New York – Chart-Based Trading Behind Big Market Swings

New York – Support levels. Moving averages. Breakouts.

That strange language is being spoken more forcefully on Wall Street these days. It is the language of technical trading, which is helping to drive recent wild gyrations in stock prices.

Within hours, stock prices have been leaping and falling in 300 and 400 point bursts.

Technical traders all but ignore fundamentals, such as corporate profits or expected growth rates. Instead they rely on stock-chart analyses that signal when to buy or sell the entire U.S. stock market.

In the absence of clear signs about the economy’s direction, more of Wall Street is turning to technical trading. When the charts say “sell,” a herd of sellers emerges, magnifying declines. If prices fall far enough, another wave of technical selling is triggered and the decline is intensified. At some point, a threshold is reached where the charts say “buy,” and stock prices get whipped higher.

“You have to have some idea of earnings and multiples for fundamental analysis,” said James Masserio, the head of equity derivative trading at Credit Suisse. “But now there is essentially no clarity on future earnings for the next 6 to 12 months.”

When traders can’t forecast the future, they turn to what has happened in the past. “Technical analysis at its heart is just a graphical representation of human emotion and psychology,” said Richard Ross, a global technical strategist at Auerbach Grayson, a New York-based broker. He says that price charts show that markets — and investors — follow reliable patterns.

A generation ago, volatility was measured in days. Now huge moves up, and then down, can happen in a matter of minutes. The moves are so fast these days because computers programmed to analyze charts are executing trades without any human intervention.

Technical trading is based on the idea that price history alone tells an investor all that he or she needs to know. Alternatively called chartists or technicians in the language of Wall Street, most investors who make decisions based on these strategies focus on the point level of the Standard & Poor’s 500-stock index, a broad index that represents about three-fourths of the total value of the U.S. stock market. Traders who want to buy or sell the S&P index during a trading day often use exchange-traded funds, which are essentially mutual funds that trade all day like a stock.

State Street’s S&P 500 fund, for example, is one of the world’s largest exchange traded funds with $76 billion in assets. Its daily trading volume has doubled over the last five days to 519 million shares exchanged, a sign that more traders are using it to track the S&P 500 index.

When evaluating when to buy or sell, chartists turn to a toolbox of over 700 different indicators. Among the most popular are noting the moving average of the S&P 500 index over the last 200 days and pinpointing the levels where it seemed to stumble before moving higher or lower. A recent low is called a support level, and a recent high is called a resistance level.

Chartists think that it’s a clear sign that the stock market is headed for additional losses when the S&P 500 index breaks past one of its recent lows. That happened last Thursday, when the index fell below 1,257. The S&P index had nearly touched this level — its closing price on December 31 of last year — during a sell-off in June. Passing through this so-called support level signaled for many that the market had lost its upward momentum. The index closed at 1,200 that day for a loss of 4.8 percent

Because technical trading strategies are built into many of Wall Street’s automatic computer trading programs, they can be self-fulfilling. During Monday’s sell-off, for example, the S&P index broke through a so-called support level of 1,172 shortly after 11 am Eastern. That triggered a second wave of selling that took the market down to another support level of 1,138 by 2 pm. The market then briefly hovered around this range, before finally closing 6.6 percent lower for the day at 1,119.

“The market was trading on technicals until the end, when panic took over and people wanted out and wanted out now,” said J.J. Kirnahan, chief derivatives strategist at T.D. Ameritrade.

Kirnahan thinks that the technical trading will account for the majority of the stock market’s ups and downs for the next few weeks. Traders will go back to looking at corporate fundamentals when they know what to expect from big picture issues like the European debt crisis and the direction of the U.S. economy, he said.

Some on Wall Street scoff at the ability of people — or computers — that employ technical trading to be successful for very long.

Joe Davis, the chief economist and head of investment strategy at asset manager Vanguard Group, thinks that chartists have a mixed record. He thinks that investors should focus instead on data like price to earnings ratios, a measure that shows how much investors are paying for a dollar in corporate profits. “The only thing that matters over a long period of time is the price that one pays for growth,” he said.

But chartists say that they are doing the average investor a favor. Charles Dow, the founder of Dow Jones and Company, is credited as the inventor of technical analysis. In the late 1800s, Dow said that technical trading strategies allowed small investors to compete with institutional investors even if they didn’t have access to the same information. A stock’s price behavior in the past could show whether a move up or down past a certain level would lead to a long-lasting change in its momentum, he said.

Ross, the global technical strategist, said that following the rules of technical trading would have saved investors a lot of money in the 2008 financial crisis. In what many technical traders considered a sell sign, the S&P 500 fell below its 200-day moving average of 1,324 the week of June 27, 2008. The S&P index remained near 1,300 at the start of September before it tumbled to 840 in October. It fell to a low of 683 in March 2009 before the start of the current bull market.

“Fundamentals have let investors down again and again,” Ross said. “Technical analysis doesn’t always work. But at the end of the day, you can’t deny charts.”