Getting Technical
You’re a hard-working investor. When a company catches your eye, you scour its financial statements, read up on its industry and carefully assess its prospects.
But don’t stop there. If you do, you’re neglecting a critical step in evaluating stocks: technical analysis.
When determining whether to buy or sell a stock, most individual investors look at obvious factors such as the company’s sales and earnings. That’s appropriately known as fundamental analysis.
Technical analysis, by contrast, is the study of a stock’s price and volume patterns on charts.
The logic behind technical analysis is simple: It provides an unbiased picture of how a stock has performed, and studying that picture can provide valuable clues about where the stock is headed.
Specifically, technical analysis sometimes flashes signals to buy or sell a stock long before those same signals will show up in the company’s fundamentals.
Of course, technical analysis doesn’t answer every question about a stock, and is best used alongside fundamental analysis as a timing tool. It’s also important to note that technical analysis isn’t foolproof; stocks don’t have to go up or down just because a chart indicates they should.
“Technical analysis is helpful, [but] it does not explain everything,” said Gary Anderson, a technical analyst at Anderson & Loe in Eugene, Ore. “It helps where it helps, but like everything else, it has its limitations.”
Still, the old saying “A picture is worth a thousand words” can certainly be true with stock patterns.
To understand how a technician works, imagine that a company reports strong quarterly earnings. A fundamental analyst might view that as a good enough reason to buy the stock.
A technician, however, would look at how the stock reacted to the report. If, for example, it fell in the face of the seemingly good news, the technician might see trouble brewing.
“The fundamentalist would look at earnings and if they’re going up, and that would be it,” said Ricky Harrington, a veteran technical analyst at Interstate/Johnson Lane, a regional brokerage firm in Charlotte, N.C. “They look at it in isolation. I look at it in how the earnings impact the price of the stock. . . . The action of the stock tells me more about the health of the stock than the actual earnings themselves.”
Not surprisingly, individual investors sometimes shy away from technical analysis in the mistaken belief that it’s too complicated. And it’s certainly true that technical analysis can be filled with such esoteric and multisyllabic terms as “oscillators,” “stochastics” and “Bollinger bands.”
But the concepts are actually quite easy to grasp.
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Technical analysts primarily study stock charts such as the two that accompany this story.
At their most basic, charts plot the daily or weekly movement of stocks. In a daily chart, each day’s price range for a given stock is recorded by a vertical line, with the top of the line representing the highest price for the day, and the bottom the lowest price. The closing price is shown by the horizontal hatch mark across each vertical line.
Charts also are used to show the corresponding volume, or number of shares traded each day. The daily volume is shown directly beneath the stock price so that investors can quickly see both.
Volume is one of the primary indicators technicians use. The absolute level of volume is largely unimportant to a technician. Rather, the focus is on the percentage jump in volume compared with the daily average over the recent past, such as 50 days.
For example, it’s more telling when a stock that normally trades 100,000 shares a day suddenly trades 200,000 than it is when a stock with a 1-million-share average rises to 1.1 million.
To understand the significance of volume, imagine that two new restaurants have opened near your house. You know nothing about either restaurant. You’re not even sure what kind of food they serve. All you know is that each time you walk by, one is only half-filled while the other has lines of people stretching halfway down the block.
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Given a choice of eating at either one, you might pick the second restaurant simply because the lines of people indicate that there’s something noteworthy about it. In other words, you know something is up, even if you don’t know exactly what.
Technicians view volume the same way. When it increases--regardless of whether the stock price itself is going up, down or sideways--it shows that something is going on.
In the best-case scenario, investors want to own stocks that are rising on heavy volume. That indicates that other investors are eager to own those stocks. And big demand makes it likely that a stock can keep rising.
Conversely, a rising stock price on average or decreasing volume is less bullish.
“If a stock or market goes up on increasing volume, that’s important,” said John McGinley, publisher of the Technical Trends newsletter in Wilton, Conn. “It means people are serious about what they’re doing.”
The same principle holds with price drops. A stock declining on heavy volume shows investors are falling all over themselves to get out. A drop on lighter volume is less worrisome.
To see how volume trends can provide insight, consider the stocks in the two accompanying charts.
The first is Western Staff Services (ticker symbol: WSTF), a temporary-help company.
On the left side of the chart, the stock is moving sideways from November through early February, at which point it moves higher on expanding volume, a clearly bullish sign. That’s known as a breakout.
The stock then follows through to $25 from roughly $17, an almost 50% jump. The pattern has repeated itself lately as the stock has again moved up on a big jump in volume, to about $30.
