charting techniques and patterns

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P A R T III

ChartingTechniquesand Patterns

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C H A P T E R 6

The Importance ofChartsA Visual

Confluence of Price,Time, and Emotion

Why Charts?

Which conveys more information about a specific oak tree, a

picture of the tree or a 1,000-word description? Now suppose

that you have just five seconds to assimilate the information.

According to an old Chinese proverb, a picture is worth

1,000 words. To which I add: A chart is worth 1,000 numbers.

A chart takes a jumble of numbers and makes them workable,

and your mind makes visual connections that are not apparentin a list of numbers.

Remember, the primary number to chart isstock price, which

is in constant flux. Each price is set where the supply and de-

mand lines meet, where willing buyers meet willing sellers.

Each time a buyer and a seller meet, the price can be different

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Deemer on Technical Analysis

from the last. It can go up and go down. You track that change

in pricethat junction of supply and demand.

So the static numberthe price on any given dayis not as

important as the direction and rate of change. And charts let

you understand them much, much more easily than looking at

a list of numbers.

When charting, always remember two things: KISS and the

90/10 rule. KISS, of course, stands for Keep It Simple, Stupid.

The 90/10 rule, meanwhile, states that you can get 90 percentof the information from something in about 10 percent of the

time, but it takes the remaining 90 percent of the time to get the

remaining 10 percent of the information.

A Basic Chart

Before we go any further, lets define the elements of a basicchart. Figure 6-1 is a daily chart that shows the emerging-

markets exchange-traded fund (EEM) from July 2008 through

April 2009 and is from the invaluable DecisionPoint.com site

that I use regularly.

The most basic thing on the chart, of course, is the price

itself. Since this is a daily chart, each vertical line or bar depicts

the trading for a particular day. The high and low prices eachday are connected with a vertical line, and the closing price is

represented by a little cross-tick.

The solid line on the price chart is a moving average. This

one happens to be a 50-day exponentially smoothed moving

average, but there are many, many different moving averages

in use among market technicians. Moving averages are used

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The Importance of Charts

to measure both trends and momentum. If the stock price is

above its moving average, its in an uptrend, and if its below

the moving average, its in a downtrend. In addition, if the

price is above the moving average and moving further and

further above it, the stock is gaining momentum, whereas if

the price is above the moving average but getting closer andcloser to it, the stock is losing momentum.

The same works in reverse, of course, when the stock is be-

low the moving average. In addition, if the stock price is way,

way above the moving average (over 30 percent, lets say), its

overboughtextended on the upsidewhich makes it vulner-

able to at least a short-term correction. The opposite is true if

Figure 6-1: A Basic Chart.

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its way, way below the moving average (as EEM was in October

and November of 2008). And obviously, the longer term the

moving average, the longer term is the trend youre measuring.

Finally, line at the bottom of the chart is the all-important

relative-strength linewhich is simply the stock price divided

by a broad market index such as the Standard & Poors 500

Index (S&P 500).

Interpreting the relative-strength line is simple: A rising

line means that the stock is outperforming the market; a fallingprice means that it isnt. Dont worry about the price of the

relative-strength line; it means nothing. All were interested in

is whether the line is going up or going down.

(One of the greatest advantages of the DecisionPoint.com

site, by the way, is that it enables you to easily chart a stocks

relative strength versus just about anythinga market sector,

an overseas stock market, and gold, to cite just a few examples,

not just the S&P 500.)There are, of course, all sorts of additional indicators and

different methods of charting stocks that are available on the

various charting websites. In this book, though, Im not go-

ing to go beyond the basicswhich is really all that long-term

investors needbut if youd like to learn more, see the Appendix

for a few suggested resources. Youll also find a list of some of the

better charting websites where you can look at individual stock

charts to your hearts content.

Analyzing the Chart

We really need to determine just four things from stock charts:

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1. Is the stock price going up or down?

2. Is the stock price gaining or losing momentum?

3. Is the stock overbought (extended on the upside) or

oversold (extended on the downside)?

4. Is the stocks relative-strength line going up or down?

The EEM chart happens to reflect the best of all possible

worlds.

1. The stock is going up; the price is above the moving

average.

2. The stock is gaining momentum; the price is moving

further and further above the moving average.

