The techniques mentioned thus far are timeless methods for consistent profitability. Transforming theory into practice can be a challenge, but realize these techniques are not theory—they only appear to be because you have yet to apply them. The challenge is to remain disciplined to the system and not let emotion take control. This will only come from time and experience. These are aspects of the market that can only be learned by participating. The following example will apply much of what has been learned to this point and explain how to apply your newfound knowledge.
Searching for suitable securities can be a time-consuming process, but it becomes more intuitive after you give it some practice. Just remember, when finding candidates to invest in for a longer period of time, you want to look at the big picture first—top-down.
The first step is to analyze a long-term chart of the overall market. This allows you to see the trend of the market and where it has come from. Figure 14-1 shows a weekly chart of the broad market S&P 500 Index.
FIGURE 14 - 1 The S&P 500 Index on a weekly timeframe.
In analyzing the overall market, we want to identify what stage the market is in currently as well as the previous stage it came from. Refer to Figure 14-1, and know that each candle represents one week worth of trading data. Although stage analysis can be a form of art, on longer-term timeframes, the stages are typically easily identified. The MAs allow you to easily identify the trend. In Figure 14-1, stage 2 markup, stage 3 distribution, and stage 4 decline are fairly obvious. On the far right of the chart, known as the “hard right edge,” we have the present moment and the purpose of our analysis. What is the probable next leg for the market? When you are doing your analysis, take note that the broad market is still in a stage 4 decline but may be beginning to base, developing the start of stage 1 accumulation. Keep in mind, opinions are expensive to harbor, so this has yet to be confirmed. That is why the stage 1 on the right side of the screen had a question mark next to it. The larger picture you should see is that the overall broad market had a huge run-up (stage 2 area), then went sideways (stage 3), and ultimately declined and lost over three-fourths of the gains established in stage 2.
As we now focus on the hard right edge (see Figure 14-2), we notice the two weekly elastic lows (tails) that find support at approximately the same level, yet the candles indicate that the bears do not close the week on a lower low. This calls the stage 4 downtrend into question. The fact that the sellers couldn’t push the index significantly lower indicates that the sellers are becoming weaker and the buyers are beginning to gain strength. As buyers gain strength, your attention to a potential stage 1 accumulation period may be near. Although all the MAs are moving lower, the 20-week MA is showing the first signs of a change in trend by beginning to move higher. This long-term weekly chart gives you the long-term bias and trend of the overall market. Remember, history repeats time and again represented by the cyclical nature of markets.
FIGURE 14 - 2 Notice how the S&P 500 gave back most of the gains it made during its run-up. Also pointed out are the elastic lows near the hard right edge.
With this potential development upon us, we must filter our early subjective views of potential stage 1 accumulation by now focusing on various market segments—the next step in top-down analysis. By reviewing the shorter-term chart of the Nasdaq Composite Index, we review a heavier technology weighted index than the overall market as seen through the S&P 500 in Figures 14-1 and 14-2. Figure 14-3 illustrates a daily chart of the Nasdaq. Though not a sector, it consists of many high-tech stocks that often lead the entire market higher due to its higher beta.
FIGURE 14 - 3 A long-term daily chart of the Nasdaq Composite Index.
Figure 14-3 shows approximately 1500 days worth of data. When comparing the Nasdaq Composite Index to the weekly chart of the S&P 500 Index, note that the Nasdaq looks like it has progressed farther toward a stage 1 accumulation phase. The Nasdaq has a stronger looking chart at this time. This is important to note because if the overall market begins moving higher, you would expect the Nasdaq to exhibit more powerful upward strength (beta) since it appears to be in a more mature basing pattern of stage 1 accumulation.
After looking at the broad market and Nasdaq on the long-term timeframe, take a look and see what’s happening on a shorter time-frame. Figure 14-4 illustrates a shorter-term daily chart of the Nasdaq Composite Index.
FIGURE 14 - 4 A daily chart of the Nasdaq Composite Index showing approximately 600 days worth of trading data.
The daily chart of the Nasdaq in Figure 14-4 gives you a closer look at what the more recent trend of the market is. It clearly illustrates that the index has mellowed out its decline in the stage 4 area, and it now appears to be drifting sideways. Also note that on the hard right edge, the index made a higher high from the prior high as shown at the 20-period moving average. This confirms what we saw on the weekly S&P chart in Figure 14-2 where the later stages of stage 4 illustrated the potential transition to stage 1. Remember, the S&P 500 failed to make the lower low, indicating the bulls are gaining strength. Couple that with Figure 14-4, and it indicates that there was a break in the recent downtrend, represented by a higher high. These are two strong clues that confirm the same bullish bias. You already know that the broad market looks like it is basing into a stage 1, and the Nasdaq looks even stronger since it is already based and now showing signs of potential breakout. It would be reasonable to expect that if a move higher for the overall market occurred, it would be led by the Nasdaq Composite Index. Therefore, we can take many steps, but the lowest risk approach would be to narrow the search criteria to Nasdaq stocks. This is the path of least resistance.
