What’s Behind the Numbers?: A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio

Chapter 7

Stock Charts: Know When to Hold ’Em, and Know When to Fold ’Em

The Most Controversial Chapter

This is going to be the most controversial chapter in the book, because technical analysis is one of those things that people use or don’t use, are for or against, and, as with the current state of U.S. politics, can or can’t understand and work with the other side. Fundamental investors analyze the balance sheet, cash flows, and income statement to find hidden value and mispricing at the rare times when downside risk is limited (this is what Tom does in Chapter 6). Technicians review the price action on a stock chart. This not only improves entry and exit timing, but also risk management, creating greater awareness of how the stocks that compose the portfolio are trading relative to each other and the broader market.

But rarely do investors take classes at both schools. While most investors sign up at either the Academy of Fundamental Analysis or College for Technical Analysts, I (meaning John here) use the best of both. So far, we have discussed fundamental analysis warning signs that portend doom for shareholders. But the technician’s ability to analyze a stock chart is also valuable in determining whether a stock is likely to rise or fall in the future. While both schools misunderstand each other, I’ll bet the technician is least understood. However, what I practice managing portfolios and trading stocks daily is the simplest, least jargon-filled technical analysis method. My short-side management employs—requires—both fundamental and technical analysts’ tools.

A stock is nothing more than a vehicle to express a bullish or bearish bet—a way to make money. While many people will tell you that they are investors for the long term, they are in the minority, and their volume makes less and less difference to stock prices each day.

For example, Netflix in November 2011 traded approximately 5 million shares per day, with a float of 50 million shares. Thus, the shareholder base was turning over once every 10 days. Netflix at the time was a vehicle for speculators to make bullish or bearish bets, and most of it was done in the short term. In other words, the stock of Netflix was nothing more than a commodity, while the business was, of course, not that at all.

The idea that you are part-owner of a business when you buy Netflix or any other stock is a fiction sold to investors to encourage them—rightly—to evaluate their holding as a business owner, learn financial statement analysis, and evaluate management. But a long investment in Netflix requires proof that management acts in your interests, either by paying you through dividends and buybacks at opportunistic prices, or if there is an activist investor putting management’s feet to the fire, allowing you to benefit as a fellow shareholder. The rest is trust that someone will pay you more for your shares later.

Think like an owner of the business on the long side. Demand tangible benefits. Trust, but verify. But on the short side, think like a technical analyst to time entry and exit for trades. I’ve found many companies with serious earnings quality issues, but not shorted them, due to timing and technical issues.

Several simple principles can be used to sharpen your ability to see weakness in shares before they collapse. Below, I discuss several of the primary factors I look at repeatedly when managing a portfolio.

Principle 1: Keep It Simple

Ockham’s Razor suggests that simpler explanations are, other things being equal, generally better than more complex ones. Consider the conventional wisdom that technicians use sophisticated computer systems, secret formulas, a protractor with grid paper, or the phases of the moon to observe changes in a stock’s trend. Some do, but I don’t. A simpler approach is better.

Pull up the chart of a stock that you want to analyze. Print it out. Tape it to the wall. Stand six feet away from it and ask yourself “Is the price going up, down, or sideways? For how long?” Let’s look at three clear examples.

The chart of Chipotle Mexican Grill shows the stock in an uptrend from October 2010 through September 2011 (see Figure 7.1). Even during an exceptionally volatile period for the stock market and world economy, Chipotle persistently marched higher in price. Burritos resisted downgrades of U.S. debt and concerns over Greek defaults. Patient shareholders who rode the trend were well rewarded.

Figure 7.1 Chipotle: Upward trend.

Conversely, shares of EBIX were a total disaster during the same timeframe (see Figure 7.2) and were mired in a downtrend for months. Investors seduced by the prospect of higher growth rates have found nothing but frustration in lower prices for EBIX’s shares. Only investors in more recent months have seen gains.

Figure 7.2 EBIX: Downward trend.

Figure 7.3 shows that shares of Coinstar have been range-bound—trading within a range of upper and lower prices—for months. Even though there are dramatic peaks and valleys, the sideways price action is clearly visible from a quick look at the chart.

