lines and place their orders accordingly—and surprise! the markets return to those spots so the orders can get executed. 

Until last week, that is. That's when the markets finally decided to stop worrying and start rallying. The conventional wisdom is that investors are excited about expected tax cuts and deregulation that will benefit corporations and possibly small businesses. Goldman Sachs's stock price has shot up and that is the explanation most analysts give, including Goldman's own. 

This week, the S&P 500 reached a 38% extension of prices from the highs of August 2016. Technical analysts would expect a pause at this level and possibly some profit-taking. Thursday and Friday morning saw some minor selling. Then again, a market with this much volume and volatility could throw traders a surprise and continue to rally. By the same token, an unexpected event could turn a small profit-taking dip into a bigger correction to the downside. 

While no one can predict anything for sure, the 2440 price level, where the 61.8% extension sits, is a target analysts will likely keep an eye on. There are other significant levels below that, like the trendline at 2360 and the round number of 2400, which may also be spots where traders have set their buy programs to take profits or add to positions. 

One way to think of it is this: you can't be sure if a market is going to go in one direction or the other, but you can identify some places where it's likely to pause while making its decision. Those are the spots where buyers and sellers will compete for control and price charts will show clusters of short price bars instead of big moves. 

On the downside, the most obvious such point is the old high around 2200. The market spent a lot of time last year hovering just below that number and it's roughly where the current rally started. It's a level where traders may have stop loss orders to get out if the rally fails and reverses. There are most certainly other levels below the current market. You should be aware of them as you plan your buy and sell orders. Even if you are a short term trader, it's good to remain aware of the larger landscape. 


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