Now that the decision is made to search Nasdaq stocks, continue to narrow the search down into tradable ideas by reviewing individual sectors for relative strength. See Figure 14-5.
FIGURE 14 - 5 Note the relative strength of the Semiconductor Index compared to the Nasdaq Composite Index.
As we scan the sectors within the market, it is easy to see technology is leading the bulls’ potential charge. The next thought should be figuring out which sectors exhibit the most upside elasticity. See Figure 14-5. As seen on the daily chart, the Philadelphia Semiconductor Index (SOX.X) exhibits stronger relative strength than the Nasdaq. Just as the Nasdaq leads the S&Ps, the Semis are leading the Nasdaq Composite. The sector is clearly attracting institutional money flow and is clearly a trend worth following at this juncture. Ask a bank robber why he robs banks and his likely reply is—it’s where the money is! Traders trade trends for the same reason! To complete the sector analysis, take a look at how the Semiconductor Index compares to other sectors. For instance, the Semiconductor Index is compared to the Biotechnology Index, as shown in Figure 14-6.
FIGURE 14 - 6 Upon examining several sectors, notice the relative strength of the Semiconductor.
Figure 14-6 shows that the Biotechnology Index is weaker than the Semiconductor Index. Other sectors within the Nasdaq should also be compared. By demonstrating relative strength, the Semiconductors should continue to show strength leading most sectors within the index, when the trend begins to turn higher.
The task at hand follows the logical top-down sequence of next looking for individual stock candidates to trade. Although you could look through thousands of stocks each day, we can limit our search to just Semiconductor stocks, which makes the task quite simple, given that this particular sector has only 15 to 20 component stocks within it.
From an investor point of view, the daily charts will serve well for stocks that are moving from a stage 1 accumulation to a stage 2 markup. By entering stocks as they move into stage 2, you participate in the trend of the stock. Continuing with the analysis, look at the stock featured in Figure 14-7.
FIGURE 14 - 7 A daily chart of a component stock within the sector that had been basing and broke out of the range on above average volume.
Armed with a picture of the overall market, you now want to go long a Nasdaq stock that looks to be entering a stage 2 markup phase. The stock in Figure 14-7 is a technology stock that has been basing for a period of time. Several days before the analysis took place, the stock broke out of the consolidations range on heavy volume. The catalysts for the breakout were a strong sector, money flow, and a better than expected earnings report. As the stock pulls back on light volume, it provides an ideal place to enter a long position, but prior to doing so it is prudent to review the fundamentals.
The fundamentals for the stock should be examined so that you know how it appears to the institutional investor. Figure 14-8 shows the 10-Q quarterly report for the XYZ Corp.
FIGURE 14 - 8 The 10-Q report for the stock featured in the present example. This information was found on the SEC Web site. (Courtesy of www.sec.gov.)
Figure 14-8 shows that over the past three months and the past six months the fundamentals have improved remarkably. Over the past three months, the revenues have nearly doubled and the income and earnings went from positive to negative. The same is true for the past six months—the revenues nearly doubled and the income and the earnings per share went from negative to positive. While the fundamentals don’t look great, they are showing improvement. By completing this simple fundamental check, you now know that the fundamentals look to be turning around, and combined with the top-down approach, the stars appear aligned. The stock meets several levels of criteria and has a strong likelihood to capture and hold the institutional interest we look for. As an investor, you should structure the entry on light volume pullbacks immediately following breaking out of the consolidation range. The following year of stock movement is shown in Figure 14-9.
FIGURE 14 - 9 After the stock broke out of its trading range, it made a strong move higher, with little reason to be stopped out of the trade.
Figure 14-10 shows that the stock pulled back to prior resistance on light volume after breaking out of the stage 1 accumulation. The rising 100-day MA was also at this level, which made it an ideal place to get long offering a low risk entry point. As the stock pulls back it makes a bullish flag pattern that implies further upside movement. This is an example of a low risk entry on a structurally sound basis of analysis. While every trade will obviously not be a winner, the statistical likelihood of having more winners than losers is undeniable. Having predetermined stops where losses are taken quickly and profits left to run, along with the statistical edge of more winners than losers, clearly beats blindly following the advice of others.
FIGURE 14 - 10 The stock gave you an ideal entry point as price pulled into an area of prior resistance and the 100-day MA as well as making a bullish flag formation.
Applying the methods of analysis is vital, but acting on the analysis completes the trader and investor. It shows that the participant can use objective analysis to gain the edge for not just proper setups, but perhaps even more importantly, proper exits. As stated in the introduction, “like it or not, when you commit your capital you also commit your emotion to the market.” The analysis is a hedge to temper emotions, but not a complete mitigation. This broaches the subject of when to sell. The emotional factors regarding when to sell (or buy in the case of covering short positions) are important to consider, for no trader or investor enters a trade when feeling bad about it—otherwise why make it? Conversely, most participants exit positions with precisely this emotional state of mind. Why? Because most participants lack a plan of when to sell. Chapter 15 addresses perhaps one of the most critical aspects of trading and investing.
