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The Advisory Firm Newsletter:  September 2012

THIS MONTH IN PERSONAL FINANCE: How to read a stock chart.

 

For the September Financial Planning Newsletter, we are going to explore an area that you don't commonly hear discussed in the world of personal finance, namely understanding a technical stock chart. You see graphical displays of the S&P 500 on the evening news and maybe a chart of Microsoft when you flip on CNBC television, but do you really understand what you are looking at? Read on and learn more....

Fundamentals vs. Technicals

Before we jump in to this, if you are an Efficient Market or Random Walk Theorist that believes the market has no memory, stocks are always valued efficiently and that there is no value in looking at trends, then read no further. If however you believe that there are trends, market cycles and that things like the Dow Theory (more on this later) holds weight, well this month's newsletter is for you.

Now, for a brief clarification. This newsletter is going to talk about Stocks, Stock Indexes (S&P 500, DOW), Mutual Funds and ETF's (exchange traded funds) in the context of following them via a stock chart, so when we look at the Gold index, we could just as easily be talking about a chart of Fidelity Contrafund or a chart of Microsoft stock. A chart is a chart is a chart, it works with any traded asset. On the charts below you will see prices on the "Y" axis and time (date) on the "X" axis.

How is a stock valued?

The most basic fundamental definition of a stock price is: The value of a company's stock is a function of the present value of it's earnings stream. Yes, we can get into the intrinsic value on a company's balance sheet, but for our purposes the market values a company's stock based on it's future earnings potential. That is why there is so much emphasis on the quarterly earnings reports and why so many analysts are employed on Wall Street to try and project a company's future growth potential. So if we had a fixed Price to Earnings multiple, say a P/E of 12 and had a good idea of a company's projected earnings we could come up with where stock prices should be and that would be it, correct? (note: a P/E ratio is simply when a company reports earnings as "Earnings Per Share" the stock price is divided by that amount to come up with a Price to Earnings ratio)

Unfortunately, it's not quite that simple. You see some stocks are valued at higher P/E ratio's while they are in growth mode, sometime much much higher ratios. And then all of a sudden growth slows and you have P/E compression and the stock price goes from $50 to $25, all because the market has assigned a lower P/E multiple for the company. Case in point are the 4 horsemen of the tech stock 90's: Microsoft, Dell, Intel and Cisco. All of these stocks were highflyers in the late 90's but after the tech bubble crashed their stock prices dropped and are still trading well beneath their alltime highs. Why is that the case if all of these companies have more cash and higher earnings now than they did back then? It's because Wall Street doesn't value them as growth stocks anymore and the high P/E multiples are gone.

Okay. Now on to the basis of our newsletter.......

_____________________________________________________

Technical Analysis?:

So we just figured out that Stock Prices can be very fickle and subject to whatever valuations Wall Street wants to apply at any given time. And from history we know that this can change very quickly. We could also hypothesize that a fair amount of the price could be due to Greed or Fear? (overvalued or undervalued, momentum chasing, etc) What if there was a way to gauge a stocks (or index, mutual fund, etf, etc) trend to see where it was in this cycle?

That is why we use a graphical Stock Chart. (Also known as Technical Analysis). At stock's chart shows us the opening price, closing price, high and low points for the day along with how much volume traded. A stock trades from 9:30am to 4pm, Monday through Friday. Same for Exchange Traded Funds and Indexes (some caveats to this one). A mutual fund only has one price for the day and that is the closing value printed at 4pm.

So below I will show you some basics of stock charting. BIG NOTE: This is not for you to daytrade your 401k. Stock charts can be useful for gauging LONGER TERM market trends and to look for extremes. Reading this newsletter will not make you a professional trader, so don't go there.

 

First let's look at the S&P 500:

These small pictures may be hard to see, but you can double click on them to open up a larger image for viewing.

This first picture is a single day chart (actually it is Monday and Tuesday morning) of the S&P 500 just to show you how the index moves in any given day.

The second picture is taking a step back and looking at the past 6 months. A little more action to see here as you notice the correction in the Spring and bounceback recently.

This last picture is a multiyear "weekly" chart of the S&P. This one goes all the way back to the 90's so you can get a much longer term view of the trend. For long term investors this one will give you the most information about the market in general. When you look to the left you see we have been in a very broad range since 2000.

 

Applying the idea:

The basic idea behind looking at a chart is to first determine the trend of the stock / index. Is it in an uptrend, downtrend or basing sideways? This helps to determine (in conjunction with your fundamental analysis), if it is a good time to buy or should you wait before stepping in. A stock could be the best value in the world, but isn't going to move until the big institutional investors start buying. Likewise, what looks cheap based on fundamentals could be that way for a reason. Case in point was Enron, remember that one? The fundamental analysts had buy ratings on it and kept reiterating buy ratings all the way down as the stock fell from over $70 to pennies. A simple glance at a stock chart during this time would have told you that it was in a downtrend and maybe it wasn't quite time to step in and buy. Think of fundamentals to tell you what to buy and technicals to tell you when to buy.

Here is a link to a historical chart of Enron along with a link to an educational document by DWA showing all of the analyst calls as Enron was dropping.

 

So as a wrap up let's take a closer look at an example of a shorter term daily chart of the Junior Gold Miners Index fund (ETF). I have put some notations on this one to help you get an idea of how it is applied.

 

Technical Analysis Summary:

So there you go. A brief introduction to charting the markets. Before we end I needed to elaborate on the Dow Theory teaser in the opening paragraph. Below is a brief explanation. Your assignment is to go to a stock website and pull up a chart of the DOW and the Transport index and report back with your findings!

Dow Theory: This was originally developed by Charles Dow (founder of the Wall Street Journal). His theory was that if there was a new high in the Dow Jones Industrial Average, it needed to be confirmed by a new high in the Transportation Index. Why? He figured that if goods were being made by the Dow Industrial Stocks that they had to be shipped via the Transport stocks. (the two indexes should move in tandom) If the Dow was rising but the Transport average was not rising with it, then it was a signal to be careful. While the theory has some flaws, it has posted an impressive record over nearly 100 years.

If you have any questions on today's topic just send me an email:

James Daniel, CFP®

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The Advisory Firm, LLC provides fee-only financial planning services for clients throughout metro Atlanta and North Georgia including the communities
of Alpharetta, Canton, Cumming, Dawsonville, Duluth, Dunwoody, Marietta, Midtown, Roswell, and Woodstock.

This newsletter if for informational purposes only. The information contained within should not be considered as financial advice nor soliciation
for financial services. Consult with your financial professional if you have any questions. The Advisory Firm, LLC is a fee-only financial planning company and registered investment advisor.