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March 17, 2004

When Good Charts Go Bad

Despite investors' worries, this bull looks as though it has a lot further to run. Many stockholders are still feeling the aftershocks of the worst bear market in more than 20 years. And while the psychological impact of the recent downturn may be only subconscious, it discourages many people from pursuing the smartest stock strategies. Moreover, investor unease seems to have grown since the stock market began treading water after more than nine months of strong gains. In fact, though, there's nothing really wrong — either with the economy or with the market.
      − Michael Sivy, "What's Next for the Bull," Money, April 2004

Now that the stock markets have risen substantially from their late 2002 and early 2003 lows, it seems that most every Wall Street analyst and his mother has come forward to tout the "new bull market." Has the economy improved? Sure, in many ways. Is the "new bull market" underway for the long term?

Well, that depends on what you know about market history. And supply and demand.

Let's start with the current situation. The Nasdaq's floor, just below the 1,200 level back in October of 2002, seems a distant memory to most folks now that that index is frollicking around in the 1,900 to 2,000 range. Since those lows, innumberable tech stocks have doubled, tripled, and more. (Here's an example — Omnivision Technologies — a nice little rocketship that I got off of just a tad too early.)

The S&P 500, for its part, also bottomed in late 2002 and early 2003, rising from the area of 825 to around 1,150 now. (That accounts for a gain of about 325 points, or almost 40 percent, for those interested in percentages. Not too shabby.) The Dow Jones Index bottomed around 7,500 and subsequently rose to the 10,700 area, also for a gain of near 40 percent.

So, after gains of that magnitude, it's generally a good idea to start looking for either a sizable correction, or else a complete reversal of the trend. (I've written elsewhere that it's foolish to think that a bull market which lasted twenty years, as ours did from about 1980 to 2000, could completely unwind itself in three; i.e., that the bull-market excesses of 1980 to 2000 were corrected fully by the bear market from 2000 to 2002/3, and now we're back to business as usual.)

Considering the U.S. market indexes, the trend, in this case, has in fact been upward since late 2002 and/or early 2003. A bull market? Yes. In that period of time — about the last year or so — it has certainly been a bull market. And a gosh-darn good one, if you've been a tech-stock investor.

But now we come to March of 2004. Nothing goes on forever, as they say. Perhaps it's time to examine the markets a little closer now, since a whole lot of good news has likely been "priced in," to indulge in a bit of Wall Street parlance. But, unlike a lot of people, I believe in keeping things as simple as possible, especially in the stock-market realm.

In that light, let us examine a few charts. This, dear reader, is about as basic as chart analysis gets, and that is also why it is so darn valuable. The first two are educational templates of a sort, both from Stan Weinstein's wonderful investing primer, Secrets for Profiting in Bull and Bear Markets. For Weinstein, profiting in the market is not only about finding good stocks, but also about using price charts to discern supply and demand. Where price charts are concerned, he classifies stocks and indexes as always being in one of four "stages." These are displayed in the generic stock price chart below.

This is supply and demand at work, portrayed about as clearly as a novice market-watcher could hope for. Market guru Justin Mamis sums it up well in his book When to Sell for the '90s when he writes, "All chart patterns are no more than individual peculiarities in the way a stock signals the underlying changes in supply and demand."

Suppose you found a stock chart that looked like the Stage Chart above. Where is demand (that is, the effort of buyers) winning the battle? (That'd be Stage 2, where prices are rising.) Where is supply (the effort of sellers) winning the battle? (Stage 4, where prices are declining.) Where are the two sides present in equal amounts, pushing and pulling at each other in fairly-well-defined price ranges, but with neither side making much progress? (Stages 1 and 3.)

As a chart-minded investor, I am always on the lookout for charts with these stages well-evidenced. (The market being a human mechanism, things aren't always quite so perfect and easily visible.) The points where the stages change — "breakouts" from 1 to 2, and "breakdowns" from 3 to 4, in particular — are where you want to make sure you're alert and ready for action. Certainly you can't be asleep at the wheel when your stock is undergoing the start of a Stage 4 decline, right?

