The first graph (just below) makes a powerful point. While the UK stock market has steadily risen in recent months, it has been unable to rise above a well-defined point on the chart.
Chartists call this line a resistance line.
There were seven attempts to rise above this line in the last eight months and seven failures. Assuming the current rally continues, the graph hints prices will struggle once they rise to the resistance line which is just two per cent above current levels.
Might the next attempt to penetrate resistance be successful? Of course it is possible. But inflation continues to worry the Bank of England. Interest rates are rising. The affect on real estate is yet to be felt. Each of these issues warns of possible trouble ahead.
Assuming shares do manage to rise above the short-term resistance line, our next chart shows an even stronger barrier to further advancement.
Note that the UK stock market has fluctuated within a well-defined rising trading channel for more than four years. Several short-term spurts and temporary bouts of weakness since March 2003 define the upper and lower boundary lines of the channel.
The top of the channel is approximately four per cent above current prices. As experienced investors are well-aware, no investment trend runs forever. So it is safe to assume that prices will eventually break out of the channel, either by penetrating its upper or lower boundary.
A graph like this one forces investors to consider three key questions. (1) How much longer will the UK stock market remain within the current channel? (2) When a breakout occurs, will prices rise through the top of the channel or fall through the bottom? And finally, (3) once a penetration occurs, how big will the subsequent price shift be?
A search through 40 years of UK daily closing price data provides some useful insights into each question.
There were dozens of channels during the last four decades. But the majority either ran for a very short period of time, drifted sideways or were declining trends. Only 14 rising trading channels (like the one shown above) ran for at least one year.
The most striking observation about these 14 channels is that 13 ended within two years. The only exception to the rule was a 35-month long channel that ran in 1994-1997.
Historical statistics like these offer no guarantees for the future. Even so, history signals the current channel which has been in place for more than four years is clearly long-in-tooth. If the past is any guide, the channel is quite ripe for a decisive penetration.
Which leads to question number two. Once a channel breakout occurs, which side is more likely to be penetrated, the top or the bottom? Here too, history offers useful insights.
Only two of the 14 channels ended with a break to the upside.
In other words, there is a 14 per cent chance of a breakout through the top of the channel. For those who hope for an optimistic result once the current trading channel ends, history suggests they are betting on a long-shot.
Several interesting similarities link the two exceptions to the rule.
The first rule-breaking channel ended in 1986. After rallying for several years, share prices suddenly began to increase at an accelerated rate. Prices penetrated the top of the channel and continued to rise for another 14 months until July 1987. The decline that followed ran for four months and included that year's October crash.
Exception number two ended in 1997. Once again, a super-charged post-channel rally ran for one year before running out of steam. The trigger was a collapse of the Long Term Capital Management hedge fund and Russia's bond default. When the smoke cleared in October1998, shares had declined by 25 per cent in just three months.
In retrospect, both exceptions to the rule continued for one year after the channel breakout occurred. Each was boosted by excessive optimism about the future. Momentum players added to the buying pressure, believing they could quickly step aside once the explosive post-channel rally peaked. Anecdotal evidence suggests many were badly hurt during the subsequent sell-off. In fact, their panic selling probably contributed to the severity of each post-channel drop. It helps to explain why both declines were so rapid and steep.
No one knows if the current channel will eventually become the third exception to the rule. But a slowing economy on both sides of the Atlantic, high oil prices, rising interest rates, real estate concerns, middle-east unrest, weak US political leadership and a host of other concerns suggest little support for this eventuality.
Each of the remaining 12 channels ended with a break through the bottom of the channel. Ten of the 12 delivered declines in excess of 10 per cent after the bottom of the channel was penetrated.
The two weaker declines were associated with extraordinary events. A potentially serious mid-year decline ended in September 1992 immediately after the UK was ejected from the Exchange Rate Mechanism. A powerful rally kicked in once investors realised a weak pound and low inflation had positive economic implications. A second small post-channel dip occurred in1983 during one of the most powerful bull market advances of all time.
In other words, history signals that it takes very extreme economic circumstances to keep post-channel declines from falling more than 10 per cent.
If history is any guide, this trading channel is worth monitoring very closely.