Well, I figure it’s time to post a follow up to my previous post. To recap, here is the chart I posted on October 5, 2009. This is a three-year weekly chart which I typically use to determine the intermediate/long term market trend driving the stock.

In this chart, ISIS’ stock has breached its 50-week moving average. Remember that breaching the 50-week moving average necessarily means that the stock has also fallen through its 200-day moving average (not displayed). To me, this means that, on a short term basis, market participants have lost conviction in ISIS’ stock. More worrisome to me than the interim breach of the 50-week moving average was the negative divergence in RSI during the stock’s previous uptrend as well as the lack of any clear areas of support before the $12 range. Coincidentally, the $12 support level defined by several previous lows as well as the prior interim high seen on the far left of the chart also coincides with the $12.12 defined by the 200-week moving average. As such, I made the call that “a retest of the 200-week moving average is not out of the question” and that there was “a potential 15-20% additional value at risk” on October 5, 2009.

Okay, now let’s look at how the stock has traded since my call.

In the month following my call, ISIS hit a daily closing low of $12.31/share, basically right at the 200-week moving average (which averaged upwards slightly since October 5, 2009).

Am I clairvoyant!?
No, of course not. In fact, I don’t even consider myself primarily a technical investor. I merely use it to guide my short term decisions. For those that write off technical analysis, however, I think this is a great example of just how it can be used to improve your investing. I wasn’t analyzing ISIS in hopes of timing my trades. I was merely trying to establish a disciplined stop-loss for a position that I hold. In the end, I did not buy back into ISIS, but instead allocated capital to BX on November 5, 2009. In the interim, I saved myself from holding ISIS and losing an additional 12% on my position.

The key to remember with technical analysis is that it does not stand in place of or in contrast with fundamental analysis. But, absent a market moving press release, it is a method of understanding how “Mr. Market’s” voting machine will vote during a discrete period of time. I know this seems like very carefully chosen wording, but there is no such thing as one strategy which works in all situations in investing. The key is to stick with what you know and have the tools necessary to analyze different opportunities. In the case of determining emotionless stop losses and profit maximizing entry points, I am a believer in technical analysis.

Full disclosure: Author is long shares of BX at the time of writing. No position in any other stock mentioned.

What I mean by technical analysis isn’t meant for predicting is that rigorous technical analysis isn’t a means for front running what you “think” may happen to a stock. It’s a means for gleaning information from an existing chart about an existing trend and helping the practitioner to make investments with underlying market supply and demand behind them.

I came across this post, “Are Sears Holdings shares headed for a correction?,” at wallstnation.com. The thrust of their argument was that SHLD’s shares had traced a head and shoulders pattern and that a significant correction was likely.

Here’s a “text book” head and shoulders pattern:

1. The stock rises to a peak and then declines.
2. The stock rises to a second higher peak and declines, but does not breach support defined by the first decline.
3. The stock rises to another peak but is unable to recapture the second peak.
4. The stock breaches the support level formed by the first decline and confirms a reversal of trend

Wall St. Nation posted this chart of SHLD as of 9/30/09:

Wall St. Nation’s contention is that a head-and-shoulders pattern is defined by the three peaks it labels. Wall St. Nation claims that this formation is “one of the most reliable trend-reversal patterns.” What they miss is the fact that simply the formation of three “head-and-shoulders” style peaks is not the predictor of a trend reversal. The head and shoulders pattern must include a breach at the end of the pattern formation. That is step 4 listed above. The head and shoulders pattern is a trend reversal  not just a “reliable pattern” for predicting a trend reversal.  Once the full pattern is formed, one can typically expect a continuation of the downtrend after initial support is breached. In the case of SHLD, baseline support was never breached. In Wall St. Nation’s own example, lows never breached the initial low in the formation and in fact have maintained an upward bias that they themselves identify in the chart.

In fact, in the chart they show, it is just as likely that a long term uptrend remains well intact and that the chart is merely in-between a series two “higher highs.’ Well, a month later, what has happened?

Well, the stock ripped off an upward run and made a high beyond the “right shoulder” of the supposed head-and-shoulders pattern. At this point, it’s hard to identify any near term trend at all. Generally speaking, it seems the 50-day moving average has provided rough support, MACD shows a bullish bias, and a lower low has not been seen all year.

