December 9, 2008: Basic Technical Analysis
December 9th, 2008
Have you ever bought or owned a stock whose fundamental picture was wonderful only to scratch your head while the stock traded down seemingly every day? You recall that the broker who sold you the stock told you about how the analyst community loved the stock and how the company’s management team is a proven winner. So you hold as the value drops. Your broker reminds you when the stock is down 10-20% from your purchase price that “normal and healthy” corrections happen and you should buy more. So you do. Then, the analysts who loved the stock begin to downgrade based on a “business-mix shift” or “valuation” or a key management departure. Then the stock goes down more and your broker calls and recommends selling that stock because this new stock is so much better. …and the cycle begins again.
If this is you, don’t worry. It is widely known in the professional ranks of traders that approximately two/thirds of all trades are losers!!! That key among professionals is to very quickly recognize when a trade is going against them. Once the trade has reached a pre-determined loss, they sell….no questions and no exceptions. Where do they get their price triggers? Technical analysis. I want to identify five technical analysis disciplines that most professionals use to help protect their capital AND to know when to enter or exit a trade. These are simple to use and can help significantly improve your trading results.
- Key Moving Averages
- Trend Lines
- Trend Channels
- Retracements
- History
Key Moving Averages
Moving Averages refer to an arithmetic average of closing prices for a number of days (or weeks) in recent history. The intent of a Moving Average is to “smooth” the price trend to help discern a reliable long-term trend. For example, a 10 Day Moving Average takes a simple average of the closing prices from the most recent ten days and produces a price point. If the current price is below the 10 Day Moving Average, momentum is thought to be weak on a very short-term basis. Likewise, if the current price is above the 10 Day Moving Average, momentum is thought to be strong on a very short-term basis. Probably the most important and widely followed Moving Average is the 200 Day Moving Average. 200 days is approximately the number of trading days in a year. We most closely monitor the 10 Day, 50 Day, and 200 Day Moving Averages.
Trend Lines
One of the central strengths of Technical Analysis is that this approach focuses on price performance. When a stock is trending up, a consistent series of higher price lows and higher price highs will be produced. This means the stock will continue attracting buyers at increasingly higher prices as sellers keep trying to sell at increasingly higher prices. Buyers get more aggressive and sellers become far less aggressive. Drawing a line beneath the price lows of this series generates an uptrend line. One of the most reliable signals of when there has been a significant change in investor psychology is when such a trend line is broken; when sellers go from passive to aggressive and buyers start becoming scarce. Using basic trend lines is a simple and effective way to quickly assess prevailing market psychology on a short-term and long-term basis.
Trend Channels
A trend channel is created when a parallel line is drawn from a single trend line. This can be used to estimate a trading range or to pin-point entry and exit levels in a trending stock. As a trend accelerates, the magnitude of higher lows should reasonably match that of higher highs in the trend. A breakout through the upper channel boundary or down through the lower channel boundary is a loud and clear warning signal that a major change in investor sentiment has taken place.
Retracements
Traders constantly search for logic and reason in an illogical and irrational world. When I traded for a portfolio management team who managed $7 Billion in mutual funds, the question would constantly be asked, “What’s going on with ABC stock or why is DEF stock getting blasted when the group is doing okay?” These questions were from very smart people who analyzed financials statements, company management, etc. Rarely, was there an answer that adequately explained the stock’s aberrant behavior. A favorite tool of professional traders is to explain trading behavior through percentage retracements. If a stock has experienced a major rally, peaked, and then begins to trade down, breaking down the rally into percentages can many times provide technical “hurdles”. A commonly-used retracement methodology is Fibonacci. This approach breaks down trends into 38.2%, 50%, and 61.8%. Once a trend has reversed, likely counter-trend targets are at these these levels. For example, if a stock rallies from 20 to 35, stalls and begins to trade lower, traders try to come up with potential downside risk. In a healthy uptrend, a 38.2% downside retracement is considered normal. So in our example, a pull-back to 28.27 is considered a reasonable corrective move. 27.5 is a 50% retracement and this level is viewed as the difference between a correction and outright reversal. 25.73 is a 61.8% downside retracement and that is the proverbial “line-in-the-sand”. A downside violation of 61.8% of the previous trend implies that the previous move was somewhat “false” and a full 100% reversal is generally expected.
