On Wall Street, there are two major schools of analytical thought: Fundamental and Technical. Fundamental analysts focus on financial statements, economic advantages, and corporate management in order to determine the intrinsic value of a stock. Hard core fundamentalists view technical analysis like astronomers see astrology – a complex weave of arbitrary numbers and events to magically arrive at a conclusion.
In truth, fundamental analysis tells you what a stock is ultimately worth, while technical analysis tells you what other traders are doing with that stock. That’s why value investing tends to be synonymous with long term strategies while “chartists,” people who use technical analysis, trade in short term patterns.
When used together, proper analysis won’t only tell you what stock to buy, but also when to buy it and when to sell it. Like all types of analysis, some metrics are more meaningful than others. We’ll take a look at some of the more important ones used in the market and what they mean in regards to the current environment.
Why Volume Matters
Arguably the most commonly looked at piece of technical data is volume. This is the amount of stock that has changed hands on a given day. It’s usually calculated as the average amount over a period of time.
Volume tells you how active the stock is. A low volume can mean that there’s little interest in the stock which can result in liquidity issues – if you own a large number of shares, you may not be able to sell them easily. On the other hand, a large amount of volume means that there’s much more liquidity making it easier to buy and sell the stock.
Take a look at Netflix (NFLX) over the past six months.
Average daily volume is around 2.3 million shares. But take a look at how the volume ramped up over 12.5 million shares while the stock dropped 19%. So what does that tell you?
A large move in price with lower than usual volume generally means that the move is somewhat arbitrary. An institutional investor may have bought or sold shares that day for their own reasons that may not align with the overall market consensus.
When a large price movement accompanies greater than average volume, it’s a good sign that the price change happened for a good reason. In Netflix’s case, it’s because the company disappointed on new subscribers, the mainstay of the company’s growth. The large increase in volume with the 19% drop means that the stock could be in real trouble and should be avoided.
Newton’s First Law
Taking from a concept in physics, an object in motion tends to stay in motion. Stocks tend to obey similar laws. Momentum is a powerful force on Wall Street that can break barriers. Basically the idea is that stocks that are rising fast will continue to do so, and those that are sinking fast will similarly continue to fall.
A basic form of momentum investing is to look at 52-week highs and lows. A stock that breaks through that barrier often continues higher. The same holds true for stocks that fall below 52-week lows.
For reference, let’s look at Domino’s Pizza (DPZ) and Monster Worldwide (MWW).
Domino’s broke through its 52-week high on the 14th on the back of an analyst upgrade, an earnings beat, and strong future growth. In one day, the stock soared 11%. That kind of explosive increase could point to a momentum change in the stock as investors reassess the company’s growth prospects and place a higher value on the stock.
The opposite could be said of Monster Worldwide which has fallen 25% for October alone. The selling has actually accelerated after it broke through its 52-week low on missed earnings and disappointing growth. While an argument could be made that the stock is now oversold, trying to invest against such strong opposition can prove to be a painful mistake.
Even if a company’s fundamentals allow for a higher or lower price on a stock, momentum can carry the price a considerable distance from its intrinsic value. The stock may eventually get to that price, but going against the tide may be futile in the short term.
Other than basing momentum off of new highs or lows, another popular and simple way to gauge momentum is with the Moving Average Convergence/Divergence Oscillator (MACD).
Basically it uses two moving averages, generally 12 days and 26 days, to come up with momentum trends. When the shorter moving average diverges from the longer one, it will return a positive value which means increased upside momentum. When the shorter moving average dips below the longer one, it will return a negative value which translates as increased downside momentum.
Take a look at the MACD when applied to Domino’s.
We can see how the 12-day average is much higher than the 26-day which points to upside momentum. This simple monitor can be used to screen for stocks with upside or downside momentum to help you get a better idea of what direction a stock is headed.
When using moving averages, remember that the one with the shorter timeline is the one that will point the direction in relation to the longer timeline. If you see the shorter one above the longer, that’s a bullish sign. If it’s lower than the longer one, it’s a bearish sign.
Well-Done or Rare?
Stocks, much like steaks, can be overdone or underdone. Sometimes investors take news too poorly and sell far past what the stock should be trading at or get over-excited and buy well past what the stock should really be worth. When this happens, we say the stock is oversold or overbought.
