Resistance Is In the Eye of the Beholder

The market has had a heck of a run. And the higher we go the higher investors scale the wall of worry. The latest cause for concern, which has been mentioned prominently by technical analysts, is that the S&P 500 is at an area of significant resistance and that longs need to be cautious.

The S&P 500 was torched during the recent bear market, surrendering all its gains from the 5 year bull and more, undercutting the 2002 lows from the previous bear market. But price has snapped back impressively. A monthly chart shows that price is now beginning to penetrate an area represented by the bottom of the trading range that prevailed throughout most of 2004, which technicians are describing as resistance.

We all know the rote definition of resistance. It’s a prior price point on a chart above the current price. But ideally it’s more than a price point. One price point jutting out on a chart doesn’t really offer up much resistance when you think about. It’s a series of opens and closes within a general price area where there was a large amount of activity that serves the purpose. That creates congestion and indicates there are many holders of the stock from that level. That’s what we have on the S&P chart from 2004.

The widely held theory is that as price approaches this level from below those who got long the stock in the area of resistance, who have been holding the stock at a loss, will embrace the opportunity to get out even. Thus price will meet the resistance of this selling when it enters the area. It will need to push into the area a second or third time to flush out the weak hands before it can move higher.

Is this valid? Absolutely. But with myriad caveats.

The most important of these is the time factor. O’Neil’s market studies show that the effects of resistance begin to fade in as little as 12 months. And by 18 months resistance is no longer much of a factor.

Why is this? Because people tend to hold losers for only so long. After a period of time they take losses for tax purposes or look to move the money into an alternative investment. They come to terms with it. But it takes time.

In other words after a year and a half that “area of resistance” on the chart you are looking at is just a bunch of opens and closes with diminished significance.

Another way of looking at resistance, which might be peculiar to the current market, is to simply ignore it! The recent bear market saw massive forced selling as the country’s financial system was on the verge of default. While this might sound like an outlandish approach, take a good look at charts like BIDU and AAPL amongst others. These stocks simply plowed through rather recent resistance after hideous declines. It’s almost as if the buyers from the left side of those charts had disappeared into thin air. When you think about it many of them did.

However you look at it to our way of thinking the 2004 “resistance” on the S&P 500 has validity only in as much as traders are looking at it and acting off it. We doubt there are any holders from 5 and more years ago just twitching at the bit to exit break even.

But bear in mind enough traders keying off of a point they feel is valid will influence trading in the short term. Traders with a longer time horizon should tune out the noise.