If I were writing the headline for this column (which I don't get to do, by the way), I'd call it "Confessions of a Fundamental Technician." What's that, you ask?
I'm a fundamental investor by early training and psychology. Looking at a company's balance sheet and long-term business prospects just seems like the right way to start a stock pick.
But over the years, I've gradually applied more and more tools for technical analysis -- which examines trends rather than numbers -- to my stock picks. I'm still not comfortable beginning my analysis with price trends, but by experience, I've come to believe that technical tools can improve fundamental analysis of a stock. And that makes me a fundamental technician.
Getting Down to the Tools
To illustrate what this means, let me show you a few examples of fundamentally attractive stocks that I've researched further, using the tools on
for technical analysis.
Let's say your fundamental research has led you to shares of
, the world leader in joint-replacement devices. You're attracted by the company's history of delivering 20% or better annual earnings growth in 19 of the last 20 years. (The exception is 1998, when charges for acquiring Howmedica broke the string.) And you like the way that an aging population plays into Stryker's strength in orthopedic implants and rehabilitation services: The company is one of the few in this economy that still has pricing power, and Stryker has been able to raise prices by 2% to 3% a year recently.
But what if the bear market isn't over? Am I still interested in buying this stock? I certainly don't want to buy Stryker, no matter how good its fundamentals, if the stock sinks like a stone whenever the market stumbles.
To figure out the trend on the stock, I turn to technical analysis.
In the "Stocks" section of
, I click on "Charts" and then type in Stryker's symbol, SYK. Once the chart appears, I click on "Price History" under the "Chart" menu, and under "Period" I chose "5 Year."
What comes up is a simple line graph of the price of Stryker shares for a period that encompasses the last stages of the great bull market that ended in 2000 and the ongoing bear market. At first glance, it sure doesn't look like this is a stock that cares about the direction of the market as a whole -- it went up in the bull, and it has kept going up in the bear.
To get a better picture of that, I go to the "Analysis" menu and click on "Moving Averages" and "200-day moving average." A moving average works to smooth out a trend -- each point on the 200-day moving average line represents the average price for the 200-day period that ends with that date. From Stryker's 200-day chart you can see that the trend is remarkably steady -- with a dip in July 2002 -- despite the general market trend.
But for good measure I want to examine that period of weakness in more detail. Was it a sign that the trend had changed? For this I go back to the "Analysis" menu and add two more moving averages, the 50-day and the 10-day. These give me smoother but shorter-term trends. And looking at these lines, I like what I see: After dropping below the longer 200-day average (a red flag in technical analysis) in April and June respectively, the 10-day and 50-day averages crossed back over the 200-day average. From this it looks like the upward long-term trend for the stock's price is intact.
Evaluating Strength of a Trend
Let's take another example:
This Rocky Mountain producer of natural gas has just finished a tough third quarter that saw revenue and income drop as the company curtailed production from second-quarter levels in response to low natural gas prices. But gas prices have started to rise again, thanks to colder winter weather and low supplies, and that gives the stock a very attractive fundamental story for the months ahead. Despite the production dip in the third quarter, natural gas production at Tom Brown will still climb 10% to 12% this year, and the company has managed to increase reserves and cut costs. Our StockScouter gives Tom Brown an "A" on fundamentals.
But the stock has had a tremendous pop in the last month, climbing to $26.65 on Dec. 13 from $22 on Nov. 22. Am I in danger of buying at a temporary peak if I buy now -- and if I own shares that I bought earlier, should I be thinking of selling them?
To figure out the strength of a trend, I turn to technical analysis.
Reconstruct the same price history chart with 10-day, 50-day and 200-day moving averages that we built for Stryker, and apply them to Tom Brown. But now, instead of using a five-year period, chose "3 Month" from the period menu. On this chart you can clearly see the strength of the bounce that began on Nov. 13.
To judge the strength of that bounce, I'm going to add other technical indicators to that chart.
