For investors who are just beginning to study charts or pure fundamentalist who don't understand charts there are some basic rules you should follow. (For those of you who don't believe in charts, you are leaving a key tool out of your investing toolbox.)
One of the first steps an investor should take is to understand the longer-term trend of the market and a stock before you make a purchase. The reason is that four out of five stocks will follow the market trend, so that should be your first step. Then you should look at the trend of the stock you want to purchase to see if it is in a sustained up-trend or downtrend.
Understanding trends and how they develop is an important key to successful investing. In order for you to be consistently profitable, you will need to focus on the strongest prevailing trends in the market. This is where the institutional money will be flowing and that is where you will profit the most.
Trends are always developing somewhere in the market. Some are short term, like when a plane crashes because of mechanical problems. That will usually push the price of airline stocks down, but, in most cases, is a short-term effect. A long- term event could be our aging population and the need for health care in the coming years.
Then, of course, there are economic forces that are short term and long term. These macro trends filter down to certain industries and then to the companies themselves. All professionals pay attention to trends in the market and how they will affect the companies that they own. As an individual investor you need to understand the basics of trends or you are in essence flying blind.
The way to examine trends is by looking at a picture of the movement in prices with charts. Charts are used in just about every business: Companies use charts to predict sales, marketing, and profit trends in their business, anddoctors use charts like X-rays, EKGs, cat scans, etc. to look at the internal health of a person. To you and me, the wavy lines from an EKG would mean nothing, but to the doctor it gives an important picture of the health of your heart. These tools help doctors evaluate your health. Stock charts do the same thing; they let you view the internal health and trends of the market and stocks.
Charts show you the line of least resistance. They are not magic tealeaves; they are just tools that give you an edge when buying or selling stocks. It is like watching a person day after day. Eventually you know how that person will react to different situations.
The same thing happens with stock. Some are wild and all over the place. Some move in steady steps and are not very volatile and some just stay in a certain range that moves up and down at particular prices. Charts reveal the personality of the people who are trading them. In essence you are watching the movement of a mass amount of people and how they react to different situations.
Stocks can move in three different trends and those trends can be measured in the short, intermediate to long-term. The three formations that can take place are:
Uptrends occur when a stock is being accumulated or being bought.
Downtrends occur when a stock is being distributed or sold.
Sideways movements occur when a stock is consolidating or has equal buying and selling. This happens when a stock is resting before continuing its move.
Today we are going to focus on the long-term picture of the S&P 500 and
If you look at the S&P 500 you will clearly see four major trends over the past 12 years on this long-term chart. (Label 1. Illustrates up-trends label 2. Illustrates downtrends.)
In the late 90s the market was in a sustained uptrend. You can see from the chart that the prices clearly broke below the long-term uptrend line when that trend ended. That would be a time that investors would certainly want to either lock in profits on their stocks or a least set protective sell stops to protect positions.
If the prices would have immediately moved back above the yellow trend line the sell signal would have been false, but that didn't happen and the downturn lasted for three years. In 2003, the market broke out of the three-year downtrend and began a new bull market.
The conditions changed in January this year when the market broke that long-term uptrend. Currently, the S&P 500 is in another downtrend and that will not change until we break back above the red downtrend line.
Apple has been a very popular stock and one that has been very strong for quite a few years. But the chart indicates that trend may be changing as it broke its long-term trend earlier this year and, as label 5 shows, has rallied up on declining volume and is failing at that level.
Label 1 shows a strong break out on increasing volume during the multi-year rally. You can see that the stock topped in January rose 6 and went into an intermediate-term decline. It then broke above label 3, which is the downtrend line in July, and began another sustained uptrend shown in label 2. (Be aware that this is a long-term weekly chart and that each bar represents five trading days.)
It is also important to remember that trend lines are not walls that hold up or hold down a stock. They are just guidelines to give investors the general direction of the market or your positions and trend lines are often slightly breached before the direction is resumed.
Also trend lines should not be used without the help of other indicators such as volume patterns, which we will take a look at another time. Using charts along with your fundamental criteria should help you to dramatically increase odds of successful investing.
At time of publication, Manning had no positions in stocks mentioned, although holdings can change at any time.
Mark Manning, AAMS, is an Accredited Asset Management Specialist and Registered Investment Advisor with Butler, Wick & Co., where he specializes in wealth management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Manning appreciates your feedback;
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