Figure 7.3 Coinstar: Range-bound stock.

There’s an old adage among traders that “the trend’s your friend until it ends.” If the chart you printed out shows the stock price climbing, it’s likely to continue doing so until some force acts upon it to change that trend. The opposing force that shifts the trend is changed expectations about the company’s prospects. This may include a poor earnings report or reduced forward guidance. A negative news article or downgrade from a Wall Street brokerage firm can also deflate a stock’s momentum. But since the event is unknown until it happens, the simplest assumption is that the stock price will continue on its current trajectory until it something causes changed expectations.

When the trend reverses, get out of the way. It seems simple, but behavioral finance wouldn’t exist if people were rational. For example, during the Internet bubble, why did investors ride companies all through the uptrend and not sell when the trend turned?

Their mistakes were in not taking advantage of a clear upward trend and not thinking beyond it—believing instead in a paradigm shift, new era, or some other bubble-headed nonsense that seemed to confirm the glossy hype of business-to-business software, fiber optic networks, Internet infrastructure, biotech drugs not even in trials, and new valuation methods. Emotion clouded judgment so that, instead of simply following the trend up and selling at any point for a super profit, investors held when the trend turned south, convinced that everything would turn around because of the good-news stories, which really were just nonstop trains to bankruptcy. No matter your strategy or tools, a stock is a vehicle for a bullish or bearish bet. Investors confused the two.

Investors must separate themselves from the emotion of thinking XYZ is a good company and therefore a good stock . A good company doesn’t necessarily make it a good stock. For years, Microsoft has been a good company. It changed the world by introducing software to make computers more useful, creating millions of jobs, boosting productivity, and enriching the lives of countless people around the globe. Microsoft generates an unbelievable amount of free cash flow, much more than it could ever need or invest. It carries billions in cash on its balance sheet and no debt, with regular dividends, special dividends, and massive buybacks. Yes, Microsoft has been a great company, but its stock has done zilch in the past 10 years (see Figure 7.4). Good company. Not so good stock.

Figure 7.4 Microsoft: Good company, not so good stock.

Therefore, when looking at a stock chart and determining a trend, it is important to focus on price action only and not other factors, such as management team, dividend yield, sector, free cash flow, P/E, or anything else that might obscure the picture. Those items are appropriate for fundamental analysis, but using them here is like taking your grocery list to Home Depot. You go home empty handed. These are not for technical analysis.

Technical analysis gets a bad rap, because it is associated with complex indicators. But indicators are derived from price. So, why not begin with price and analyze price trends, without muddying up the process by throwing mathematically complex indicators on the charts?

Principle 2: The Laws of Supply and Demand Will Not Be Repealed¹

The same principles of Economics 101 supply-and-demand curves hold true for stocks. When supply is increasing, the share price will be under selling pressure. When demand is robust, the share price heads higher. I live by the tenet that there is always someone who knows more about a stock than I do and that what people say and what they actually do are sometimes two different things. The best way to figure out what the well-informed investors are actually doing, rather than just what they say they’re doing, is to analyze supply and demand for shares by simply following the volume traded. You do not need to be a geometry whiz to draw wedges, triangles, squares, wiggles, or any other type of chart-pattern analysis. Volume trends are clear on the stock chart.

To study supply and demand, I use two indicators available on MarketSmith charts produced by William O’Neil + Co., Inc.: up/down volume ratio and accumulation/distribution rating. Up/down volume ratio is pretty straightforward. If a stock price is down for the day, all of the volume traded that day is assigned to down volume. If a stock price is up, then the volume is assigned as up volume. Compare the up and down volume sums over the prior 50 days to create a ratio of up to down. A ratio of 1.0 means as much volume was traded on up days as on down days: the volume patterns in the stock are evenly balanced. Anything greater than 1.0 means there is more buying power than selling pressure, and anything less than 1.0 means heavier selling than buying. Figure 7.5 shows this metric for OpenTable, which at the end of 2011 had a score of 0.6, showing far more selling than buying.

Figure 7.5 OpenTable: Up/down volume ratio of 0.6.

