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Chart Smarts for Tough Value Investors
By Lynn Carpenter
This past week, Hari, an IDE Unplugged fan, said he’d like to know if there were some cues to follow to tell when stocks are recovering or getting worse. Well, yes … That’s the territory of the chart reader, the trader who revels in technical analysis. For instance, here’s something that happens to every value investor eventually. You buy a stock that’s priced right. The company is strong. Then all the sudden, everyone jumps on with you and sends the price to crazy levels. The company you liked at a price-to-earnings ratio of 18 is now at a P/E of 32, way over its fair value. A disciplined value investor might mark this stock for a sale. But he might also give up a ton of profits while the stock is still climbing. Using a chart can help you make the right decision. Because investors usually don’t know anything about technical analysis, many tend to use stop losses in cases like this. Typically they will sell if the stock falls 25 percent from its high. And that, to me, is just plain dopey. Why take a 25-percent cutback if it is obvious the stock has turned bearish by the time it is 15 percent down? Or eight percent? Or some other number? Also, why sell a stock when it’s 25-percent down if it makes moves like that and recovers all the time? A set stop loss is a money management tool for people who don’t have a clue about what else to do. A sharp long-term investor would just follow the company fundamentals. A real trader would use the chart. An investor who is already thinking it makes fundamental sense to sell can get the best of both styles by using chart skills to time his selling … and to ride his profits while he can. Today, and for the next three weeks, we’re going to have an “introduction to technical analysis for real investors” session. If you’re already a technical expert, this is going to be elementary stuff. But this doesn’t mean the tool is weak or only for beginners. Not at all. I use a bunch of technical tools in trading options - ADX, MACD, Bollinger bands, stochastics, and my favorite point-and-figure charts, to name some of them. But I still use trendlines. The best signals often come from this basic tool. In fact, if you were forced to have only one technical tool to use for the rest of your life, your best choice would be the foundation - trendlines along with support and resistance. Four Varieties of Lines You’ve seen charts with lines connecting high or low spots. These are trendlines. They come in four basic types: bull support, bear support, bull resistance, and bear resistance. We’ll cover each, one at a time. And since we are in a bear market and still watching more and more stocks break down, we’ll start with bull support line. This line gives you a way to tell if the stocks you own have gone into a death dance or are about to do so. The first thing you have to do is draw the line. Surprisingly, even pros tend to make mistakes in this simple step. Martin Zweig complained that his assistants were always running to him with a hot trade, showing a stock that broke a trendline, only they hadn’t drawn the line correctly. It’s pretty simple. Find the lowest spot on the chart. Put your ruler on it. Connect it with the next lowest spot (going ahead in time) and draw a straight line. That’s it. The dilemma come in whether you use bar or line charts, or pick the wrong lows. A line chart will show closing prices, and here’s how a bull support line would look on it:
You can see that when the price dropped in November 2007, it fell through the old bull support line. That was a good cue that the stock was turning bearish. As it worked out, it did fall a lot more. A person using a 25-percent trailing stop would have waited until the price reached $25 to get out. A chartist watching trendlines was warned around $27.50.
The new trendline is steep, and the price rise is even steeper. There’s a caution hinted at with this, too. When the price goes so far above bull support, it means there’s a lot of potential drop in it … without even turning bearish. Prices tend to drop toward the bull support line periodically. It could be a rough ride. But at the moment, the stock would not be turning bearish unless it fell to $20. Now let’s look at that bull support line again, this time with a candlestick chart.
Same stock, but slightly different information. The new support line comes to $18.80 instead of nearly $20. That means the stock has that much farther to fall before reaching its support line. In some charts, the difference can be sizeable. In the old support line, the difference was less, but it still would have saved investors about 20 cents if they exited right on the line. The bull support line is a foundation for an uptrend. No stock moves in a straight line, and when the price of a bullish stock falls back a little toward this line, those who aren’t in the stock yet see their chance to get a good deal. Every time the price reaches this point, the stock tends to attract new buying. In fact, that’s one measure of how reliable a bull support trend line is. The more times the price touches the line or comes close and turns back up, the stronger the trend. Eventually, this line will run out, but some bull support lines go on for years. This is especially true if you use a chart with a weekly or monthly price bar. If you are following a strong, long-term investment, do use at least a weekly chart to keep from running out too soon. A monthly is OK, too. What happens if the stock falls to bull support and no swell of new buying appears? The trend is over. That’s when you have a breakout. One extra word about using the bull support line. Be aware that even if you just started using this great tool, others already know about it. Many pros don’t bail the moment a stock goes through its bull support line because they know thousands of other investors are getting out as the stock approaches that price. Those traders are anticipating a signal, and their action may cause a temporary dip that gives a false signal. So you may want to wait for the next day or until the stock goes at least a couple percent below the line. There you have it - the basics of bull support lines. Now you can use it. When your stock is trading above a bull support line, it’s still bullish. Even if the price is falling. But when it goes through a well-established bull support line, it has probably turned bearish, especially if it follows through the next day. Next week, we’ll do bear support. That’s a really useful line with a whole different benefit to you. Respectfully, Lynn Carpenter P.S. To let me know what you thought of today's article, send an e-mail to: feedback@investorsdailyedge.com. [Ed. Note: Investor’s Daily Edge currently publishes eight investment research and options trading services, plus two that are soon-to-be released. The total annual value of these services is more than $10,000. Click here to learn how to get $77,020 Worth of Financial Research... Absolutely Free!. ]
Watch this Birdie
By Lynn Carpenter The two reports I care about in the slew that came at us this week are capacity utilization and core PPI (producer price index, a peek into inflation’s roots). They are worth watching because they speak to business conditions and give us a view into what’s going on at the factory level. These days, we really need help with that. Most of us investors are business owners, service industry people, or white collar types. Unless we live in a factory town with a good newspaper, we don’t have a clue what’s going on at the Nissan plant, the solar panel factory, or the steel foundry. Not until it’s late in the game and we read stories about layoffs, that is. Capacity utilization gets hardly any media attention except from economists. You might find it buried in a thousand bits of data in Barron’s or The Wall Street Journal. But you’ve never seen a headline such as “Capacity Utilization Hits Nine-Year Low!” You probably never will, not even with a sleek nickname to make it shorter - “CapUt” doesn’t have quite the catchy ring as “CapEx.” Or PPI, CPI, FBI, or ABCDEFG, for that matter. But the February number came out bright and early Monday, and I see possibilities. The headline might have been “CapUt Going Kaput?” The Brits would do it. Their newspapers have a lot more fun than ours. The number in the report is a percentage - how much potential manufacturing capacity is being used. Every station manned on every shift and no down time would be 100 percent. That never happens. The average for “total industries” for the last 30-some years has been 81 percent. The highest level was 85. The low was 76. That gives you some context. Now for current conditions ... For the past three months, the number has been falling, a sign that the nation’s manufacturing sector is running slightly farther below its full potential. But the total industries picture still looks good, at 80.9. The problem is that the mining industry is really strong (92), and that is covering some weakening elsewhere, as in manufacturing (79.3). This is still decent, though barely. And it is sliding toward trouble. When CapUt reaches 78 and lower, it is usually a sign the economy has slowed enough to worry about recession. At 75, you don’t have to worry. You know things are bad. Once again, for recession watchers, we’re not quite there on this scale. But we were definitely headed in the wrong direction as of February.
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