Saturday, February 10, 2007

Mastering the Art of Bullish Trend Discovery.

Successful investors all understand how due diligence works. We hear of a stock on CNBC or some other financial news source and the story intrigues us. However, since this isn’t Atlantic City and were not gambiling, we don’t risk our capital on the first pretty face we see. Instead, time is taken to grasp and understand the core fundamentals backing the company of interest. Essentially, this is composed of all the quantitative information pertaining to the economic viability of the company. This can include such items as brand equity, market share, liabilities vs. assets and earnings. Once the appropriate time has been taken to grasp the inner workings of the company, we the investor can make the decision to purchase shares.

However, simply because the fundamentals of a company appear immaculate doesn't dictate that Wall Street will reward the stock accordingly. This concept has confused me on many occasions. If the company is performing so well, why then is the stock languishing in 52 week low la-la-land? The reasons for this phenomenon are difficult to pinpoint. It could be as simple as a company’s lack of exposure to Wall Street. If the market does not realize the company’s success then is cannot respond accordingly. Other issues such as political legislation may present difficult obstacles for the company to achieve adequate growth. This was seen on April 1, 1970 when President Richard Nixon signed the act to ban all tobacco advertisement on TV. Despite this laughable set back, we all can rest assure that our friends down at the Altria Group Inc. (MO) have done just fine. Regardless of the reason, what’s important here is that the company’s stock and the underlining company’s economic performance don't always parallel. Due to this phenomenon, investors may come across a successful company, buy shares, and then watch as the price-per-share (PPS) dwindles.

So what is the solution? How can we accurately time market entry in our favorite stocks without missing the big moves? The key is patience and observation. I've had difficulty with this task and was deservingly punished. However, there is hope for us all. Within a stocks chart hides valuable alarms which can signal an underlining change in market sentiment. Finding and capitalizing on these signals is the solution to proper market entry. Although not all investors practice or grasp an adequate understanding of technical trading or trading through the utilization of charts, a basic understand of moving averages and the importance of volume and price development will suffice.

Power Spike

In his 2001 book The Master Swing Trader, Alan S. Farley signifies the importance of volume in relationship to price development. Common trading knowledge dictates that volume precedes price. Without adequate market participation a stock can't sustain a rally. It is in these moments of high volume that emotions and market participation reach an unprecedented level and allow stocks to run.

Every stock creates an average daily participation which oscillates through price development. Instances of volatility, external events and surprise press releases have a high percentage of shocking this harmonic average, which in turn can propel the stock into a new trend. When previous levels of resistance are tested on high volume, more often than not, that established barrier can be broken; allowing the stock to move higher uninhibited. Identify these events when volume exceeds 150% of the daily average. These instances can be the catalyst required to grab the attention of the market and generate higher participation during the days, months and even years that follow.

Some words of caution. With increased volume comes increased volatility. Be aware of an exhausting power spike that can deplete the potential supply of buyers. In these cases the volume spike may be so intense that there is no one left to carry the stock higher. Be sure to rule out potential mergers and acquisitions as the reason for the move. These events will generate high volume movement, but leave little or no room for upward PPS development. Finally, if the shocking event comes in the form of a press release, read the news and determine if it is in fact worthy of the excitement that Wall Street is giving it. There is nothing worse than being stuck with a long position after a company has released some superfluous news that draws in participants and leaves them holding a very large, overprice bag of worthless shares.

The Golden Cross

For those of us with little knowledge of technical trading, I will give a brief description of moving averages. There are many types of moving averages such as simple, exponential and linear weighted. For the sake of simplicity we will use and discuss the simple moving average as the basis for this post. According to StockCharts.com, "A simple moving average is formed by computing the average (mean) price of a security over a specific number of periods." Basically this means that if we are calculating a 200 daily moving average (200 DMA) we take the sum of the closing prices for the last 200 days and divide that number by 200. Nevertheless, we shouldn’t have to calculate these numbers ourselves because modern charting programs such as Stockcharts.com already have this feature built in.

These moving average ribbons smooth price action out over the duration of the average. The longer the moving average, the more smooth the price action and the more weight it carries. Thus the 200 DMA is viewed as the best indication of long term market sentiment. As the shorter term 50 DMA crosses the longer term 200 DMA, the underlining market sentiment of the stock changes from bearish to bullish. Stocks trading above their 200 DMA often continue to trade higher, while stocks trading below continue to drift lower.

The idea behind The Golden Cross stems from the interaction between the 200 and 50 DMA. In the instance of Microvision Inc. (MVIS), the stock was trading below its 200 DMA in September of 2006, but as the pps began to move higher the shorter term moving averages such as the 20 and 50 DMA began to move higher as well. Eventually, in December of 2006, the 50 DMA crossed over the 200 DMA forming a golden cross. This point in conjunction with the power spike on November 4, 2006 sent strong buy signals, which if acted upon would have resulted in substantial gains.

The usage of these market signals is important when determining the entry point of our favorite stocks. As I stated in my first point, the reason we buy and sell stocks is to make money, so what then is the purpose of buying fundamentally attractive stocks when the underlining market sentiment is bearish? Successful recognition of the technical indicators mentioned above and others can lead to more accurate price prediction and if used in accordance with sound fundamental analysis, can yield great investing returns.



1 comment:

Woodshedder said...

Nice post!
Re: MVIS
I wonder if it will fulfill the common wisdom that a move starts from one Bollinger Band and continues at least until it reaches the other band.