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CHAPTER 1
Using Moving Averages and Relative Strength Performance to Beat the Index
Relative Strength Index, Money Flow Index, Keltner Channels, and Standard Deviation, with Apple Exhibits
KNOW THE PLAYING FIELD
There are fundamental and technical ways to make money in the stock market. The fundamental techniques require education—an MBA or CFA would help—and long hours of research about the financial data of a stock and prospects for future growth. Further, since Wall Street, sell-side analysts are highly paid to do this, you are competing with professionals, while you may be only an amateur fundamental analyst. It is possible, but not probable, that you will be a better stock picker than the professional analysts. Professional fundamental analysis is widely available and free, so use it instead of doing it yourself. Value Line is free at your local library. Online brokers supply such reports as the Standard & Poor's analyst reports free of charge, and most brokers supply a reputable fundamental service or their own fundamental, so called sell-side analysts.
The second way is technical analysis. It can be learned quickly, just by reading this book, and used to make money in the markets. Looking at charts first, and then reading what the fundamental analysts have to say, is an easy way to make profits in the stock market. Doing fundamental research and then looking at the charts is the hard way. I could never understand why some portfolio managers insisted on doing it the hard way. The system is rigged against them because the first call they receive is from a highly paid, sell-side fundamental analyst with his recommendation to buy a stock. The caller hooks right into the portfolio manager's fundamental bias. The first step in their stock selection process is wrong. The portfolio manager should be looking at charts first, and then he should call the analyst for the fundamentals. This book suggests that you not make the same mistake as the portfolio manager.
Many chart readers, using technical analysis, don't care what the fundamental analysts are saying because they are interested only in price movements and making money based on those price movements. Most known information from the analysts and everyone else, including illegal inside information, is already in the price of a stock. That does not mean the price is right or fairly valued. For example, misinformation leads to incorrect pricing. A false rumor circulated about a takeover will take price up. That price will be wrong because important misinformation is creating demand and taking price up. Technical analysis will correctly measure that demand and will be wrong when the truth comes out and price reverses back to where it was.
When you see a comment in print or hear it on TV, it is usually too late to act on because it is already in the market price short term, but it is still valuable information to use for your long-term investing. You wait until the price pulls back from its current, frothy high created by the media blitz and then you buy on weakness like the pros. Traders do just the reverse, riding the momentum created by the media.
Of course, there are always breaking news stories that the market knew nothing about, are not in the price, and immediately affect the price as the announcement is made. This is why all the Wall Street traders (but not portfolio managers) are glued to the news feed looking for positive and negative surprises or rumors.
Wall Street is a whisper business, and all the valuable information is passed over lunch, on the golf course, or whispered on the phone in coded words. It is not given to reporters or put on TV, because valuable research needs a customer willing to pay. It is not given away free in the press or on CNBC, Fox, or Bloomberg. What is given away free is “hype,” when the longs or shorts want to get the investing public to move the price on a position they have already taken. It may be good information, but the small investor hears it last from the media when price is frothy and it is about to pull back. The only time there is a level playing field for the small investor is when there is breaking news and it catches the pros completely by surprise. Then the small investor and the pro have the same information at the same time. This is also true for the small trader versus the professional trader. Stay tuned to CNBC, Fox, and Bloomberg for the news that nobody knew.
David Einhorn, a famous hedge fund manager, exposed Green Mountain Coffee when he went public with his thesis on why the stock was a poor investment. Even if you were the last to hear this research from Einhorn, you made money on Green Mountain as it went down. Sometimes it pays to listen to the TV news or attend conferences to hear speakers like Einhorn. (We will look at Green Mountain Coffee in Chapter 8.)
APPLE COMPUTER'S 200-DAY MOVING AVERAGE
The first and easiest way to make money in the stock market is to buy a company whose products are really “cool” and whose products you are using yourself. Peter Lynch was a proponent of this approach for the small investor. Such companies are making plenty of money and growing with new products. Apple is a good example. It is also possible that a company is making popular products that you are using and the company is losing money on every sale they make. You don't want this company! So always check the chart first and then the fundamental analysts to avoid these momentum chart traps. Just because the chart is good does not mean it has good fundamentals and is a solid, real company. Penny stock scams show stocks with good charts and companies with no fundamental reason for existing.
Notice in Exhibit 1.1 that the initial, long-term buy signal for Apple in 2009 is when price moved above the 200-day moving average. This technical analysis signal is widely used by most long-term investors. It is the solid trend line moving up under price on Exhibit 1.1. That long-term uptrend is still in place. Portfolio managers dream of stock moves like this one, where price moves from $100 to $600 in less than four years. Is it any wonder that almost every portfolio manager has Apple in his or her portfolio? The small investor has a better chance of quickly buying this stock at its low and selling it at its high, unlike the portfolio manager with millions of shares to buy.
Also notice that every time the sellers showed up in red, taking price down on the chart, they were quickly stopped, not even able to move price down to the 200-day moving average. The first real test by the sellers taking price down to test the 200-day line did not happen until the middle of 2011. Price still failed to violate the 200-day, long-term uptrend. Every test by the sellers that fails to break below the 200-day long-term uptrend is a confirmation signal that the positive uptrend will continue. It is a signal to buy on weakness for long-term investors. This is the first and most important technical analysis signal for investors.
