Today’s Markets & Money contains a defence of, and advocacy for, charting.
If you’re not already aware, charting is a form of analysis that uses a stock’s price history, plotted on a chart, to determine patterns. Those patterns in turn give clues to future price movements.
Charting is a much maligned market craft. The sceptics claim that it simply uses the past to try and predict the future…at best. At worst, it resembles tea leaf reading or some other hocus pocus.
I’ll admit, I’ve seen charts so badly mangled by technicians drawing lines all over them that I understand where the detractors are coming from.
And while I understand the criticisms, a lot of it also has to do with ignorance and dogma.
Most critics are ignorant of the power of charting simply because they have seen so many bad examples of it. They therefore assume all charting is bad.
Then there are those who believe in fundamental stock analysis above all else. That is, analysis of the balance sheet, as well as income and cashflow statements. It is the numbers that give you all the information you need, not ‘squiggly lines on a chart’.
That’s a shame, because it’s actually the ‘fundos’ who should get the most out of charting as a complementary analytical tool.
The other thing that gives charting a bad rap is that many people practice it in half-hearted fashion. That is, they use it as an analytical shortcut. They think that by spending five minutes drawing some trend lines on a chart they can make an informed investment decision.
Well, it just doesn’t work like that. There are no shortcuts to making money in the stock market. If you don’t put in the work, the market will eventually extract the cost of an education from you.
Over the years, I have found charting to be most beneficial if used simply. That is, by not drawing all over them or projecting where prices should go. A few moving averages — to give you the underlying trend — are all you really need.
The power of charting comes from interpretation. That is, ‘what are the charts saying’? What are they hinting at? You can only answer that question accurately if you also have a good understanding of the fundamentals. Because a chart is partly a representation of a stock’s fundamentals.
But it is more than that. It is also a reflection of the emotional state of investors. Consider this quote from one of my favourite books on the market, The Money Game:
‘There are fundamentals in the marketplace. But the unexplored area is the emotional area. All the charts and breadth indicators and technical palaver are the statistician’s attempts to describe an emotional state.’
A breakdown of charting
A chart, therefore, is a combination of the emotional state of the market combined with its fundamentals. The role of the analyst is to use this information to determine whether the market is too optimistic or pessimistic about a company’s prospects.
Of course, that is easier said than done. When it comes to the market, everything is.
The first step is awareness, and looking at charts through this analytical lens. It takes time and practice, and there is never really a ‘right’ answer.
Remember, you should always ask: What is the chart telling me?
A lot of the time the charts don’t ‘say’ much. But at other times, like now in the US, things get interesting. Stocks recently took a big swoon. But they’ve since bounced back, and the emotional state of the market appears much calmer. On the surface at least.
This is where charts can be helpful. But first, a word of warning: You can use charts to see what you want to see, rather than to see what really is. So try to avoid using them as tools to confirm what you already believe to be true. Be objective.
Amazon and Netflix are worth keeping an eye on
With that in mind, check out these two charts below. I noticed them when I was scrolling through a bunch of charts on the weekend. Given they’re the two of the pin-up stocks of this rally, I think they’re worth keeping an eye on. And it’s worth trying to work out what they’re saying.
First up is Amazon.com, Inc. [NASDAQ:AMZN]. It sold off sharply, but then rebounded just as sharply. It’s now rallied back to all-time highs at around $1,500, but it’s at risk of stalling here. Upward momentum appears to be ebbing.
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Netflix, Inc. [NASDAQ:NFLX] looks similar — a sharp correction and rebound back to the highs. But again, investors appear reluctant to push the stock to new highs.
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The strong run since the start of the year represents an extreme in investor enthusiasm. Amazon’s price jumped 25% in January while Netflix’s price jumped nearly 50%. Coming at the end of extended share price runs suggests this could represent a type of blow-off top for both stocks.
After such strong long- and short-term runs, the probability is low that the run will continue. If these stocks can’t beat their January highs shortly, I expect to see another correction unfold. And given these stocks led the market higher, they will take it back down too.
Editor, Crisis & Opportunity
Editor’s Note: This article was originally published in Money Morning.