The Meaning of Charts
6 Tips for Better Investing
“Defensive Growth” Stocks in Favor
One of the advantages of using stock charts and technical analysis (along with fundamental analysis) is that few other investors do, or at least, few know how to correctly interpret them. Heck, most bigwigs in the industry still ridicule the practice of using stock charts-that’s why most of the big brokerage houses have a few dozen industry and economic analysts, but zero technical analysts.
However, with the spread of the Internet, more and more investors are being exposed to charts, which is good. But that also means the financial industry can gain more web page views by writing headlines (and bare bones articles) about the chart of XYZ stock. So as we poke around the Internet, we see headlines like “Why XYZ’s doji reversal is an ominous sign” and “Will this death cross put XYZ out cold?” Even someone like me who knows better will end up clicking on a bunch of these to see what they have to say.
And, actually, it can’t hurt to click all you want on these types of articles; maybe there will be a tidbit here or there that can help. But today, I want to briefly write about some things to keep in mind if you read these types of articles, and what we think of them.
The biggest thing to remember when it comes to stock charts-at least the way we practice them-isn’t all the exotic-sounding patterns (doji, catapults, head-and-shoulders, engulfing days or weeks, etc.) and what they mean. Instead, charts simply reflect supply and demand in action, i.e., whether big investors are accumulating or distributing the stock.
One of the best ways to determine accumulation or distribution is simple-look at the stock’s trend. If it’s generally heading up (especially if it’s outperforming the market), big investors are buying. Simple, right? But such simple, time-tested advice doesn’t generate clickable headlines!
Of course, there’s more to it than just trend, but between trend, volume patterns and relative performance, you have 90% (or more) of what you need regarding charts.
The other thing I want to say is that, by their nature, these articles tend to be short-term in nature; they’re creating a sense of urgency and drama … that something important has happened today. But except for the occasional earnings gap or meaningful breakdown through key support (or breakout), it’s rare that a single day truly changes a stock’s overall, intermediate-term picture.
Lastly, I’ll just say that no matter what you’re dealing with in the market, once a factor becomes well known and much talked about, it usually stops working as well. I remember reading about golden and death crosses (when the 50-day moving averages crosses above (golden) or below (death) the 200-day moving averages) when I first began learning about charts. The history of such signals in the market was pretty good for many years.
But starting about six or seven years ago, I began reading about these signals all over the Internet; most recently, the small-cap Russell 2000 had a death cross a few weeks ago. The really interesting part is that, when it happened, I read a study that showed for the past 25 years, buying the so-called death cross-which is supposed to be a bearish event-was a hugely successful trade!
Don’t get me wrong. All of us in this industry live in glass houses, and I’m not trying to make it sound like our advice is the gospel and others’ are worthless. But when it comes to charts, it’s important to have the right perspective-technical analysis should be something that helps give you a clear reading of a stock’s standing, not something that adds confusion!
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With Thanksgiving and a long holiday weekend coming up, it’s a good time to do a little “self scouting.” Like an NFL team during its bye week, when you have some time off, it’s often fruitful to go over the basics and tighten up any issues that might have cropped up in your trading. These issues, by the way, happen to even professional investors.
In recent weeks, I’ve heard a bunch of good questions from investors who, knowingly or not, are engaging in some self-scouting. And I thought it would be helpful to relay some of the common issues (and solutions) I’ve heard so far.
First, a lot of sins can be overcome with proper position sizing and loss limits. I’m not going to get into it all here, but if you’re investing too little (1% of your account) or too much (35%) in one stock, or have stops that are too tight (3% off a volatile stock’s peak) or loose (25%), your results are going to suffer-you’ll either have trouble sitting through normal volatility (if stops are too tight or positions are too big) or not make any real money (if your position is too small or you take some huge losses). The lesson is to be consistent and to be comfortable with what you’re risking ahead of time.
Second, have a plan-where you’ll buy, how many shares, and then some rough guideline of what would cause you to sell (profit target, loss limit, 50-day moving average, etc.). We can never completely remove emotions from trading, but if you live and die with every medium-sized move in your stock, it’s going to lead to some bad decisions.
Third, when the going gets tough … go smaller. There’s nothing wrong with buying half or two-thirds as much as you would normally (dollar-wise) if you’re in a rut. That way you’ll be in the game but less exposed.