First, from the lower half of the "Analysis" menu, I choose "volume chart." This creates a second chart below the main price history chart populated by black bars of varying heights. These bars represent the trading volume in thousands of shares for Tom Brown on each day during the period of the chart. What I'd like to see is trading volume increasing as the stock takes off in price -- that's an indicator that the move is attracting more investors interested in buying the shares even as the price climbs. And that's what I see with Tom Brown for most of the last month. (If the stock were sinking and I were interested in seeing how strong the downward trend was, I'd check volume again. Rising volume as a stock falls is a bad sign -- it indicates that the selling is attracting more sellers. Declining volume would indicate that the selling is exhausting itself.)
If you want a more detailed read on investor sentiment than you can get from this volume chart, take a look at the MACD indicator. If you choose it from the analysis menu, it will pop up in the lower chart box, replacing the volume chart. This indicator, developed by technician Gerald Appel, looks for changes in the convergence and divergence of two moving averages (hence its full name of Moving Average Convergence/Divergence indicator) as a way to indicate changes in buy/sell opinion by investors on a stock. When the black line crosses over and moves above the red line, that's a buy signal -- and as long as the gap between the two lines stays open (or better yet widens), the indicator continues to advise buy. When the gap closes and the black line crosses below the red, the indicator is advising that sentiment on the stock has changed for the worse and it's time to sell. On Dec. 13, the MACD indicator on Tom Brown was still flashing a very strong buy as the gap continued to expand.
Current and Future Fundamentals
For a final example, look at
On current fundamentals, Smithfield Foods is nothing special to look at. Earnings for the quarter that ended Oct. 27 were down 93%, thanks to a 33% collapse in hog prices over the last year. The company expects the bust in hog prices to continue in the current quarter. That's enough to earn the company's stock an "F" on fundamentals from StockScouter.
Which is why the recent uptick in the stock's price is so intriguing. If you look at the a one-year chart for Smithfield Foods that shows 10-day, 50-day and 200-day moving averages, you'll notice that the share price moved above both the 10-day and 50-day moving averages on Nov. 11 and bumped into the 200-day moving average a month later, on Dec. 13.
To get an early heads-up when current poor fundamentals are about to turn into future attractive fundamentals, I turn to technical analysis.
Technical analysis works because stock prices move on fundamental news, and that makes the prices themselves useful encapsulations of all the information the market has on a stock. Because it's a whole lot easier and quicker to use technical analysis to scan 100 stocks for changes in price trend than it is to study 100 stocks looking for changes in fundamental trends, technical analysis is a good way for fundamental investors to get a fast heads-up on a changing fundamental situation.
A simple price history chart with moving averages will give an investor this kind of heads-up. Whenever a stock's price moves above a major moving average -- the 50-day moving average, for example -- it's an indicator to a fundamental investor to take a look at the stock.
Other indicators can tell you how significant the stock's price move is -- in relationship to its normal day-to-day volatility -- so a fundamental investor can concentrate on just those cases likely to indicate important fundamental changes. For example, from the "Analysis" menu, choose "Moving Average Envelope." This indicator uses moving averages and a measure of the stock's normal deviation from those averages to create a channel that contains most of a stock's price movement, in the same way that a river bed contains a river's normal flow of water. Price movements that break through this envelope signal changes that aren't business as usual, just as a flood isn't business as usual on a river. Looking at this indicator for Smithfield Foods, for instance, a fundamental investor would notice that the stock's price broke above the top of the envelope on Nov. 26. That would be a solid suggestion to go looking for pending major changes in the company's business. (Hint: It has to do with the pending reversal in the direction of hog prices -- from down to up -- that the futures markets may be signaling for the spring of 2003.)
I've given you just three examples of ways that fundamental investors can use technical analysis to improve their investing. There are plenty more that include helping to set buy and sell targets, establishing stop-loss limits and guiding the timing for gradual buys to establish a position.
Fundamentally, when it comes to incorporating technical analysis into your investing style, you're really limited only by your own creativity.