The Stock Market Cash Flow Page 12

  •The vocabulary used in chart reading and technical analysis

  •Various technical tools used in stock analysis

  •Some of the criteria used in trading stocks

  As you’ll recall from the previous chapters, one of the things we learned is that we cannot control the fundamentals of a sovereign nation or a corporation. The same is true of technicals. However, as you will see, we can use technical analysis to choose our cash flow strategy and to manage our risk.

  Why We Need to Know Both Fundamental and Technical Analysis

  Several years ago there was a story in BusinessWeek about the transition at Enron when CEO Jeffrey Skilling resigned and incoming CEO Ken Lay took over. When a CEO of a corporation resigns, the news might trigger a change in the stock price. This was especially true in the case of Enron because investors suspected something fishy might be happening. Here’s what BusinessWeek had to say about the situation when they interviewed Ken Lay:

  There’s been some concern among investors that perhaps there’s more to his resignation than meets the eye. Perhaps accounting or other issues that have not yet come to light. Is there anything more?

  That’s a pretty straightforward question for Ken Lay, the new CEO. This was his answer:

  There are absolutely no problems that had anything to do with Jeff’s departure. There are no accounting issues. There are no trading issues. No reserve issues. Apparently they say I have plenty of money. No previously unknown problem issues. The company’s probably in the strongest and best shape that it’s ever been in. There are no surprises. We did file our 10-Q…

  Lay is referring to the 10-Q statement the SEC requires all publicly-traded companies to submit each quarter. It contains the information on the fundamentals of the company. Lay continued:

  We filed this 10-Q with the SEC a few days ago, and if there are any serious problems, they’d be in there. If there’s anything material and we’re not reporting it, we’d be breaking the law. We don’t break the law.

  In hindsight, we know that the company was indeed breaking the law. But at the time, an investor would have looked at Enron’s fundamentals and thought everything was in good shape. They lied big time!

  But a chart of the stock’s price doesn’t lie. Even when a company lies about their numbers to the government, they can’t lie about what the market thinks of the stock because it’s always reflected in the stock price. That’s just one reason it’s so important to know how to do both fundamental and technical analysis. Both approaches tell different parts of the same story, a story you need to know.

  Once we know what is likely to happen it’s natural to want to know when it will likely occur.

  Whether the news is good or bad, we like to know the details. If I tell my son what is going to happen, like going to the dentist’s office, he immediately asks when we will be leaving.

  If I tell the kids we’re going to take a family trip to visit a Disney resort, they want to know what time we are leaving. Leaving in ten minutes has a completely different value to them than leaving in 10 days.

  You will notice that fundamental analysis did much more than just show us the strength of the entity. Now that we have learned a little more about how fundamental analysis works, you can see that it also helps us figure out if we are receiving the value we want for the money we spent on buying shares of a company’s stock. It helps us diagnose problems with policies—on the personal level, the corporate level, or the sovereign level. It can help us see both sides of the coin, such as when you compare what your mortgage looks like on you financial statement and what it looks like on your bank’s financial statement. In looking at your mortgage from two points of view, it’s easy to see the winner and the loser in a transaction. But another thing you might have noticed in the last chapter is that fundamentals can give us keen insight into what is likely to happen next.

  For example, suppose we have been closely watching the sovereign fundamentals of the United States. As the Federal Reserve enacts more quantitative easing, we think about what is likely to happen: inflation, an increase of systemic risks, weakening of the dollar, and volatility. All of these are distinct possibilities. In these circumstances, we might consider some investments to guard against volatility and exploit inflation. But when, and at what price point should we make these investments?

  Keeping our eyes on the stock charts and technical analysis strategies can help us know when to make our move. This is true for all types of investments, not just individual stocks. The charts we use in technical analysis show us whether a company’s stock price is revving in place, moving up another gear, or has run out of gas.

  Technical analysis is the business of looking at the charts to find the right time and place to enter or exit an investment. This is what we’re going to delve into more deeply in this chapter.

  Let’s begin by looking at the forces that can make a stock price move.

  Introducing the Market Makers

  If you’ve ever watched a financial news channel or seen some of the electronic signs in Times Square in NYC, then you’ve probably seen a stock board with ticker quotes.

  Like everything else in the world with a price tag on it, the changes in share price depend on supply and demand. The stock market is made up of a vast sea of investors who want to buy and sell stocks. You can probably imagine how the law of supply and demand works in the stock market because it works the same way with everything we buy, from the price of gasoline, to a package of sugar, to car insurance. In any open market, we find that when there are more sellers than buyers, the price goes down. Conversely, when there are more buyers than sellers, the price goes up.

