There are two primary forecasting methods used in the financial markets. The first method, fundamental analysis, relies on financial data such as earnings reports, price/earnings ratios and news releases in order to predict the future market direction. The other method, technical analysis, relies solely on chart patterns and other indicators based on price data. The theory behind technical analysis is that all relevant fundamental information is built into the price data.
A company’s earnings data is one of the major pieces of information considered in fundamental analysis. One important statistic is the earnings yield, which shows the percentage earned on every dollar that was invested in a company’s stock. A high earnings yield is considered a signal of strength. The inverse of the earnings yield is the price/earnings or p/e ratio. This ratio expresses the market price of a share/earnings per share.
According to technical analysis, various chart patterns are thought to repeat constantly and therefore serve as indicators of future price direction. Some of these patterns are as follows:
Double bottom: The price hits a market low, rallies back slightly, and bounces off the low again. This signals a rally.
Double top: Like the double bottom, except the price reacts twice off a market high. This signals a decline.
Head and Shoulders: The price makes a top, declines and then rallies again to form a higher top, then declines and rallies again to form a lower top. The trend line connecting the two lows formed by the declines is the “neckline.” When the price breaks through this line after the third top, it signals a decline. When this pattern is reversed and the price breaks above the neckline, it signals a rally.
Support and Resistance
Support and resistance are concepts that fall under the category of technical analysis. These are significant price levels calculated based on previous price highs and lows. Basically, if prices have reacted several times at the same price level, that price level is considered significant in determining future reactions. Traders sometimes use techniques such as Fibonacci projections (38.2%, 50% and 61.8% of a price range) in order to determine additional support and resistance levels.
Many technical indicators use price data to generate market forecasts. Arguably the most popular is the moving average convergence divergence (MACD). This indicator subtracts a long period exponential moving average from a shorter period exponential moving average. Then it creates another exponential moving average of the one that was just created, which is referred to as the signal line. When the original moving average crosses above the signal line this indicates strength and when it crosses below the signal line this indicates weakness.
Some studies have suggested that financial markets repeat in certain recurring cycles. One example is the business cycle, which measures growth and decline over five stages. Another example is the Kondratiev Wave, which claims to identify super cycles lasting from 50 to 60 years in capitalist economies. Some people feel that if they can identify which part of a cycle the market is currently in, they can accurately forecast future performance.