Large institutions buying or selling stock have the ability to move that stock over a period of time. All of the action doesn’t happen in one day. Institutions such as Fidelity or Putnam or even the largest hedge funds are simply moving too much capital around to complete their orders in one day. Therefore, the up/down volume ratio provides an easy way to grasp the trend of where the buying power and selling pressure of stocks in the market are occurring.

As a short seller, I like to see the up/down volume ratio trending lower in conjunction with other technical signs discussed in this chapter. Therefore, a ratio below 1.0 is not necessary, although it may be preferred. More important is a ratio declining from 1.5 to 1.2 and ultimately dipping below 1.0. That signals increasingly intense selling pressure from large institutions.

The second indicator is the accumulation/distribution rating, also a proprietary metric from William O’Neil + Co., Inc. Generally, I am skeptical of using proprietary indicators, because I can’t be certain of the math behind them. However, because the accumulation/distribution rating relates to supply and demand for shares of stock, it’s highly probable the inputs reduce the chances for error. It’s worth using as one tool, so long as it’s not the only one. The rating systems runs from “A+,” indicating substantial demand—accumulation (buying) far in excess of distribution (selling)—to “E” for heavy selling of shares—distribution that dwarfs buying. Figure 7.6 shows this for Ciena, which has a rating of C–, showing considerable distribution.

Figure 7.6 Ciena earns a C–, showing considerable distribution (selling).

Principle 3: Be Alert for Divergences

Divergences occur when the stock price and an indicator do not confirm each other. For example, there’s divergence when the price makes a new high and an indicator fails to make a new high.

Relative strength is a measure of the stock’s price performance over a period of time. William O’Neill + Co. weight it more toward recent prices. The scale is 1 to 99, with 99 indicating a stock that has done better than 99 percent of stocks and 1 indicating a stock that has done worse than 99 percent of stocks.

I look for two primary divergences. First, I analyze the relative strength line—a weighted moving average—in comparison with the price action of the stock. If the stock price is breaking out (rising dramatically in relation to previous flat or range-bound performance) and the relative strength line is lagging, that is a divergence. Although the price is reaching new highs, the performance of the stock relative to the rest of the market is weakening: For some reason, other stocks are performing better. This is a negative divergence for the long buyer and positive for the short seller.

The opposite divergence occurs when the relative strength line is breaking out to new highs, but the price of the stock is lagging. The performance of the stock is accelerating relative to the market even though it’s not yet reflected in the price. This is a positive divergence for the long buyer and negative for the short seller.

For example, Figure 7.7 shows that WMS Industries made a new high on the weekly chart May 7, 2010, yet the relative strength line failed to make a new high and surpass the level from October 23, 2009. Then, as WMS rallied again on December 10, 2010, the relative strength line was in a clear downtrend. Each time the stock attempted to push higher, the relative strength line lagged by a greater amount and eventually fell off a cliff. Increasingly, the stock was coming under selling pressure relative to the rest of the market, even though this was not yet reflected in the stock price. That’s positive for the short seller and negative for the long investor.

Figure 7.7 WMS Industries: Relative strength line lagged compared to stock’s new highs.

I also look at the slope of the relative strength line—the “falling off a cliff” at the right side of the chart. If the relative strength line is trending down, but the price of the stock is on an uptrend that is a bearish divergence: the relative strength of the stock is not confirming the move in price. For WMS, by February 2011 as the stock was just starting to break down, dropping significantly compared to its previous action, the relative strength line was already in a clear downtrend with a dramatic slope, a leading indicator of lower prices ahead.²

The second divergence relates to the price action of the stock and its volume. If the stock is breaking out to new highs or out of a base (a period of flattish prices), but on weak volume, substantial buying power is probably not supporting the stock. I define weak volume as volume below the 50-day moving average of volume or lower than prior breakouts on the chart. In order to sustain their upward trajectory, stocks need more and more buyers to drive the price higher. Unless and until large institutions decide to support the price of a stock—indicated by up/down volume, accumulation/distribution, and divergence that’s positive for the buyer—I’m dubious of an upward trend.