  However, when you buy a stock you do not buy it directly from another investor on the other side of the table. It’s not a direct transaction like going to the neighborhood fruit stand and giving a local farmer a few dollars for a bushel of peaches. Instead, you buy shares through a middleman called a market maker or a specialist.

  A market maker is a person or firm willing to accept the risk of holding a certain number of shares in a particular company and stands ready to buy and sell shares of stock of that company from and to other investors.

  Why are market makers important? They provide a degree of liquidity for the market.

  As a stock trader, a logical question to ask is, “If I decide to sell my shares of stock, how do I know there is someone in the market willing to buy them?”

  The answer is that you can generally buy or sell shares of stock at any time you want because the market makers are standing by ready to buy and sell at any given time. In fact it is their job to maintain liquidity.

  In Chapter 2 we spent some time discussing the fact that one of the things that makes the stock market unique is its high level of liquidity. It’s difficult to sell a house or clear a warehouse full of inventory with the click of a button. But stock traders do it every single day—sometimes many times per day. So it’s worth spending some time to understand how market makers keep the stock market liquid.

  Suppose you have 100 shares of IBM and you want to sell them, how do you know there will be any buyers? Well, one of the features of the markets is that there is always a balance of buyers on one side and sellers on the other.

  Let’s look at how the market maker maintains this balance. Now let’s suppose you want to buy a certain stock. Your first step—after doing your fundamental analysis, of course—is to check the stock quote provided by the market maker. In today’s world, getting a stock quote from a market maker is easier than ever before. Unlike decades ago when we had to call a broker, today we can get real-time stock quotes on our personal computers and even on our smart phones.

  To buy a stock, you can look at your smart phone and see that the market maker is currently asking $52.17 per share. This is called the ask price, which is the price the market maker is willing to sell it for. If you want to sell the same stock, we can see that the market maker is offering to buy it for $52.15 per share. Th
is is called the bid price.

  Do you notice the small difference of $0.02 between the bid price and ask price? This is called the spread, and it is how the market maker earns his living. When there are a lot of shares being bought and sold, this spread is usually quite small, as in the example above. But in a situation where there are not many shares being traded, the spread is typically larger.

  The market makers will always buy your stocks and they will always have stocks to sell you. Their goal is volume, and by adjusting their prices, they can achieve volume whether the price is shooting up or falling like a rock.

  Market makers keep the balance between selling and buying. If there are too many buyers, they take the price up until it reaches a point where sellers are willing to part with their shares. If there are too many sellers, with everyone trying to get rid of a stock, they take it right down until some people start saying, “Gee, that’s cheap; maybe it’s worth the risk at this price.”

  This is why you want to learn more about technical analysis: So you can easily decipher the story in the price charts. A large, strong company, like Procter & Gamble or Walmart, might record increased earnings. The share price goes up. The improvement in earnings is not what directly moves share price, however. What directly moves the price is the increase in actual buying of the stock, the effect of supply and demand. In this example, the price movement is indirectly connected to fundamentals, but this is not necessarily always the case. Prices can move for a variety of reasons—news, a rumor, a tip in the media, profit-taking, short-covering, group rotation...or for no obvious reason at all.

  Market makers are not concerned with how high or how low a stock’s price goes. Their concern is to keep a balance between buyers and sellers to maintain the spread between the ask and the bid prices. This can be disconcerting for those determined to hold shares for the long term. There comes a point when you realize that the long-term prospects of a stock price depend on other investors being willing to pay more for it than you did. People like low prices—not high ones. So a company must sustain enough growth over your investing timeline of 30 years or so to maintain a price/earnings ratio that can justify higher prices fundamentally. Then you must rely on other investors to actually place the orders to drive the price higher technically.

  Types of Trends

  Through fundamental analysis we saw how to read the story of a company through its financial statements. Now we’re going to read the story of a stock through the behavior of investors and their effect on the stock price over a period of time.

  An uptrend occurs when there is a trend of high demand and low supply of a stock—the price goes up to persuade those holding the stock to sell.

  A downtrend occurs when there is a trend of high supply and low demand—so the price drops to persuade investors to buy the stock.

  Sometimes a stock price doesn’t really go up or down much at all, so we refer to the trend as sideways or stagnant.

  It’s important to note that technical analysis can be useful to tell the story of supply and demand for any market. We can also use charts to monitor the story of anything that has a price that is affected by supply and demand. It’s common for investors to look at charts of commodities like oil, corn, or gold to name just a few. We can look at real estate prices and determine trends. You can study trends in an index such as the Dow or the NASDAQ, or various other markets. Some people think that learning technical analysis is just for stock traders. Nothing could be farther from the truth. Robert Kiyosaki is a huge advocate of learning technical analysis regardless of the asset class or classes you’re investing in because investors must understand trends! All four of the assets classes—business, real estate, commodities, and paper—have trends. Thus, technical analysis is vital for investors of all types. Commodity investors can use charts to track the price of everything from gold to oil to soy beans. Business owners can identify trends in their sector. Real estate investors can use charts to track the supply and demand for rentals, housing prices, employment trends, and more. But one thing is common to all these stories of supply and demand: tracing what prices people are willing to pay. At what point do people say “no” and resist paying the price, and at what point will they say “yes” and support a certain price?