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Volume can be revealing in other circumstances as well.
Consider the stock in the second chart. Keane Inc. (KEA) is a computer services company that consults on the year 2000 software problem, among other services. Keane has posted strong earnings in recent quarters and its stock has benefited accordingly, most recently doubling from roughly $30 in November to almost $60 late last month.
But since then, Keane’s shares have dropped sharply even though the company has reported no bad news.
Investors appear worried that sales will suffer once the year 2000 work is complete. They also seem rattled by a plan by the company’s founding family to sell a portion of its shares. The plan was unveiled April 21, the day the stock peaked.
An investor using fundamental analysis might have been blindsided by the stock’s sudden and dramatic reversal. But a good technical analyst would have seen it coming.
Let’s start with the rally that begins at the left side of the chart. A close look shows that volume increased on many days the stock advanced, a bullish sign.
But now look at the shaded areas. Overall volume picks up noticeably compared with its previous level. Initially, the stock continues its ascent but then turns around and heads down on equally heavy volume. The stock rises again to a new high, but then slips right back.
All this action occurs on far-above-average volume in a dynamic known as churning. That’s when volume is heavy but a stock is unable to make much further upward progress. It’s a classic signal that a stock is weakening: Buyers are continuing to pile in, but for the first time in a while, they’re being met with a large number of people wanting to get out.
By late last month, the stock was in a free fall on big volume. But by the time the latest descent was underway, the savvy technician was already out of Keane.
Besides volume, chartists also use other tools.
Consider Western Staff Services again. Before the first advance shown, it had moved sideways for several months in what’s known as a base. A base occurs when the stock is in a tight trading range and volume lightens.
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Bases serve as a sort of digestion period for stocks. During this time, volume dries up as both buyers and sellers disappear. The key is the sellers. Most investors who want to unload the stock have already done so. That sets the stage for the next advance. The next time buyers swarm into the stock (assuming all other factors stay positive), they’ll be met with few sellers. That, naturally, will push the price up.
One key with bases is the length of time they last. They’re normally suspect if they’re shorter than about eight weeks, some technicians say. It takes time for a stock to consolidate its gains.
“The larger the base, the further they race,” said Martin Pring, a newsletter writer who is the author of several books on technical analysis. “It’s like building a skyscraper. You need a strong foundation.”
Bases lasting six to nine months are not uncommon. However, one that lasts more than a year may no longer be a base, but rather a signal that the stock is going nowhere.
Chartists also rely on a tool known as a trendline. Look at the diagonal line in the Keane chart--that’s a trendline.
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As the name implies, these lines identify trends. Investors draw trendlines by linking price points on a chart--for example, drawing a straight line that touches the lowest intra-day prices reached during a stock’s uptrend (as is shown in the Keane chart).
Investors, of course, want to know when a stock that’s been going up may no longer do so. Trendlines can set off alarm bells when they’re broken. With Keane, for example, when the stock broke down toward $50, it had clearly violated its intra-day -low trendline.
Beginning investors shouldn’t rely too heavily on trendlines, some experts say. “Most people feel that a trendline has some magic force field around it and that it has support just because a ruler is straight. It’s just hooey,” Anderson said.
Several factors are important in drawing and evaluating trendlines. The first is the length of the trend. A trend that’s been in place for two years is more significant than one that began two months ago. Second, the more times a stock touches a trendline or comes close to touching it, without significantly penetrating it, the more powerful the trend.
But note: When drawing a line, “two points do not establish a trendline,” McGinley said. “You need three points minimum, and the more touches on the trendline, the more valid it becomes; and the longer it’s been in effect, the more important the break is.”
Finally, the angle of the ascent or descent is important, Pring said. A overly steep angle is likely to be broken.
Walter Hamilton can be reached by e-mail at walter.hamilton@latimes.com.
This column is one in an occasional series explaining technical market analysis for individual investors.
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Western Staff: From Base to Liftoff
After moving sideways for several month in a “base,” Western Staff Services’ stock had a “breakout” on heavy volume in February, a bullish sigh to a technical analyst.
Stock price
Volume, in millions
Source: Bloomberg News
Keen Eye on Keane
An investor who paid attention to Keane Inc.’s stock chart saw warning signs developing before the stock went into its recent slump. Volume jumped significantly in March, but the stock, after a lengthy run, struggles to make a new high. This kind of behivor is often a signal that trouble is brewing.
Stock price
Volume, in millions
Source: Bloomberg News