Because the laws of human nature have not been repealed, individual investors are still often late buyers. They latch on to a trend because they hear more and more about the “hot stock” or “can’t-fail business.” Their volume can boost a price at high levels because no one is selling yet and their smaller volume has an effect. They are the paradigm of the average investor’s experience of buying high and selling low. They are the last to know that trouble is just around the corner, because they are buying a story and the price rise is a classic example of confirmation bias—“everyone else is doing it, therefore I must be right.” Large institutions are more than happy to unload their shares to individual investors at inflated prices.

An underlying truth has never been better expressed than in O’Neil’s analogy of a large institution to an elephant in a bathtub. All these indicators and their divergences matter, because in the intermediate term, large institutions have such significant assets under management that when they buy and sell a stock, it is impossible for them not to influence the price. They are elephants that, no matter how poised while bathing, splash water all over the place. Plus, they too may operate in herds, subject to confirmation bias. The more they buy, the more the stock rises. But when they start selling, look out below. A sure sign is when individual investors pile in, often indicated by rises on low volume. This is bearish for the long investor and bullish for the short seller. After all, the elephant also splashes water all over the place when it gets out of the bathtub.

Let’s see all these factors at play in shares of Green Mountain Coffee Roasters. As they pushed higher in 2011, they did so on less and less volume (see Figure 7.8). By the time the stock price leveled out in September 2011, the up/down volume ratio was just 0.80—a ratio of less than 1.0, showing prior 50-day selling volume greater than buying. The accumulation/distribution rating also flashed warning signs with a D score. More selling volume (likely from institutions with large blocks of stock) was occurring on down days than volume when the stock was up (likely from individual investors late to the party). While the relative strength line was 99 and Green Mountain was outperforming all other stocks in the market, chinks in the armor were forming. Volume was not sufficient to sustain a push higher. Unless something changed that altered the fundamentals favorably and brought in new buyers, shares of Green Mountain likely were in trouble. Because of this, I dramatically increased my short position. Figure 7.8 shows that the stock blew up on its earnings announcement and set off a domino effect of company problems and further stock price collapse.

Figure 7.8 Green Mountain Coffee Roasters: All indicators bearish.

The unknown is always a risk. The long investor insists on a margin of safety, rationally fearing a negative, fundamental change in the business that can reduce the value of the stock. The short seller also must consider that something favorable can alter his short thesis. Just as individual buyers may buy once the good news is long gone and before institutional buyers sell, private equity firms or other acquirers have been known to overpay. Using these technical tools reduces upside risk, just as Tom’s deep-value investing on the long side reduces downside risk. Perfect timing is not the goal. Reducing the risk of wrong timing most definitely is.

Principle 4: The 50-Day Moving Average Is the Maginot Line

It should be clear that it is not necessary to have a plethora of indicators, moving averages, and gadgets on a chart to figure out the trend in a stock. They are nothing more than derivatives of price, which any of us can see if our eyes are open. However, one derivative I do value is the 50-day moving average (50 DMA) of price. Fifty days are long enough to eliminate much of the noise around prices but short enough to capture intermediate trends. By the time a stock breaches (falls below) its 200 DMA, for example, the price may have fallen considerably, leaving insufficient reward for the risks to take a short position.

I call the 50 DMA the Maginot Line of stock prices. Before a big move to the upside or downside, it is the last line of defense against those wishing to suppress prices or push prices higher. Once it is breached, up or down, a stock can move considerably further in that direction.

There is one fact about the 50 DMA and 200 DMA that is worth noting. Any stock that has ever fallen to zero has breached both levels. This may seem obvious to most readers, but it’s a sign to sit up and pay attention. When stocks is below both levels, it’s most important to concentrate on understanding the fundamentals on the long side or short side. You might think “it’s already so far down,” then take a gain, but it could be poised really to die. The 50 DMA tells the current trend and potential future of a stock price. With a short candidate, I want to see significant volume when the stock breaks below its 50 DMA, preferably hundreds of percent higher than the 50 DMA of volume. Such a massive volume shows that institutions are shedding shares with reckless abandon.