History
This is the single biggest difference between fundamental and technical analysis…the usefulness and application of past prices in current analysis. We believe that history is an invaluable tool in assessing the current strength or weakness of a stock in its current trend. While there are many glaring examples of this, the best one is in the S&P 500 (SPX). On March 24, 2000, SPX peaked at 1553.11. After a volatile five month period, the index tried in nine different days to break above 1520. Each attempt failed and on September 5, the index began a downward acceleration that took the index to 768.63 by October 10, 2002; down 50.51% from its 2000 peak. Fast-forward to 2007. In July and again in September, the index challenged 1553 as resistance. At the intraday peak, the index reached 1576.09; 1.48% above the 2000 peak. Five months after the first serious challenge of 1553, the index rolled over and began to accelerate lower in early December 2007. From peak to trough (so far), SPX declined 52.98%. History showed that 1553 was a potential major peak and while that did not catch THE absolute top, using history as a guide would have produced a variety of sell signals long before “the street” turned the least bit cautious.
In summary, the above five tools are only a small sample of technical analysis “tools” that we use get independent, unbiased research conclusions on stocks and/or indexes. They are simple to use. The best thing about using these types of tools is that they reveal what investors are DOING, not what they are SAYING.
December 5, 2008: Mid-Day Impact for the Russell 2000
December 9th, 2008
12-5-08
Russell 2000 Impact at Mid Day
Winners
THOR; up $3.02 to $27.77
Yesterday after the close, THOR reported that “an interim analysis of a late-stage study showed its HeartMate II device to be statistically superior to an existing heart pump.” The stock opened up 8.28% and by shortly after 11:00, the stock was at 29.08; up 17.49% from yesterday’s close. While this news may be a total game-changer for the company, the chart suggests a bit of caution. On September 19, THOR peaked at 29.72 and fell 36.44% over the next three weeks. Then on October 17, the stock rallied to 29.50 and fell 37.29% by November 21. If this move is “real”, THOR will rally up through 29.72 and hold above that level on a retest. Until that happens, we must recommend a defensive approach to THOR and would be a seller into this move.
MSCC; up $1.10 to $12.43
From the close on December 2 to the low on December 4, MSCC fell 43.65% on reports that the company’s CEO “misrepresented” his degree from BYU. Last night after the close, the company said that the CEO has the board’s full support and that the board is reviewing the CEO’s academic credentials. Volume on the 43.65% decline was extremely heavy suggesting that investors are very willing to sell the stock; even on un-verified data. However, on a technical basis we think the selling was overdone and would buy MSCC. We think the stock can recover to the 17-18 area in the near-term.
AHL; up $1.63 to $20.58
No company-specific news. The stock is likely trading up in sympathy with HIG (guided higher this morning). Since November 21 when the stock set its 2008 low at 13.53, AHL has rallied 53.48%. 21-23 is major resistance and we would be selling into this rally. In our view, AHL has near-term risk to the 13-14 area.
Losers
CXO; down $1.19 to $16.92
CXO is scheduled to present at the JP Morgan SMid Cap conference today. Whatever the company said, investors did not like it and sold the stock down below the three previous reaction lows going back to October 10. The decline, however, reversed above the reaction low from October 2007 of 14.30. We believe CXO now presents an attractive risk-reward scenario. We believe that CXO can recover to the 22 area before encountering significant resistance.
