As an investor looking strictly at the charts, you want to see one thing: a breakout from a base. We are currently in one of the best markets to find these chart patterns in a long time. There have been catalysts for improvement on the fundamental side, many of which I’ve been talking about for three months in Market Observations and on the Financial Sense Newshour.
We just had another two hit the tape today in more QE from England and a Greek austerity agreement (needed for another bailout). But at the end of the day for an investor, reading and writing about fundamental data you agree or do not agree with will not get you paid in the market—buying charts that go up will. I wanted to dedicate this Market Observation to some of the current market conditions that exist today that have proven over the years to reward investors.
Just like there is a bottom-up and a top-down approach to viewing macro fundamentals, there is a bottom-up and a top-down approach to technical analysis. I typically focus on the macro by discussing market breadth and sentiment, but also by looking at how commodities, bonds, equities, and currencies relate with one another. It’s time to take a look at the bottom-up approach, and by doing so we can gauge the health of the market overall by inference.
The Investor’s Way
As an investor, you are looking for trends and those trends have to start from somewhere—a base. There are two kinds really: 1) a base following a declining trend and 2) a consolidation after a rising trend. V-spike recoveries happen, but they typically get retested and in that process they develop bases. Investors should do a majority of their investing in stocks that breakout from a base and in a small part from continuation buys while traders should do the opposite, focusing on momentum after a continuation breakout.
A base is not the same thing as a consolidation in a declining trend. The best way to differentiate between the two is to use a moving average, like the 30-week moving average. If a stock is going sideways for some time, but you still have a declining 30-week moving average, it’s not a base but rather a consolidation in a declining trend. You need a flat moving average to declare a base and that can take time, especially after a deep correction as in the chart of Netflix (NFLX). A bear market can send consolidating stocks within declining trends right back over the ledge to new lows.
In September 2011, NVIDIA Corporation (NVDA) looked like the same chart as Netflix does now. It was rallying from depressed levels but was rejected by a declining 30-week moving average. Now, however, look at the chart. The price is moving above a flat moving average and breaking out above the September and December peaks. This is what an investor should look for in a chart. Additionally, the 10-week moving average (or 50-day moving average) is rising and nearing a possible crossover with a flat 40-week moving average (or 200-day moving average). This is called the golden cross in technical analysis.
Going a step further, as an investor, identify if whether the stock you’re looking at is in a favorable sector. A favorable stock in a favorable sector is how you get performance. A favorable stock that’s basing or trending higher in an unfavorable sector will struggle to perform, like in utilities this year.
The Forest for the Trees
Given that this article is a Market Observation piece and not a stock investing 101 class, here’s how I can relate the information above into today’s market. Do you know how many charts are basing, breaking out, and trending higher right now? Numerous. After reviewing the individual charts of the S&P 500 to determine whether they were basing or trending higher, I summed the numbers up. Now let’s break it up into sectors. This should give you an idea on what’s working.
Working our way up the market from individual charts to sectors, it’s clear to see here that pro-cyclical sectors are working for investors. The majority of favorable charts can be found in technology, financials, consumer discretionary, and industrials. Looking through the lens of sector rotation theory, the model tells us that the market has bottomed and the economy is in an early recovery stage.
Now that we’ve looked at the trees of the forest to identify which charts are basing or trending higher, and we’ve categorized them in sectors to identify the business cycle, let’s look at the forest. 358 charts in the S&P 500, that’s over seventy percent of a broad index, are either basing or trending higher. Eighty percent of the S&P 500 issues are trading above their 200-day moving averages, trading above the 70% area now for only one week. The last time the market did that was in December 2010, and it didn’t drop below that level until June 6th, long before the August crash last year. This is all to say that the market is healthy overall.
The Next Step
So you’ve done your technical homework to identify which companies have basing patterns, breakouts, or trends. It’s time to see how the company is executing strategy. Do your fundamental homework now to see what the analysts say. Look for positive and sustainable change, new products and new markets. Cisco Systems (CSCO) is a good example of this:
Cisco had costs that were prohibitive to the company’s growth and earnings. Those are now under control and new products have created three quarters of positive change that looks sustainable for the foreseeable future (as per the comments from two analysts on CNBC after their earnings release yesterday). Cisco broke out of a basing pattern last October, with a golden cross (50-day cross above the 200-day) in November.
What about the airlines? You say oil prices have gone up and will continue to hurt margins. What if I told you the industry has discovered new sources of revenue and strategies to hedge their oil based on expected forward demand? You’ll pay the extra fee on your luggage, even if you don’t like it, because you’re not going to walk or drive from Washington to New York to see family for the holidays.
So do your homework. There are plenty of charts and companies to review with 358 companies within the S&P 500 showing favorable chart patterns. From a market price level, 1353 was the July high last year and 1370 was the May high during 2011 for the S&P 500. This is what you would call an extreme supply level, i.e. resistance zone. What held the S&P 500 back last year? Financials and cyclical stocks held the market back and are now the favorable groups. While the S&P struggles with this area, the Nasdaq 100 has staged a continuation breakout after a year-long consolidation in 2011. We haven’t seen this price level for the Nasdaq 100 since February 2001. The “lost decade” in stocks—at least for tech—appears to be coming to an end.
Tech, for lack of a better and more descriptive word, is bullish. You wanted Intel (INTC) at 100 times earnings 13 years ago but not at 11 times earnings? Investors are re-thinking tech when Intel breaks out to multi-year highs. Sentiment is improving and that can move P/E multiples higher. Apple (AAPL) is nearly 16% of the Nasdaq 100 and it’s trading at all-time highs. It continues to blow the minds of investors with stellar growth, up 17.6% after announcing fourth quarter earnings. That does explain a lot of the Nasdaq’s growth, but again, look at the favorable charts of its 55 peers in the S&P 500. All boats rise with the rising tide.
Yes, there are black swans out there. A possible one right now is a war with Iran, what with three carrier groups and concerns Israel may strike. How will peripheral nations react to a Greek debt write-off? They’ll probably want one of their own; however, a fiscal pact is being drawn up now for the region so that the root of the Sovereign Debt Crisis doesn’t happen again. It will though, eventually, as Greece used financial engineering to keep their debt to GDP low until the next administration came in and said, “The last administration was cooking the books. Things are worse off than we thought”. Eventually, another MF Global will cheat the system and steal because they found a way around the system. That’s what crooks do. There will always be something around the corner that could change market sentiment. Monogamy has no place in the market. You can’t be married to any stock, sector, or market. We do not have a free capital market. Central banks intervene. That’s the game. Get with the program. I believe buying stocks with favorable charts in favorable industries with positive, sustainable change in bullish markets is how investors get paid.