The 50 DMA is a tool of the short side, but it’s no magic bullet. A stock may pierce the average to the downside only to bounce back and resume its upward trend. However, persistent selling around the average over time is an indicator of potential future weakness. Therefore, I analyze volume patterns not only around current price action at the 50 DMA, but also around what occurred in the past—such as the last 12 months. Imagine that stock price is an onion. Every time it breaks below the 50 DMA on high volume, a few layers are peeled away, until nothing is left. There’s no buying power to support the stock, and ultimately it plunges sharply lower.

Trading around the 50 DMA may require taking many small losses before ultimately capturing a large profit. It may be the eighth trade before it works as expected. So it is more about what you do with a trade once it’s on, once you’ve found the trade idea in the first place. Juniper Networks in early 2011 (see Figure 7.9) shows the small-loss-before-big-gain process well.

Figure 7.9 Juniper Networks: Trading around the 50 DMA, a few small losses and then the big drop.

We looked at Juniper Networks in Chapter 2, highlighting how a change in revenue recognition policy pointed toward overstated growth. This is a classic example of a stock that started to break down before the deteriorating fundamentals were well known. The stock broke below the 50 DMA on January 20, 2011 on volume 188 percent greater than the 50 DMA volume. But the stock quickly rebounded toward a 52-week high by early March.

On March 18, the stock broke the 50 DMA on heavy volume, and, yet again, Juniper rapidly rebounded and attempted another comeback, but this time it did not set new highs. The third time was the charm. On April 4, Juniper shares broke the 50 DMA on greater than average volume, closing off 3.6 percent near its lows for the day. The stock was already weak. And then on July 27’s profit warning, the stock ripped apart, falling 21 percent on nearly five times average volume. It extended the drop to 35 percent in eight more trading days and, as of December 5, 2011, had not closed above the 50 DMA.

The 21 percent gap down in price was the confirmation of the Juniper revenue recognition thesis. Yet, the stock was already showing signs of weakness before the fundamentals became well known in the market place. This underscores the value of paying attention to both the fundamentals and the technicals: Oftentimes, changes in momentum precede changes in the fundamentals.

It is easy to get caught up in the minutiae of moment-to-moment changes in stock prices. One day you see that there’s a bailout of a major economy that sends stock prices soaring, only to find that the next day the same or another economy is in the tank and stocks come crashing to earth. Intraday, the swings can be even wilder, especially with the advent of computer programs such as high-frequency trading. Even the most rational investor can’t hide from media fear and greed or up-to-the-minute stock quotes. This noise can lead investors to believe they have a feel for the market, lulling them into making decisions against their strategy and beyond their competence. They drop the most important thing any investor has—a disciplined, repeatable process—and flail in the wilderness, losing money.

I used to stare at a quote machine all day long. After my blood pressure reached 160/120 it just wasn’t worth the stress. Today, with no loss of performance, I pay virtually no attention to intraday prices. The closing price is what matters, and it is more important the longer the timeframe.

I can see everything I need to know on daily, weekly, and monthly charts. If a stock is at an all-time high, then it doesn’t really matter what it did each nanosecond before it reached that high. If a stock breaks out to the upside on a monthly chart after years of sideways action, that is far more important than what happened during the last few days or hours.

The myth is that technicians live like day traders, trading pennies by rapid fire. Some do, some don’t. I don’t. I focus on a few metrics that matter and prefer charts over a longer timeframe. The orders of precedence I give stock charts are monthly, weekly, and daily. I prefer all three to be headed in the same direction. If the daily chart is breaking down but the weekly chart is still firmly in an uptrend, then I give more weight to the weekly charts. and so on for the monthly. Confirmation among the three provides more confidence that my trade may be profitable.

Principle 5: Risk Management Is More Important Than Picking Stocks

When you’re looking to maximize profit, risk management is key. Controlling losses may not be as exciting as focusing on the upside, but it’s crucial to generating winning returns. Most investors focus on the blue skies ahead, but you make just as much (if not more) money not getting drenched in the rain. Many of history’s most accomplished investors achieved their incredible track records, not by hitting home runs, but by sidestepping bombs that could have destroyed their portfolios’ returns for years. That’s why the size of your trades and whether you actively manage them are more important for risk management than simply choosing a stock.