ENER; down $2.74 to $23.08
A fundamental analyst downgraded ENER to underweight from equal weight this morning and investors apparently agree with the analysis. With the stock being down 68.98% from August 28, 2008 to yesterday’s close, investor psychology was/is very tentative. We believe that ENER is quickly becoming over-sold. November 21 and 24 were the only two days in 2008 during which the stock traded below 20. November 20 was also the first day since June 25, 2005 that the stock was below 20. In our view, ENER can be bought with a near-term target of 36. We recommend a stop-loss of 19 on long positions.
CBST; down $1.65 to $26.33
An analyst downgrade (market-perform to underperform) this morning produced a decline of 11.79% from yesterday’s close to today’s session low at 10:45 this morning. CBST is still being directly influenced by a massive downside gap that occurred on January 1, 2002. That day, CBST gapped down 45.73% from 31.51 to 17.10. Yesterday, CBST reached 28.74 which is the 2008 high and also the highest price since the 2002 gap formed. Until that gap is “closed” by the stock trading convincingly up through 31.51, we strongly suggest a cautious/negative approach to CBST and think there is risk to at least 19-20.
October 8, 2008: S&P 500 Index
October 8th, 2008
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The Fundamentals of Technical Analysis
December 26th, 2007
A basic definition of Technical Analysis is as follows: Technical Analysis considers all public information about a stock to be discounted and reflected with each trade. Said another way, Technical Analysis looks for the clearing price of supply and demand to determine a stock’s value.
The over-arching goal of investment analysis attempts to predict stock prices. Many well-read and widely followed academics insist that one can glean clues from financial statements, management meetings, or other pieces of company-specific information to ascertain the future direction of a stock’s price. These people fall squarely into a fundamental analysis mindset. At its core, fundamental analysis is really trend and psychological analysis. Looking through a multitude of Financial Statement ratios, industry data points, and corporate management’s statements, Fundamental Analysts strive to synthesize these data to determine if, when combined, the avalanche of data will be net positive and inspire buyers or net negative and inspire sellers. Earnings TRENDS, sales TRENDS, and the like help the fundamental analyst develop a picture of strength or weakness.
The Technical Approach looks far more closely how investors respond to the known information about a stock; by buying or selling. While a Fundamental Analyst looks at earnings trends, and earnings-related ratios to form an opinion on a stock, a Technical Analyst looks at how “the crowd” responds to the data and forms an opinion accordingly.
Where the disciplines most widely diverge is when it comes to history. Fundamental Analysts rely heavily on “forward looking statements” which are estimates for future quarter and years regarding sales, earnings, and other company-specific projections. This approach largely ignores history. Recall some of the historically bad stock declines witnessed during 2000-2003. These declines largely occurred with the majority of analysts having “buy” or “strong buy” opinions on the stocks. The future looked, at least according to what management said, stronger than ever. Many of these stocks are now considered vulgarities in Fundamental Analyst circles. The two classic examples of widely-loved stocks are Enron and Worldcom. These were Wall Street darlings until the filed bankruptcy and many of key leaders were convicted of fraud and given significant prison terms.
I point these stocks out because they were indicative of the last phase of any Bull Market Trend….greed. Alan Shaw, one of the pioneers on Technical Analysis, wrote in the Financial Analysts Handbook, 2nd edition in 1988, that markets (and stocks) travel in three-phase trends. Bull trends consist of DISBELIEF, BELIEF, and GREED. Bear trends consist of DISBELIEF, BELIEF, and FEAR. If ever greed was apparent, it was the six month period between October 1999 and March 2000. Given the severity of decline after the market peaked in 2000 and that many indexes are in close proximity to their price peaks from 1999-2000, there is at least reason for caution today if not outright bearishness. Below are basic descriptions of each trend phase.
Bull Market Phases
Disbelief
After a bear trend has been going on for a long period of time, investors simply get tired. No news is good news and the media (along with Wall Street) recognizes that the markets can’t seem to rally for any sustainable length of time. Magazine covers and newspaper (physical or virtual) headlines are dominated by Armageddon-esque scenarios that are calling for multi-year declines in major averages. Investors load up on high-dividend yield names and look for “recession proof” names. Investors simply do not believe that, despite price stability in major averages, the current downtrend could possibly be over.
