The UK stock market has fluctuated within a well-defined rising trading channel for more than three years. As our graph illustrates, several short-term spurts and sudden sell-offs since March 2003 defines the upper and lower boundary lines of the channel.
Nothing runs forever in the world of investing. Experience teaches that all trading channels eventually end. Prices will break out of the channel in due course by penetrating the upper or lower boundary.
Graphs like this one force investors to focus upon three key questions. How much longer will the UK stock market remain within the current channel? When a breakout occurs, will prices rise through the top of the channel or fall through the bottom? And finally, 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 that came and went during the last four decades. But the majority either ran for a very short period of time, drifted sideways or were in a declining trajectory.
There were only 14 rising trading channels (like the one shown above) that ran for at least one year.
A thorough examination of these 14 channels provides some thought-provoking information. For one thing, they typically ended within two years. The only significant exception to the rule was a 35-month long channel that ran in 1994-1997.
As experienced investors are well-aware, a statistic like this one offers no guarantees for the future. Even so, history clearly signals the current channel which has been in place for three and a half years is clearly long-in-tooth. If the past is any guide, the channel is quite ripe for a decisive penetration.
Once a breakout occurs, which side of the channel is more likely to be penetrated, the top or the bottom? Here too, history offers useful insights.
Most important of all, only two channels ended with a break to the upside. In other words, there is merely a 14 per cent chance of a breakout through the top of the channel. For those who hope for an optimistic result once the 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 October 1998, shares had declined by 25 per cent in just three months
In retrospect, both exceptions to the rule continued for one year. 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 of these traders were badly hurt during the subsequent sell-off. In fact, their panic selling probably contributed to the severity of each drop. It helps to explain why both post-bubble 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, middle-east unrest, weak political leadership and a host of other economic and governmental concerns suggest little support for this eventuality.
The remaining 12 channels each ended with a break to the downside. 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 the positive implications of a weak pound coupled with low inflation.
A second weak 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.
As far as 2006 is concerned, the lower limit of the current trading channel is near 5600 on the FTSE-100, not too far from current levels. If history is any guide, this price level is worth monitoring very closely.
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