We did know that Apple was a great company led by Steve Jobs and they were coming out with fabulous products. Fundamentally, analysts liked the stock and it was “Growth At a Reasonable Price.” (GARP stocks usually have a good PEG [PE/G], which is a favorable price-earnings ratio (PE), compared to the 5-year growth rate [G].)
Technically, the chart showed that price was going up. So you buy it, using the 200-day uptrend signal at the end of 2009. When price stops going up, you sell it, using the 200-day signal when price breaks below the 200-day as it did twice in 2008. That is the easiest way to make money in the stock market and beat the index. As the 200-day trend started up in 2009, both the fundamental analysis and the technical analysis were completely “in sync.” When you have both going for a stock, it is hard to lose money, except in a market crash or a negative surprise, as discussed later in the Herbalife and Green Mountain chapters (Chapters 4 and 8). (Note that the overall market crash even took Apple down below the 200-day in 2008. When it broke above the 200-day, it was a golden opportunity for the long-term investor to “buy cheap.”)
20-, 50-, AND 200-DAY MOVING AVERAGES
We can show you the basic signals of the 20-, 50-, and 200-day moving averages with any stock. But Apple is a very exciting story and is in almost every investor's portfolio. In Exhibit 1.1, we show the 200-day moving average for Apple and its long and uninterrupted uptrend since the bottom in 2009. Likewise, in Exhibit 1.2, we show the 20-, 50-, and 200-day exponential moving averages (EMAs) for Apple. EMAs weight recent data more heavily, whereas the simple moving average weights each day equally.
The line well below price, near the volume bars shown at the bottom of Exhibit 1.2, is in an uptrend starting at the left, bottom corner of the chart. It is the long-term 200-day moving average used by most portfolio managers as a key technical indicator of long-term trend. The upper line, moving up just below price on the chart, starting in January 2012, is the 20-day moving average. You can see that it quickly changes when price changes direction. It follows the short-term trend of price. Traders and hedge fund managers watch this short-term indicator.
Between the 20-day line at the top and the 200-day at the bottom part of the chart, you will see another line, which is the 50-day moving average. This is an intermediate trend line. When it drops down to the 200-day, portfolio managers become worried, as supply takes price lower and threatens the bullish uptrend shown by the 200-day.
As indicators of supply and demand, these moving averages provide a very visual picture and clear buy and sell signals that identify supply and demand. From January to April 2012 in Exhibit 1.2, you can see demand as all three moving averages are in an uptrend. Apple is a short-term, intermediate-term, and long-term buy, according to these signals. Demand is in control and taking price up.
The first sign of trouble is when price breaks below the 20-day the week of April 9, a signal that this price move up is over short term and price has topped out at $644. Now supply is in control and taking price down short term. The 20-day uptrend turns to a downtrend, confirming that Apple is now in a short-term selling cycle. Then price breaks below the 50-day and now you go from a short-term selling cycle to a more worrisome intermediate selling cycle. Another bearish signal of supply occurs when the 20-day breaks below the 50-day. You can see that this happens in Exhibit 1.2 before price bottoms at $522 during the week of May 7.
Finally, there are some signs of demand as price bounces up from $522 but on light volume, indicating light demand. The 50-day line is no longer in an uptrend but going sideways to down. Another good sign of demand is when the 20-day breaks back above the 50-day during the week of June 25. Price is now also above the 50-day, yet another sign of demand. At last at the beginning of July, the 20-day turns up and the 50-day turns up. The selling cycle is over and demand is taking price up.
Although this was a 19 percent selloff from $644 to $522, the 50-day never turned into a downtrend and the 200-day uptrend was never even threatened. For the portfolio manager and small investor this was a “buy on weakness” signal given by the moving averages. Moving averages are very valuable technical analysis signals and the first and easiest to learn and use.
RELATIVE STRENGTH VERSUS THE S&P 500 INDEX
Relative strength performance versus the Standard & Poors (S&P) 500 Index is the key to analyzing any large-cap (capitalization) stock, and is revealing when viewed in Exhibit 1.3. In this chapter, we will exploit the easiest and most powerful examples of technical analysis signals that tracked the demand that took Apple price up so dramatically. Relative strength is simply the comparison of a stock's price movement to the price movement of the index. This is a simple, straight forward arithmetic ratio. It is then plotted and shown in Exhibit 1.3 as “AAPL: $SPX.” Notice the uptrend in the line created when the stock price is doing better than the index. As long as this line is in an uptrend, it classifies the stock as one that is outperforming the index. The trend line is calculated as a 20-week EMA. If you want to outperform the index this is the signal to watch.
There is no magic in these signals. Demand takes price up, and these signals measure that demand. It goes without saying that you must check the fundamentals of any stock you trade or invest. Portfolio managers do that “due diligence” for you, and you can rely on their published stock picks. They may not be good stock picks for performance, but they do have good fundamentals. The chart will tell you whether they are outperforming stock picks. Some stocks will be “special situations,” for example, takeover candidates, and the charts won't help. Use Bloomberg, CNBC, Barron's, the Wall Street Journal, and Investor's Business Daily as sources for takeovers. Relative strength and the moving averages will help you beat the index and keep you rotating into winners and out of losers. These are important technical signals identifying demand, which takes price up, and supply, which takes price down.
KELTNER CHANNELS
A quick glance at Exhibit 1.1 and you will notice that the latest move up in price started in January 2012. It came to a peak that was a much larger move than the previous peaks. You can see this more clearly in Exhibit 1.3 by introducing channels around the prices on the chart. The...