Belief
The markets have largely rallied several percentage points (10-15%) from higher reaction low established and the extreme low. Investors begin to think that the proverbial toe that they stuck in the water may not, after all, get bitten off. Increasingly, reaction to news becomes more logical. Constructive-sounding corporate news is met with cautiously optimistic buyers who maintain that they are ready, at the first sign of trouble, to bail out of bad positions. Economists and Strategists begin to roll out tentative growth projections. After being largely wrong in the Disbelief phase, here the prognostication community as a whole is feeling their collective predictive ability coming back to them and they begin speaking a little more regularly. Typical to this phase is the widespread recognition of the recession or bear market were just came out of.
Greed
All news is good news for the major averages. Earnings misses, negative surprises, or otherwise bad corporate news are immediately spun to be buying opportunities. Regardless of the nature of the news or the severity of that news, if it makes a stock go down, it is assumed that the decline is not a long-term shift and likely a “one-time event”.
On the Economic front, any data that is pro-growth, even modestly inflationary, is just fine. Common to this phase is a growing belief that the “old rules” don’t apply. Typical talk is about departure from the way markets used to function or a new paradigm in investor behavior. All the while, the major averages stop going up and start to consolidate. Volatility increases to a fever pitch as investors furiously bet that the current environment is a mere stepping stone into a new era of investing.
Bear Trend
Disbelief
As the Greed phase of a Bull trend wears on and money managers who have had a cautious or defensive approach are getting fired or forced to change their archaic approach, investors see the averages and a growing number of stocks fall into a drift. There are fabulous rallies followed by rapid declines that net very little movement. Increasingly, an ultra short-term mentality begins to color the market. The major averages start having “corrections” close to historically significant prices that generated large declines. These corrections quickly attract because the markets simply can’t go down….there’s way too much good news out there.
Belief
Gradually, rallies do not quite reach recent rally highs and trading volume begins to increase on price declines and decrease on rallies. Fewer and fewer stocks are holding in their up trends and are beginning to test past levels of support. Price corrections start to last a bit longer and reach a bit lower. Investors start talking about the long-term benefits of diversification as they openly discuss the risks and ‘age of the bull market”. The fundamental community begins to recognize that the market went up for a long time (or a large percentage amount) and may need some time to “digest gains”. Meanwhile, investors start insidiously focusing more on bad news potential than good news potential. As the major averages begin to break down through past support levels that previously held up on sell-off attempts, the media and analyst community start publicly acknowledging the prior bull market and maybe having ended.
However, they assure, if we take a long term view (since 1900), the markets ALWAYS go up. So these corrective moves are healthy.
Fear
The polar opposite of Greed in a bull phase, all news here is construed as bad news. Recall that in the Disbelief phase of the Bull trend, there was an overlap with the Fear phase of a Bear phase. The early phase of Fear is marked by the market reaching for new multi-year lows and the consensus of predictions is for much more pain before the “worst is over”. As the few remaining hold-out Bulls begin to turn Bearish (cautious is usually the strongest negative from this group), the major averages seem to accelerate lower with each passing day. Analysts and the media are increasingly suspicious of the accuracy or validity of earnings reports and subsequent guidance. Also, in a broad sense, trust worthiness of corporate leadership starts to get questioned. Just when things seemingly cannot get worse, they get worse…again and again. This phase silently morphs into Disbelief of the next Bull Trend and the entire process starts again.
Another excerpt from Shaw’s writing in the 1988 Financial Analyst’s Handbook summarizes the Greed and Fear categories quite well.
Stock (and market) trends often tend to accelerate at or near the end of a move. On the upside, the acceleration of demand can be likened to the, “everyone’s got to own ‘em stage. On the downside, the familiar climactic “washout” occurs. These respective trends we also refer to as the greed and fear stages.