Fourth, know the characteristic action of your stock. If a stock moves around, say, 3 points per day on average, you can’t panic if the stock is down 3 points on the day. Conversely, if the same stock falls 20 points over three days, that’s probably not normal. This sort of gets back to the position sizing comments above, but the point is to give the stock room to breathe … but not so much room that you ignore a breakdown.
Fifth, diversify, but don’t overdo it. I heard from one investor who owned something like six different energy stocks at one point … yet owning small positions in six names in the same group didn’t prevent him from getting nailed when oil stocks went over the falls. In fact, it’s often easier to bail on one or two larger positions than five or six smaller ones. You really only need one leader in a few different groups to be diversified.
Lastly, be careful of “style drift” where you drastically change your approach based on your past month’s worth of trades. “But Mike, you always tell us to tweak things to improve our trading!” That’s right, and tweak is the key word-slightly shifting or improving your game plan is great. But going from, say, buying stocks in uptrends to buying only dips, or moving from an intermediate-term trader to a day-trader, usually causes more trouble than it’s worth.
Hopefully you’re having a fantastic year and are printing money and just need to keep doing whatever you’re doing. But even if that’s the case, it’s possible one or two of the above points could help you do even better going forward.
As for the current market, after an amazing three-week snapback from the mid-October lows, we’ve finally seen some selling pressure emerge. The selling hasn’t been seen so much in the major indexes, but under the market’s hood, where there’s been a rolling pullback, so to speak, with a sector or two getting hit every couple of days.
You can usually tell a rally’s fortitude (whether it’s the market as a whole or an individual stock) by how it handles its first pullback after a breakout or big thrust higher-a deep retreat tells you the prior dip didn’t shake out enough of the weak hands, while a tight, calmer pullback indicates big investors are generally accumulating shares.
Given the fact that the selling pressures on the current market have been contained, I remain bullish and optimistic; I still believe the odds favor higher prices going forward. That said, I’m also not flooring the accelerator yet, and have been spending extra time going through various screens to really get a feel for what’s working.
Interestingly, to this point I’m seeing a lot of what I call “defensive growth” stocks do well-auto parts retailers, some managed care firms, REITs, defense contractors, stuff like that. Yes, there are some real growth stocks doing well, too, but some of the most powerful straight-up moves since mid-October have come from the defensive groups.
Because our screens for Cabot Top Ten Trader focus on finding stocks showing unusual recent strength (as well as a few other qualifiers), a bunch of these names have appeared in Top Ten since mid-October. One I like is a firm called Allison Transmission (ALSN), which has a unique story and is spinning off a ton of cash. Here’s what I wrote about the company in Top Ten on November 10:
“We’ve seen a variety of auto-related stocks show extraordinary action since the market low in mid-October, and Allison Transmission-the largest maker of fully-automatic transmissions for commercial truckers, as well as hybrid systems for buses and other products-is one of them. The stock is strong today for three main reasons. First, of course, is the bullish outlook for the entire auto industry; with the economy picking up steam, demand is accelerating. Second is a longer-term factor: With demand up, trucking firms are finding it difficult to find drivers experienced with complicated standard transmissions in trucks. And third is that Allison has spent a bunch of money during the past couple of years to expand capacity; with its investments in the past, the firm’s increase in sales is creating a torrent of free cash flow, which management is starting to return to shareholders.
The third- quarter report was fantastic, with sales up 19%-the fastest rate of growth since 2011-earnings up 39%, profit margins of 17.3% (!) and free cash flow that totaled more than twice reported earnings! Management is now giving that cash back to shareholders in a big way-it just bumped up its dividend (1.8% annual yield) and wants to buy back $500 million of stock (8.3% of all shares) within the next two years. We like it.” As you can see in the chart below, ALSN built a long, sloppy, choppy base for much of 2014, before hitting the skids in late-July, and really went over the falls in September and October.
But since that October bottom, ALSN has soared to new price highs (though, to be fair, its relative performance (RP) line is a bit short of new highs) and has been consolidating those gains tightly in recent days. I don’t think the stock’s going to double, but there’s a real story here and the stock’s action tells me it wants to head higher. You could nibble around here or, preferably, on dips of a couple of points, with a stop around 30.
Working to make you a better investor,
Chief Analyst, Cabot Market Letter
And Cabot Top Ten Trader