  Support and Resistance

  For the following examples in understanding more aspects of technical analysis, let’s look at a fictional company named ACME.

  You can see, when the share price of ACME is at the level of the bottom dotted line, it starts to go up. At that point, investors are saying “yes” to the price, they think it provides good value. They are in support of buying at that price. In fact, we know that more investors want to buy at that price than those who want to sell because the market maker begins to move the price up. The bottom dotted line indicates a support line where people are willing to buy the stock at that price. And they continue saying “yes” to the price…right up until it reaches a level where they aren’t comfortable anymore. That’s when they change and say “no” to the price. At this point, the market maker drops the price because there are not enough buyers at the dotted resistance line at the top. This is the price at which buyers resist any further price increase, and the price goes down.

  Investors are very interested to see points of support and points of resistance because they represent where attitudes change. By looking at these points on a chart we can see where and when investors changed their view on what they were willing to pay.

  In the chart above, we can see the price going up and down. Notice that in this case, when the price turns downward, the falling price does not drop all the way to the original support level. Over time, the stock chart tells us when investors have a new opinion on what the price should be. So, when we look at a stock chart, there are new levels of support and new levels of resistance that appear as we watch the story unfold.

  In the chart above we can see a new higher level of support. This is where investors see the price of ACME as a bargain and begin buying again. This buying at a higher price formed a new support level.

  As buyers outnumber sellers, there will be a surge in the price until it reaches another resistance level. If at some point buyers lose interest in the stock at higher prices, they will begin selling again.

  Note in the example above that with each surge, the support levels and resistance levels moved a little higher. Through these ups and downs, we can see the story’s main plotline of a general uptrend during this period.

  There are hundreds of technical indicators but, for me, looking at support and resistance levels is one of the most important parts of technical analysis. And the more you practice, the better you get at analyzing them until you find that you automatically build support and resistance lines into any chart you study.

  Swing Highs and Swing Lows

  Another way to look at the chart is as if it were a sketch of mountain peaks and valleys. We have a number of mountain peaks, where the price met with resistance. We call these swing highs. Where the price drops to its support levels we have valleys, which we call swing lows.

  To say that a stock is in an uptrend might seem pretty easy. But professional stock investors are picky and get very specific about what constitutes an uptrend. For a stock to be considered in an uptrend, both the mountain peaks and the valleys must be getting higher. So an uptrend is a series of upward-trending swing highs and upward-trending swing lows. Each swing high is higher than the last and each swing low is higher than the last—higher swing highs and higher swing lows.

  The uptrend tells us that investors like ACME shares and they are willing to pay more and more to buy them. Technical analysts love to spot breakouts of new swing highs quickly so they can position themselves to profit from a sustatined uptrend. They also watch for the first time a price fails to achieve a higher swing high. If the stock fails to make a higher swing high, the uptrend is over, for the time being.

  In fact, if the market shows resistance and the price fai
ls to form a higher mountain peak, that is often the first evidence that a downtrend could be developing. If, after a stock fails to achieve a higher swing high and then descends to form a lower swing low, the stock is now in a downtrend.

  With a sustained downtrend we can see a series of lower swing lows and lower swing highs. Just as in the case of an uptrend, technical analysts are very keen to spot trends early so they can position themselves to either gain protection from the downtrend or to profit from it.

  Finally, we can have a sideways market where the stock is sluggish and the swing lows and swing highs remain at the same level.

  Go with the Trend

  A very common approach for technical analysis is to apply the analysis of trends to the broader market. We can look at a chart of the S&P 500 or the NASDAQ and ask ourselves, “Are investors buying stocks right now, or selling them?” The trend is the reality of the situation, and we want to go with the trend.

  Before investors look at individual stocks, they first identify the broad market trend. After they see the overall trend of the market, they can then find individual investments that match the same trend.

  You can’t change the fundamentals or technicals. You can’t control the trend. You cannot force a stock price to go up. The stock price is beyond your control.

  But you have complete control over your own strategy as to how to position yourself in the market. You can decide when to enter, when to pull out, and whether to go short or go long. These terms will be explained in detail in the chapter on cash flow, but basically, by going short, you have as many opportunities to make money from a downtrend as you have from going long in an uptrend.