The best way of checking whether a stock you’re interested in is oversold or overbought is by checking its Relative Strength Index (RSI). The mathematics behind it are a little bulky but it basically uses gains and losses over a period of time to get an idea of how the stock normally trades. Luckily, almost every charting program calculates RSI for you so you don’t have to.
The result is a figure that ranges from 0 to 100. Numbers below 30 indicate a stock is oversold while a reading above 70 indicates that a stock is overbought. Let’s take a look at a real-world example to illustrate.
Here’s the chart for Apache Corp. (APA), an independent oil and gas producer.
If we look at the smaller chart above, we can see how this stock has been both overbought and oversold at different times this year. Back in June, the RSI climbed above 70 and stayed there nearly all month long. If we compare that to the actual price movement in the stock, we can see the price steadily climbed along with the RSI from March. However, once the RSI hit 90, the stock teetered up and down between $97.50 and $102.50 until it began to fall.
For October, the RSI has sunk to around 10 while the stock has shed about 30% off its high. That tells us that the stock could be oversold and should reverse direction back to the upside soon.
Gauging Demand In A Stock
Perhaps no other piece of technical data is referred to and used more than Support and Resistance. Simply put, it tells us the supply and demand in a stock with the supply represented by the bears who sell and demand represented by the bulls who buy.
Support is the price level at which demand is expected to keep the stock from sinking any lower. In other words, when a stock begins to sell off, the thought is that more and more buyers will pick up the stock as it gets cheaper until an equilibrium is established.
Resistance operates in the same way, but with sellers rather than buyers. As the price increases, more sellers get rid of the stock until it balances out.
Like RSI, calculating support and resistance levels can be a tedious process. It uses the previous day’s high, low, and closing price to come up with differing levels to watch for in the next trading day. If you want to create these levels on your own, you can check out this website and just enter the data on the security you want to use: https://www.easycalculation.com/finance/pivot-points-trading.php.
As I mentioned before, focusing on just one type of analysis won’t give you the complete picture of a stock. It’s important to put context into the figures used in technical trading.
Sometimes the figures don’t tell you the whole story. A stock may show an RSI below 30 which normally indicates an oversold position that you might consider buying, but if you don’t check its fundamentals, you might not see that its being sold off because its financial statement indicates an upcoming bankruptcy. Its lower price could very well be justified.
Technical figures in a vacuum are dangerous. Without fundamentals to back up the data, you’re not truly investing, you’re just trading blindly.
Let’s take a look at Ford (F) and apply everything we’ve discussed regarding technical analysis:
We start by looking at the increase in volume for October and the associated drop in price. Without looking at the fundamentals just yet, we can safely assume that the drop is justified by some kind of negative news or event and not just a trading aberration.
The MACD tells us that the stock was trading downward with momentum recently, but has now begun to balance back out. The difference between the shorter and longer moving average is marginal so we can assume that any downward pressure is no longer being applied to the stock.
Finally, the RSI is registering at 31.75 – very close to our oversold limit of 30. This could mean that the stock is oversold, or very close to being considered oversold right now. Used in context with the MACD, it tells us that there was a lot of selling which forced the price down, but now looks overheated and could be a good value buy.
We could place support and resistance levels for Monday (10/20) on the stock if we wanted as well. Plugging in Ford’s intraday high, low, and final closing price gives us a top resistance level of $14.47 and a top support level at $13.63. With that information, we can safely say that Ford will trade between these two figures for Monday and any breakthrough higher or lower than these levels could indicate a momentum shift for the stock.
To put it all together, we check up on its fundamentals. It trades cheaply at just 8 times earnings with a long term growth rate above 10% and even pays a dividend yield of about 3.5%. These are all strong classic value signs. Double checking though, we see the reason for the drop in October – management reported weaker than expected growth and accordingly lowered guidance.
We can say that the stock was justified in dropping because it lowered earnings estimates for the future, but it looks as if the stock sold off more than it’s actually worth. It could be a good value buy right now.
Ultimately a good investor uses all the tools at their disposal to come up with an outlook for a stock. By incorporating some technical data points along with solid fundamental analysis, you can increase your market knowledge and make more accurate calls when choosing where to invest.
CEO, Elite Wealth Management
Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.