In the case of the 3-year, weekly price chart, SHLD has just this year managed to return above its 50-week moving average which I believe signals a potential long term trend reversal. For more on that, check out my post on long term technical analysis and trend reversals.

Full disclosure: Author has no position in the stocks mentioned in this post.

It is interesting to note that, in the area marked in the above graph, all short term indicators were overwhelmingly positive just before Google’s swift and violent correction over the last month.

The reader was clearly a technical analysis skeptic and questioned whether or not one should use indicators at all. While I admit that technical analysis has its limitations (particularly for long term investors), I’d like to write a quick response to this reader’s contention and share it here.

When I noted that Google’s near short term indicators were overwhelmingly positive, I was speaking in reference to the following Google chart:

In the marked area, you’ll see that MACD had bullishly crossed into positive territory and diverging positively. RSI was making higher highs in conjunction with relative highs in the stock chart. Positive volume was ascending both in daily magnitude and regularity. Add in that the stock had strongly crossed its 50-day moving average and quickly ascended to the top of its Bollinger Band, and you have all the makings of a potential trend reversal and formation of a new uptrend. 

The one thing people forget in technical analysis, however, is that it is governed by the principle that price movements are ultimately governed by a long term trend, or continuum, and short term movements will ultimately conform to this trend. In the case of Google, a stock for which value is predicated more on growth than intrinsic value, the use of trend analysis can be used to establish disciplined entry and stop loss points and still allow you to take advantage of long term value creation.

Take a look at Google’s yearly chart with weekly bars. The stock clearly peaked in late 2007 and started a down trend – a series of lower highs followed by lower lows. It’s bearishly crossed its 50-week moving average and its 200-week moving average. Worse yet, the 50-week moving average has recently crossed the 200-week moving average signalling a potentially deepening downtrend. With this kind of negative bias surrounding the overarching movement of Google’s stock, is it any surprise that the stock recently failed to test support at its 50-day moving average? 

As a rule of thumb and to protect against whipsaw losses, buy with the trend. Even when near term indicators based on 50-day and 200-day moving averages signal potentially positive price moves, a stock in a long term downtrend will usually find its rallies ephemeral. Just as Google’s recent rally did not last more than a month.

So, how would a long term investor use this strategy? As mentioned above, I typically use technical analysis to guide my long term growth plays. Growth stocks can offer very high rates of return, but very little downside protection. Furthermore, multiple compression or expansion is nearly impossible to predict. This is where an understanding of relative value and relative supply demand allows you to better control your risk/reward. Yes, you might miss out on a little return as you wait for trend confirmation, but I’m willing to lose a little upside for some peace of mind. 

For those of you interested in learning about using technical analysis for short term and day trading, check out The Curious Investor‘s affiliate, the MarketClub Trader’s Blog.

Full Disclosure: Author is long shares of GOOG at the time of writing.

This is a situation where I may differ with Benjamin Graham and Warren Buffet. I don’t necessarily have the bankroll to continuously average down my positions. Further, I live by the tenet that paper losses can often turn into material losses with the passage of time and unexpected needs for liquidity. Thus, I realize that often times the trend really can be your friend. In the words of an investor I admire, it is often better to be in the wrong stock at the right time than in the right stock at the wrong time. So, how do we determine the “right time”?

The Rightside Chart

Here’s Google’s weekly chart from January 2005 to January 2008. This is a near perfect longterm up trend. This is what all investors wish their stocks’ charts looked like 50-week moving average (1 year) support as well as the longterm trend coincide nearly perfectly signaling a modest and sustainable trajectory. Using a weekly chart gives you the overarching trend or, as an investor I admire calls it, the stock’s continuum, and can provide context when you’re fretting over more volatile day-to-day price movements. 

Trend Reversals

Here’s Apple’s chart between mid 2002 and early 2004. Apple was notoriously trading near cash on the books before investors realized that this was not the same Apple of the mid-1990s and the rest is history. Given Apple’s history of poor cash usage and inability to get traction in its computer business, even the most seasoned value investor might not necessarily have felt completely comfortable with the stock. But, a look at the chart provides technical confirmation that the market is beginning realize the intrinsic value at Apple.

