Monday, December 5, 2011

Relating Charts to Market Analysis

Here is another article I wrote for Scottrade way back when (Jan 2010). Again, I figure the statute of limitations has run out for an article I wrote for free so here it is - for novices.
To many investors, technical analysis is either an unknown world or something rather suspicious. However, even for the skeptical there are many benefits to be had. The most important is simply figuring out if your stock or the market as a whole is in a bullish or bearish trend. 

Why is that important? Knowing the trend dictates the strategy. For example, in a bull market, traders buy dips while investors may simply buy and hold. Certainly, the latter was a great plan from 2003 to 2007. It did not work so well in 2008 when the bear market was in full force.

Charts Simplified

Let's talk briefly about what technical analysis, or just simple charting, is all about. First, analysts of all types use charts even if they shun technical analysis. What is always reported in the news? The trend in employment, earnings growth, projected sales and the Fed funds rate. All of these data are displayed in chart form to show how they have changed over time. 

Charting stock prices is no different. With one picture, we can see where a stock has been so we know right away if the current price is relatively cheap or expensive. Clearly, saying a stock has a price of $50 is meaningless if we do not know if it traded at $40 or $60 last month, or if we do not know if earnings have been growing at the same rate. 

Historical Analysis with Charts

When the stock market peaked in October 2007, analyst estimates for earnings were still strong and everything seemed to be status quo. Buy stocks, watch them go up, sell at a profit. Not bad.
Further, market psychology, or attitude, was very good. After all, the market survived the extreme sell-off of August 2007 when news of the sub-prime mortgage crisis broke. The Standard & Poor's 500 shook it off and rallied to new highs in short order. 

So, when prices pulled back again in November of that year, it appeared to be another buying opportunity. Good stocks were on sale again, but this time, price gains did not last. The market sold off again in December, and that time, there was no new high first. Something was different.

When prices slid below the panic lows of the previous August, chart watchers knew the trend had changed. The strategy had changed from buying dips to selling rallies; essentially a plan for getting out of the market.
What really had changed? The fundamentals were still good. Analysts still maintained buy ratings. Bear Stearns and Lehman Brothers were still alive and well.

Simply stated, the market was in a declining trend. Rallies were sold earlier and declines had to extend lower to entice demand, and that is what happens in bear markets. 

Conversely, at the March 2009 low, the fundamentals looked very bleak, but stock prices started to rise. It is hard to justify, even in hindsight, that the price chart said the trend had changed to a bull market (there were other technical reasons, however). But for investors missing the March to June run, they got their signal in July. After a rather sizable pullback, prices moved on to new highs. Stronger rallies and quick, shallow pullbacks became the norm - exactly the opposite of what happened in 2008.

Charts & Trends

Clearly, simple chart reading will not point out major tops and bottoms as they are happening. However, the market will often tell us sooner rather than later when the existing trend is over, and the best way to read any possible signals is to read and analyze basic price charts. 

The charts may signal the end of a rising trend when conditions become similar to those of previous bull markets. Rallies usually become weaker and pullbacks may have to go lower to entice buyers. There is no magic bullet for reading charts and using them to anticipate trends - if there were, we would all be rich. Different analysts interpret charts different ways, and it's up to you to do your own analysis and decide where you think the market is going.

As they say, the trend is your friend. Finding the trend, not predicting the future, is the goal. Once that is done, investors can use the trend to help them decide to hop on for the ride or simply step out of the way.

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