Consider two famous investors’ opposite risk management philosophies. First up is the strategy espoused by Bill Miller, famed for beating the S&P 500 for 15 straight years from 1991 to 2006 as fund manager of the Legg Mason Value Trust. His strategy is “lowest average cost wins.” Once he has made a decision, and presumably values the security, if its price falls, he is willing to buy more shares to lower his average cost. If his research proves correct and the stock recovers in price, he earns even better returns than if he hadn’t averaged down.

On the other side of the spectrum is the strategy used by Paul Tudor Jones, who at Tudor Investments has made billions of dollars for himself and his investors. Jones’s strategy is “losers average losers.” In other words, if you average down, you will lose more, because you compound your mistakes. Jones doesn’t add to stocks that aren’t going his way; rather, he cuts his losses and tends to increase positions that are going in his favor. He employs technical analysis.

Which strategy is correct? In my opinion, Miller’s strategy is risky and overconfident. Buying more on the way down assumes that you know something the market doesn’t and that handsome rewards await you once your analysis proves to be correct. That sounds good in theory, but what happens when you own shares of businesses that seem top-notch—companies like Enron, WorldCom, Wachovia, Bear Stearns, AIG, and Freddie Mac—and never snap back? Miller owned all of these stocks in his fund, and as he found out, this strategy can destroy performance. He didn’t know what he owned.

Conversely, Jones’s strategy keeps you in the game long enough for your research to work out and for you to realize higher returns with less risk. When the bottom fell out in 2008, Tudor Investment’s flagship fund lost a mere 5 percent while Legg Mason Value Trust lost more than 55 percent—over 11 times more. Miller confused growth with value backed by tangible assets. He averaged financials and other black boxes when he could not know the companies’ underwriting and other standards or investments.

In my own fund, I applied Jones’s methodology with my own twist.. First, I set a target position size, usually 5 percent for a company with serious aggressive accounting issues. I might only target 2.5 percent for one with fewer red flags. Then, I don’t short all at once. For a 5 percent position, I may only short 2 percent initially. If the stock starts to sell off, I add to my position. If my thesis proves correct, and the company misses earnings estimates and the stock price gets clobbered, my position is now maximized for full effect. If the stock moves slightly against me, I might short a bit more, say, from the original 2 percent to 3 percent. However, if the stock continues to move against me, I don’t add more until the stock starts to fall again.

I don’t employ Bill Miller’s strategy on the short side, which would be “highest average cost wins.” If the stock continues to rise, I put in a protective stop—a stop-loss order—above the recent high to ease out of the position in case it continues to climb. In my experience, stocks rarely reach new highs and then implode. They reach highs, sell off, rise again but not as high, and then implode. They almost always start to sell off before big problems occur. Individual investors are the last to the volume party, but the institutions—the elephants in the bathtub—have already started selling. You don’t have to take this on faith. You see it in price and volume.

Conclusion

With this strategy, my portfolio is always tilted toward what is working in my favor and away from what isn’t. I’m willing to take numerous small losses on a stock, if there is a large gain to be had if and when it works out. If I’m completely wrong, I’ve minimized the damage by having smaller positions in those stocks. Tom and I can control our processes, but not the results.

Sizing and active management are far more important to risk management than your original stock selection. Size one big loser wrong, and you’re out of the game. Size positions appropriately, and you can keep playing to win.

William O’Neil + Company is a Registered Investment Advisor providing research and marketing data services, including WONDA^®, to more than 350 of the world’s leading institutional investment professionals. Founded in 1963, William O’Neil + Company is headquartered in Los Angeles, with offices in New York, Boston, Chicago, and London.

WONDA provides access to over 55,000 global equity listings with key fundamental and technical data laid out in an easy to read proprietary Datagraph^®. Additional benefits include time-saving Preset Lists, Quickscreen, and proprietary Ratings and Rankings to find new ideas and monitor existing holdings. For more information visit www.williamoneil.com .

Chapter 7Stock Charts: Know When to Hold ’Em, and Know When to Fold ’Em