First, we see the stock trade towards it’s 50-day moving average and weakly break towards the 200-day moving average. The stock subsequently spends 6-months testing prior resistance while the 50-day and 200-day moving average converge. Finally, as highlighted, we see a breakout on heavy volume simultaneously with inversion of the 50-day moving average as well as a moving average cross over. In subsequent months, we see the formation of a new rightside chart where the 50-day moving average acts as support for the initial acceleration phase and we’ll eventually see the 200-day moving average (roughly equivalent to the 50-week moving average) become the support for the long term continuum. 

Apple’s chart shows reversal happening in a swift and nearly simultaneous fashion. The truth is, reversals can be longer and more painstaking. Generally, several steps will be accomplished: 

1. Breakout through the 50-day SMA
2. Initial “weak” rise towards 200-day SMA
3. Retracement and testing of the 50-day SMA (accumulation)
4. Repeated testing of 200-day and 50-day resistance and support leading to convergence between the two moving averages
5. Strong breakout above the 200-day and the formation of a new rightside chart

A Case Study for Today

The Buckle is a company I’ve been watching for a while. The stock has been punished by the current retail pull back despite being one of few retailers able sustain same store sales growth, no debt, and significant upside for square footage growth (in the event of an economic turn around). Retailers, particularly ones with true growth stories, are rarely true value plays. They typically rent locations and source their clothes from other manufacturers and thus have few hard assets and, if run properly, are inventory light. For example, the Buckle has just $6.87 in tangible book value per share, a significant amount of downside risk if the Company were to be forced into liquidation for one reason or another. 

But, given how well the Company has managed to perform through the downturn and management’s shareholder friendly policies including a significant dividend (3.5+% at current prices) and a buy back plan, it would seem that the fair value for this stock is likely significantly better than $20-$22/share. Despite this, even if I believe that this stock has significant value above the current price, I’d be reticent to invest at these levels given the current risk/reward trade off. Looking at the current chart, though, it seems that the stock has found downside support and has begun base formation (accumulation). For me, I would be willing to trade a few basis points of return for a confirmation breakout which would provide a higher likelihood of immediate return and series of resistance levels to use as stop losses. 

Full Disclosure: Long shares of Apple and Google at the time of writing. 

Charles Dow believed that, in order to confirm primary trends in the broad market, averages must conform with one another. In particular, Dow used the Dow Jones Industrial Average as a proxy for the general markets and the Dow jones Transportation Average as a conforming indicator. Why was this?

Transport stocks are typically more susceptible to economic changes than other stocks. In Dow’s time, these stocks were typically rail businesses and other freight shipping businesses which would notice shipment decreases well before the rest of the market turned down. These days, the DJTA is highly airline heavy which adds a layer of complexity to the issue as airlines are not a direct 20th century analogue to the rail and freights of years past. Yes, airlines derive much business from business travelers but they are also susceptible to changes in consumer demand. That does not mean that the transportation average is no longer applicable in Dow Theory analysis. One could say that airlines provide an even better leading indicator as their typically high debt loads create added susceptibility to interest rate changes and their fuel needs adds in a level of reaction to energy prices in addition to their susceptibility to business climate changes.

So, how do the DJTA and DJIA work together to provide a better picture of the future direction of the markets? Generally speaking, the DJTA is supposed to lead movements in the DJIA. Furthermore, trend changes in one index must be confirmed by trend changes in the other index. Spotting trends is done the same way as described in the last Dow Theory post – peak analysis with volume confirmation.

Here, I’ve graphed the DJTA above the DJIA for the last year. What we see is that the DJTA entered a downtrend just as the DJIA made its last gasp at a higher high. Later on, in the second area denoted by vertical lines, we see the DJTA bottom and make a higher high as the DJIA just reaches what seems to be a bottom of its own.

You might be tempted to conclude that the transportation average must lead the industrial average. But, this is not the case and I will reiterate that the only “rule” provided by Dow Theory is that averages must conform when signaling trend changes. An example can be found in the period between the second and third vertical lines, we see the DJTA break above its projected downtrend and make a relative high. The DJIA did not make a similar move and instead only made a lower high, the second in what would be a series of lower highs and lower lows. Thus, the only conclusive evidence we have here is that the two averages much conform with one another before a trend change is officially identified.