Stockscores.com Perspectives
For the week ending June 5, 2004
In this week's issue:
What does it all mean? Technical analysis has a way of mechanizing stock market research, making the future direction of stocks a matter of logical mathematical indicators. "Buy when the short term moving average crosses above the long term moving average" say some while others argue "sell when the Stochastics get to overbought levels". "The VIX is at an all time high, it is time to buy in anticipation of a reversal."
Those who excel at logical reasoning love these kinds of indicators because it makes a science out of investing in the stock market. By establishing rules that can be tested with rational thought processes, the investor can have confidence in their trading decisions.
My greatest complaint about technical analysis, and perhaps the reason I don't consider myself a true technical analyst, is that the application of many aspects of technical analysis miss the point. In general terms, stocks don't go up because the MACD Signal line crosses in to positive territory. Short sell opportunities are not created when the Williams Volume Accumulation indicator goes negative. We should not buy stocks simply because the Sentiment Stockscore crosses above 60.
Investors and traders need to remember that all technical analysis indicators are just a reflection of what really drives the stock market; information and emotion. When we consider any technical analysis indicator, we should discuss it in terms of how that formula reflects what a company's future holds, and what the investing public thinks of it.
Since I choose chart patterns as my main motivation for entry and exit signals, let me discuss what the six aspects of chart patterns truly represent. Support and resistance, optimism and pessimism, low volatility and abnormal behavior are the basis for virtually every trading decision I make, and it is important to understand what these technical analysis criteria are based on.
Support and resistance are typically horizontal lines drawn on a chart that represent floor and ceiling prices that the market has shown a willingness to bounce from. However, if we understand that stock price is based on the present value of future earnings expectations, then support and resistance represent the limits on what the market believes the company's fundamentals to be worth. Based on all available information, investors don't believe that a stock is worth more than the resistance price, or less than the support price. The oscillation of stock price inside the limits of support and resistance is due to the uncertainty that the future holds.
Therefore, breaks through support or resistance are significant because these breaks may be motivated by new information. A group of investors may know of a significant change in the fundamentals of a company, and act on that information before it is widely disseminated to the public. Breaks through support or resistance offer a privileged glimpse in to the insider's world of information.
Optimism and pessimism are relatively easy to see on a stock chart; optimism is characterized by rising bottoms while pessimism is shown in falling tops. How can the application of a sloping line on a price chart say so much about the mood of investors?
Consider what a rising bottom represents. If we understand that a downward trend demonstrates a greater motivation among sellers than buyers, and an upward trend is created when buyers are more eager than sellers, then a rising bottom pattern is created when the enthusiasm of buyers outweighs that of sellers. Over time, the sellers show less strength, which causes the bottoms made in the waves of the uptrend to rise. Over time, the mood of investors is generally optimistic, as they are more willing to buy and less willing to sell.
Falling tops are created by the precise opposite motivation. During the short waves when the stock is rising, the buyers are unable to push the stock as high as they did on the previous up wave, which creates the falling top pattern. Over time, the buyers are losing strength, and therefore, investors are generally showing pessimism.
We should think of price volatility as an indication of how confident investors are about the value of the company. Remember that price is based on the market's expectation for future earnings. If the market is uncertain of what future earnings will be, then prices will move with a lot of volatility. If investors are confident in what they know the company to be worth, then the stock will not trade with a lot of volatility. This is why penny stocks, whose future is very uncertain, tend to be very volatile compared to the shares of established companies.
If investors have new information that is important, stocks will tend to behave abnormally. Price volatility will increase, and trading volumes will pick up. Therefore, abnormal behavior in the trading activity of a stock can indicate that new information is being priced in to the market.
To summarize, support and resistance represent limits on the fundamental value of a company, and breakouts can be motivated by new information. Rising bottoms and falling tops represent optimism and pessimism among investors, and are important considerations when evaluating a trading opportunity. Price volatility defines investor uncertainty, and abnormal behavior is often caused by the pricing in of new fundamental information.
It is important to try and relate these technical analysis concepts, and all others, to the market dynamics that move them. Understanding what is behind a technical analysis indicator will help you make better investment decisions.Back To Top
This week, I did a very simple Market Scan on Stockscores to demonstrate the points of the commentary. I sought out stocks that had a low volatility index rating on Thursday, but had an abnormal day to the upside on Friday. I then added in a liquidity minimum of 500 trades a day, and ran the scan. 25 stocks came in the results, and a few stocks stood out as potential trading candidates. They are discussed below.Back To Top
1. AFCO
The stock broke from low volatility on Friday, and in doing so, broke its downward trend line. That may mean that the pessimism of the market is turning around, and the optimism demonstrated in the short term rising bottoms may lead in to a trend reversal.
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2. NUTR
NUTR has made a break through resistance to a new high, and looks like it will try to continue the upward trend. The stock has been rising for quite some time, so entry here is getting risky, but this may be a stock that a swing trader can exploit.
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3. ODP
Something got investors excited to buy this stock on Friday, and that enthusiasm may serve to shake the pessimism that has dominated ODP for the past few months. The stock will find resistance at $19.50, but has decent potential to make a short term move toward that price.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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