3. The stock is not yet overbought; the price isnt all that

far above the moving average.

4. The stock is generating relative strength; the line at the

bottom of the chart has been going up since October.(And the fact that EEM generated relative strength

throughout the markets bottoming process was the

tipoff that it was destined to be a market leader after-

wards, as youll see later.)

Please note that it takes virtually no time at all for you to de-

termine these four points, which is all that you really need

to be aware of as a long-term technically savvy investor. The

90/10 rule rules!

I am also happy to be able to report that the best of all pos-

sible worlds worked out very, very nicely for investors. EEM,

which was 28.14 when this chart ended in April of 2009, hit a

high of 44.02 in April 2010 and sold at 50.43 in May of 2011.

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Lessons from a Basic Long-Term

ChartMcDonalds

Figure 6-2 is one of my all-time favorite chartsan 11-year

chart of McDonalds from 1970 to 1981 from the Securities

Research Corporations Blue Book. It illustrates the basic chart

concepts very clearly, especially relative strength. Even more

important, it highlights the importance of sentiment in pre-

dicting future stock prices.To fully understand this chart, some background is necessary.

The big investing fad in the early 1970s was predictable

consumer growth stocks. At that time, the United States was

going through a time of unusually high inflation and unusu-

ally high interest rates, so companies found it difficult to bor-

row and expand. But approximately 50 giant consumer-goods

companies were growing so fast that they generated their own

cash needs and could finance themselves internally, so they

didnt have to go to the capital markets to raise operating cash.

They were fortresses in an angry sea. The inflationary seas

were raging around them, but these companies were so strong

that they could withstand the angry seas and still do nicely.

This group became known as the Nifty Fifty, and Mc-

Donalds was a leader among them.

McDonalds growth rate was phenomenal! It was 25 percentper year compounded. And that growth rate was steady and

unbroken throughout the decade. The Nifty Fifty investors

foresaw this in 1973 (three years into the chart) and paid 75

times earnings for the stock. And Putnam, where I headed the

Market Analysis Department, was one of the biggest of the

Nifty Fifty investors.

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Figure 6-2: McDonalds as a Nifty Fifty Stock.

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In 1973, every kind of fundamental analysis indicated that

the stock price would go even higher.

But look carefully at the chart to see where McDonalds

stock price actually went. (The earnings line is plotted on a

scale such that if the price line is at the earnings line, the stock

is selling at 15 times earnings. If the price line is above the

earnings line, the stock is selling at more than 15 times earn-

ings. If it is below, it is selling at below 15 times earnings.)

McDonalds stock price went from a high extreme of 75times earnings in 1973 to a low extreme of 7.5 times earnings

in 1980.

Well, 75 times earnings was, and is, a lot to pay for even a

predictable growth stock. But the most stunning thing on the

chart is that as the period of enthusiasm gave way to a correc-

tive process, the price/earnings ratio of McDonalds plummet-

ed from 75 times earnings to 7.5 times earnings even though

the companys compounded earnings growth rate was 25 percentthroughout the period and it never missed a quarter.

At Putnam, the fundamentally oriented money managers

were driven to tears. They had analyzed the company and

correctly forseen very good things. And those good things all

came to pass: Every quarter, McDonalds earnings would come

in at the expected 25 percent growth rate.

But the stock didnt do well. And it didnt do well quarter

after quarter after quarter, despite those fabulous earnings.

Why?

Heres what happened:

In 1973, McDonalds stock price increase had been driven

by euphoria, by a recognition of future earnings. This eupho-

ria pushed the stock price to an extreme valuation.

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But once the emotional peak was reached, in 1973,

the stock was all done. Basically, the market said, Hey,

McDonalds, youre a great company; you are going to do

fabulously well over the next seven years. But, at 75 times

earnings, Ive already anticipated that and paid for it, and Im

not going to pay more.

And so the stock price stopped going up.

After that, the only question was, How low was it going

to go?If in 1973 I had predicted that all the analysts earnings and

growth forecasts for the next seven years would come true and

that McDonalds, as a company, would do everything anyone

expected and more, but despite that, its stock price would be

lower in 1980 that it was in 1973, I would have been consid-

ered a lunatic.