Here's another Weinstein example, but with more detail (and terminology) added:

"But it can't be that simple in real life," I hear someone saying. "No way charts can look that perfect." Well, you're right . . . usually. But take a look at this current Amazon.com (AMZN) 2-year chart, and judge for yourself:

It's worth noting another item here. The slanting blue line in the chart is the 200-day simple moving average (SMA), which is roughly equivalent to the 30-week moving average which Weinstein employs in his stage-analysis charts. It's used by market technicians as a gauge of long-term trend; the orange line is the 50-day simple moving average, which is often used as a gauge of intermediate-term trend. Price crossing beneath the 50-day average (and staying there) is bearish — a supposed indication of lower prices ahead. Price crossing beneath the 200-day average is even more so. The 50-day SMA crossing below the 200-day SMA, as seems about to happen with AMZN, is even more bearish.

Though nothing is certain in the stock market, it appears that a major change of trend is underway in AMZN. In Weinsteinology, the stock has moved from Stage 3 to Stage 4. This chart just happens to be one of the most pronounced examples I've found.

Amazon, however, isn't rolling down the hill alone. Here's another example; this time it's a stock that carries even bigger implications for other tech stocks, and for the Nasdaq in general. Again, we're looking at a 2-year chart:

That would be Intel (INTC). The key price level to examine here is the $30 level. After the long uptrend, buyers held strong at that level three separate times from October of 2003 to early-February of 2004. But when that buying support was overwhelmed by sellers and the prices broke through to the downside in mid-February '04, it meant the downtrend (Stage 4) was likely underway. Understand that this isn't about predicting the future. Rather, it's about understanding the nature of supply and demand on a visual basis, and deciphering which side (buyers or sellers) is taking control. If you're a holder of INTC stock who's looking at this chart, just realize that at the $30 level, the "smart money" was on one side or the other. Both sellers and buyers were applying whatever knowledge they brought to the table and voting with their hard-earned dollars. Over time, the sellers were stronger than the buyers, and it probably wasn't by accident. If you see the selling on the chart, you don't need to know the motivation — just the power behind it.

As Justin Mamis writes in When to Sell for the '90s, "If the law of supply and demand — the one thing you can keep track of objectively, the one tool that is devoid of emotion — tells you you're wrong, it's wise to accept it."

Now, let's change perspective a bit. Take a look at INTC's 5-year chart:

Astute observers will note that the 50- and 200-day moving averages are not at the same price levels as the 2-year chart above. That's because in the 2-year chart, they are 50-day and 200-day moving averages; in the 5-year chart, they are 50-week and 200-week moving average. That, however, is not the important distinction to make here. From the 5-year view (the super-high "aerial shot," if you will), one could argue that Intel has simply been in Stage 1 since late 2000 and early 2001. If you're one of the folks holding from the $50 to $70 range — and since the stock traded there for the better part of a year, there are many — then that's a darn long time to hold a stock with either a zero or negative return (Intel doesn't pay a dividend large enough to be worthy of note — its dividend yield at the current price is something like 0.6 percent).

For those who might chime in, "Well, I haven't lost anything until I sell," you're wrong. There is such a thing as opportunity cost. For all the time your money was tied up in a languishing, long-term Stage 1 stock, you probably could've used that money to pay off some credit-card debt, or tucked it into a CD earning 2 or 3 percent, or something. Just paying off credit card debt, for instance, would have guaranteed you a return of anywhere from five to twenty percent right there. (What you'd have saved in interest charges.)

But I digress. Here's another chart working its way through a similar topping formation ... or is it?

With EMC Corporation, the Stage 3 top isn't yet completed. But that's why the $12 level bears close watch. Buyers have held strong at that level three times since October of 2003. But with other tech stocks breaking down all around, like those above, how much hope can EMC investors hold out?

Anyway, it's times like these that make chart analysis so darn interesting. Not all stocks make their Weinstein stage movements at the same time, so the best a market watcher can do is monitor a variety of stocks and, after observing the action of those stocks, make educated guesses as to the condition of the market overall.

Where the Nasdaq goes from here? Wish I knew for sure. But at least I (unlike Mr. Sivy, apparently) know my Stages.

And without Intel and the semiconductor group playing ball, the Nasdaq might just find itself on the injured list in very short order.

Michael | March 17, 2004

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