Stocks and stochastics

Here's what this chart trading signal says about US stocks.

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On January 3, 2022, the S&P 500 hit an all-time high near 4,800. Since then, US stocks flirted with a bear market correction (i.e., a more than 20% decline). The tech-heavy Nasdaq has already plunged more than 30% this year, as has the Russell 2000. Soaring inflation, multiple rate hikes by the Federal Reserve, the war in Ukraine, supply-chain-related inventory problems, and other factors have overwhelmed generally resilient corporate earnings, driving stock prices down.

But if you think stock prices have come down to a level more aligned with their intrinsic value and may trade in range over the short term while these risks remain in focus, then stochastics—an indicator that is used by chart analysts for market signals—might suggest active investors could be cautiously optimistic over the short term.

What are stochastics?

Similar to the relative strength index (RSI) and moving average convergence/divergence (MACD), stochastics are a momentum measure that ranges from 0 to 100. The reason why momentum indicators like stochastics are considered more useful in sideways markets, compared with uptrends or downtrends, is due to the nature of the way they oscillate between relatively overbought and oversold prices. If you add this indicator to your charts, stochastics can typically be found beneath the price chart (see Stochastics applied to the S&P 500 below).

Stochastics is actually made up of 2 lines, which tend to move in tandem. %K (blue line in the bottom half of the chart above) represents the level of the stock or index's closing price relative to the high and low range over a specified period of time, and %D (black line in the bottom half of the chart above) attempts to smooth out the %K line by taking a 3-day moving average of the %K line. Consequently, %D is generally considered the more important of the 2 lines.

The theory behind stochastics is that these lines generate buy or sell signals when closing prices are near recent extreme highs or lows (i.e., sell signals after an uptrend and buy signals after a downtrend). Note that the time frame you pick when using stochastics, or other indicators/fundamentals, is at your discretion, and there is no consensus view as to what time frame optimizes stochastics.

Generally, the area above 80 indicates an overbought region, while the area below 20 is considered an oversold region. When stochastics is above 80 and moves below that number, it indicates a sell signal. When stochastics is below 20 and moves above that number, it indicates a buy signal. 80 and 20 are the most common signal levels used, but can be adjusted per individual preferences.

What are stochastics saying about stocks now?

Looking at the chart above of the S&P 500 with slow stochastics applied, both the %D and %K line dropped below 20 on April 11, generating a buy signal. Since then, stocks have continued to decline, for the most part, and stochastics for the S&P 500 have risen above and fallen below the 20 level several times. Short-term investors who like using stochastics can continue to look for it to drop below 20 and rise above that level for a buy signal. 

There is reason to think the most recent stochastics decline below and subsequent rise above 20 could be giving a more optimistic signal than prior signals. Both stochastics may have recently formed what could be a potential triple bottom, which is a bullish reversal signal. After bottoming 3 times since mid-April, both stochastics broke above 30 by May 17 (%K is near 25 and %D is near 32, as of May 19).

Another pattern that can be observed when using stochastics is a divergence between the direction of the stochastics indicator and a stock or index, such as the S&P 500. Divergences form when a new high or low in price is not confirmed by a new high or low in stochastics. A bullish divergence, for example, forms when price makes a lower low but stochastics forms a higher low. This could indicate less downward momentum and could foreshadow a bullish reversal. This has not occurred recently, as both the S&P 500 and stochastics have made lower lows in recent weeks (although stochastics has made higher highs). It may be worth monitoring over the short term to see if there is a divergence.

Stochastics in context

It's worth noting that, once a trading signal is generated by a technical indicator such as stochastics, that doesn't necessarily mean that signal (to buy or sell) stays in effect until a contrary signal is generated. Rather, they can be thought of as a trading indicator that is relevant for a short period of time (e.g., a few days) after it is generated.

Also, momentum indicators—including stochastics—can remain above 80 in overbought levels for extended periods after an upturn, without indicating that the security is becoming more overpriced. Similarly, stochastics can remain below 20 in oversold territory for extended periods after a sustained downtrend, without meaning the stock is becoming more oversold.

Of course, you shouldn't take a trading action based solely on this one signal. Like any technical indicator, stochastics is best used in combination with other technical indicators, such as volume trends, as well as a macroeconomic analysis of the market and business cycle, and, if used with individual stocks, an analysis of earnings and more company fundamentals.

More importantly, ongoing developments with inflation, the war in Ukraine, the pace of potential rate hikes, and lingering effects of the COVID-19 pandemic remain the most impactful factors to watch.

Next steps to consider

Find new investing ideas and get up-to-the-minute market data.

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