But thats what happened.

McDonalds was unusually high priced at even 60 timesearnings. When it went to 75 times earnings, the risk was even

higher. Investors, of course, can never know ahead of time ex-

actly when risk will be perceived as too much. At some point,

though, the risk levels become high enough that the stock is

going to respond. So all a technical analyst can do with these

long-term charts is to say that risk levels are high or risk levels

are low and that the stock is in a position to respond negative-

ly to high-risk levels or is in a position to respond positively

to low-risk levels. Predicting exactly when this will happen,

though, is impossible. (John Maynard Keynes may have said

it best: Successful investing is anticipating the anticipation of

others.) But this gives you a long-term perspective, whether

you are in an enthusiastic period, where risk is way higher than

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usual, or you are in a period of pessimism, where risk is lower

than usual.

McDonalds actually turned out to be a happier case than

most. Its stock price was buoyed more than usual because its

earnings kept growing. In a more normal situation, earnings

would have been more sideways, and the price would have

been biased to the downside.

So the price didnt go down much. But it didnt go up ei-

ther, and people were not paying Putnam to own stockswhose prices went sidewaysespecially since a lot of other

stocks were going up during that time. Our competitors thus

got busy soliciting our clients and told them that Putnam has

McDonalds and it has gone sideways over the last few years,

and your account has gone sideways, whereas in our account

we have bought such things as US Steel at five times earnings,

and it is now at eight times earnings. And our accounts are

going up.But was McDonalds a bad purchase? It neednt have been,

not with some sensible longer-term timing and planning.

During its heyday, McDonalds went from 9 1/4 to 75 over a

period of 2 1/2 yearsand I can assure you that there were

some down days, some minor corrections, along the way. But

the stock price generally went up because investors anticipated

great earnings. The trick is to spot when the price stops going

up based on anticipation and its time to sell. Remember: No

stocks performance ever exactly tracks the performance of the

underlying company. And no stock goes up forever, no matter

what the companys earnings do.

And if the stock price is no longer going up, you have to

accept that it is going down and not try to get back into it every

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time there is a little upside correction. Keep your eye on the

long-term movements.

And what were things like at Putnam when McDonalds fi-

nally bottomed? Youll never guess: The following is the tran-

script of an interoffice memorandum exactly as it appeared at

Putnam in 1980.

AnecdoteThe Wall Street Week Memo

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AnecdoteThe Story of Baxter, US Steel,and John Maurice

This is from a special report I wrote and published on

April 9, 1999:

Back in the Good Old Days at Putnam (circa 1973),

when the Nifty Fifty were the only game in town and

the Putnam Advisory Companywhich was everybit as big a Nifty Fifty player as J. P. Morgans Carl

Hathaway, who got all the media coveragewas

bringing in new accounts almost daily, the advisory

managers used to make regular trips to the trading

room to deliver a stack of buy tickets for their Core

List stocks and a stack of sell tickets for the stocks

they had inherited.

One afternoon, John Maurice, the manager of the

Putnam Growth Fund, a card-carrying contrarian

and one of the best and most astute money managers

I have ever worked with, looked at the advisory man-

ager who had just brought in that days stack of buy

and sell tickets and said, Do you mind if I ask you

something?

Sure.

Do you ever wonder if US Steel, which youre selling

at five times earnings, might possibly be a better stock

than Baxter, which youre buying at 50 times earnings?

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No, came the instant reply. We were sold to ournew client as a growth stock manager, and a growth

stock manager we shall be.

But the deeply depressed US Steel wasa better stock

to buy in 1973 than the immensely exploited Baxter.

Not only that, the money that came flooding into

Putnam in 1973 and 1974 because of the sensational

past performance of high-quality growth stocks leftjust as quickly toward the end of that decade, due to

the underperformance of those growth stocks.

One final note: When I told this story in Boston, some-

one reminded me that the Nifty Fifty performance, which

crested in 1973, caused John Neff, the highly regarded value

manager of Vanguards Windsor Fund, to come within onequarter of being fired at the time. Neff stuck to his style of in-

vesting, though, and his fund subsequently performed so well

and got so big that it had to be closed to new investors 15 years

later. Carl Hathaways did not.

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