Every few months, I like to write about what I call Chart School, and that’s the topic of my column today. I’ll show you a few things that I’m seeing in the market and relate them to stock market indicators that you can use in your investing going forward—think of them as timely tricks of the trade.
Today I focus on chart-based stock market indicators in three areas: earnings gaps, volume clue support and relative performance (RP). Let’s get right to it.
Stock Market Indicator #1: Earnings Gaps
I’ve already written 100 times about how positive earnings reactions are usually a bullish sign for the intermediate-term, while gaps lower on earnings tend to depress a stock in the weeks ahead. But you still need context by considering (a) how big the rally was, (b) how large the volume was and (c) where the stock is on its chart following the gap.
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Let’s look at Zendesk (ZEN), a fast-growing provider of a cloud-based customer service platform, and consider the three items above.
First, ZEN gapped up 15% on earnings, which is great—certainly large enough to catch my attention.
Second, volume was great but not outstanding—while volume was nearly five times average, you can see that ZEN had larger volume on an earnings gap down in early November, and ZEN also suffered a big 4.3 million share downmove in mid-January.
The third item (where the stock is on its chart following the gap) is the most important—even after the huge 15% move, ZEN is still positioned below overhead supply (potential sellers) in the 29 to 32 area.
None of the above means that ZEN is a black sheep—and in fact, the gap tells you the deep September-December correction (38% deep) is probably over. But in terms of an immediately buyable gap, ZEN doesn’t fill the bill.
Stock Market Indicator #2: Volume Clue Support
I find trading volume provides some of the best chart-based stock indicators. What I want to touch on today is a “follow up” pattern if you missed buying a big earnings gap or breakout.
I call it “volume clue support,” which is easy to understand: If a stock has many days in a row on the upside of huge volume, then it’s likely to find support on dips during the next couple of weeks. The reason? Big investors that were buying during the prior surge probably didn’t finish building their positions. So they nibble on dips in the days ahead.
Let’s take a look at Skyworks Solutions (SWKS), which was my Top Pick in Cabot Top Ten Trader on January 23. The stock’s earnings gap saw volume of nearly six times average (which was also the largest total in many years), and the two big up days after that also sported excellent volume.
That tells me that there were plenty of big investors looking to buy in the 85 to 91 area. And sure enough, every time SWKS pulled back toward 90, buyers stepped in. It’s not always as picture-perfect as this, but the point is that after a big-volume, multi-day surge, pullbacks into that area will likely see big investors supporting the stock as they build positions.
Stock Market Indicator #3: Relative Performance
A relative performance (RP) line tells (in graphic form) how a stock is performing relative to the S&P 500. I always check a stock’s relative performance line (RP line for short), which tells me whether the stock is outperforming the market, underperforming it or acting about the same—effectively telling you whether it’s showing real power or just getting pulled up by the market.
Personally, I like to see an RP line currently at new highs (or pulling back for a couple of weeks after recently hitting a peak).
Let’s take a look at ServiceNow (NOW), a firm that looks like an emerging blue chip in the enterprise software space. The stock itself has eked out new prices highs recently after a solid upmove.
But below we have NOW’s RP line. On that basis, NOW isn’t any higher relative to the market than it was back in late October.
To be clear, this “negative divergence” between the stock and the RP line is NOT a death knell—in a strong bull market, it sometimes doesn’t matter much. But the RP line can be a very useful tool that helps you avoid laggards and identify stocks that are clearly under a lot of accumulation.
NOW remains on my Watch List, but I’d like to see the RP line make a decisive new high, and then look to play the first controlled pullback after that.
A Stock That Incorporates All Three Indicators
For my stock idea, I looked for a stock that incorporated all three of the indicators above. One stock that checks all the boxes technically is Louisiana Pacific (LPX), one of the top producers of engineered wood products. It’s not changing the world, but a major business upturn has arrived—fourth-quarter earnings trashed estimates, that quarter’s cash flow was up 150% and analysts see earnings up 73% this year and another 175 in 2018.
Moreover, the chart is outstanding, with LPX just beginning a new advance after a four-year consolidation. Looking at the daily chart, LPX rose 4.5% on the day of its earnings report on volume that was nearly triple its average, but then followed up the next day with a 9% gain on its heaviest volume since November 2015. And it has kept rising from there!
With the RP line clearly out to new highs (chart not shown but trust me on that), the huge-volume buying in the 22 to 24 area should offer support on any pullback. Dips below 24 would be tempting and a stop between 21.5 and 22 should limit risk.