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P A R T III
ChartingTechniquesand Patterns
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C H A P T E R 6
The Importance ofChartsA Visual
Confluence of Price,Time, and Emotion
Why Charts?
Which conveys more information about a specific oak tree, a
picture of the tree or a 1,000-word description? Now suppose
that you have just five seconds to assimilate the information.
According to an old Chinese proverb, a picture is worth
1,000 words. To which I add: A chart is worth 1,000 numbers.
A chart takes a jumble of numbers and makes them workable,
and your mind makes visual connections that are not apparentin a list of numbers.
Remember, the primary number to chart isstock price, which
is in constant flux. Each price is set where the supply and de-
mand lines meet, where willing buyers meet willing sellers.
Each time a buyer and a seller meet, the price can be different
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from the last. It can go up and go down. You track that change
in pricethat junction of supply and demand.
So the static numberthe price on any given dayis not as
important as the direction and rate of change. And charts let
you understand them much, much more easily than looking at
a list of numbers.
When charting, always remember two things: KISS and the
90/10 rule. KISS, of course, stands for Keep It Simple, Stupid.
The 90/10 rule, meanwhile, states that you can get 90 percentof the information from something in about 10 percent of the
time, but it takes the remaining 90 percent of the time to get the
remaining 10 percent of the information.
A Basic Chart
Before we go any further, lets define the elements of a basicchart. Figure 6-1 is a daily chart that shows the emerging-
markets exchange-traded fund (EEM) from July 2008 through
April 2009 and is from the invaluable DecisionPoint.com site
that I use regularly.
The most basic thing on the chart, of course, is the price
itself. Since this is a daily chart, each vertical line or bar depicts
the trading for a particular day. The high and low prices eachday are connected with a vertical line, and the closing price is
represented by a little cross-tick.
The solid line on the price chart is a moving average. This
one happens to be a 50-day exponentially smoothed moving
average, but there are many, many different moving averages
in use among market technicians. Moving averages are used
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The Importance of Charts
to measure both trends and momentum. If the stock price is
above its moving average, its in an uptrend, and if its below
the moving average, its in a downtrend. In addition, if the
price is above the moving average and moving further and
further above it, the stock is gaining momentum, whereas if
the price is above the moving average but getting closer andcloser to it, the stock is losing momentum.
The same works in reverse, of course, when the stock is be-
low the moving average. In addition, if the stock price is way,
way above the moving average (over 30 percent, lets say), its
overboughtextended on the upsidewhich makes it vulner-
able to at least a short-term correction. The opposite is true if
Figure 6-1: A Basic Chart.
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its way, way below the moving average (as EEM was in October
and November of 2008). And obviously, the longer term the
moving average, the longer term is the trend youre measuring.
Finally, line at the bottom of the chart is the all-important
relative-strength linewhich is simply the stock price divided
by a broad market index such as the Standard & Poors 500
Index (S&P 500).
Interpreting the relative-strength line is simple: A rising
line means that the stock is outperforming the market; a fallingprice means that it isnt. Dont worry about the price of the
relative-strength line; it means nothing. All were interested in
is whether the line is going up or going down.
(One of the greatest advantages of the DecisionPoint.com
site, by the way, is that it enables you to easily chart a stocks
relative strength versus just about anythinga market sector,
an overseas stock market, and gold, to cite just a few examples,
not just the S&P 500.)There are, of course, all sorts of additional indicators and
different methods of charting stocks that are available on the
various charting websites. In this book, though, Im not go-
ing to go beyond the basicswhich is really all that long-term
investors needbut if youd like to learn more, see the Appendix
for a few suggested resources. Youll also find a list of some of the
better charting websites where you can look at individual stock
charts to your hearts content.
Analyzing the Chart
We really need to determine just four things from stock charts:
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1. Is the stock price going up or down?
2. Is the stock price gaining or losing momentum?
3. Is the stock overbought (extended on the upside) or
oversold (extended on the downside)?
4. Is the stocks relative-strength line going up or down?
The EEM chart happens to reflect the best of all possible
worlds.
1. The stock is going up; the price is above the moving
average.
2. The stock is gaining momentum; the price is moving
further and further above the moving average.
3. The stock is not yet overbought; the price isnt all that
far above the moving average.
4. The stock is generating relative strength; the line at the
bottom of the chart has been going up since October.(And the fact that EEM generated relative strength
throughout the markets bottoming process was the
tipoff that it was destined to be a market leader after-
wards, as youll see later.)
Please note that it takes virtually no time at all for you to de-
termine these four points, which is all that you really need
to be aware of as a long-term technically savvy investor. The
90/10 rule rules!
I am also happy to be able to report that the best of all pos-
sible worlds worked out very, very nicely for investors. EEM,
which was 28.14 when this chart ended in April of 2009, hit a
high of 44.02 in April 2010 and sold at 50.43 in May of 2011.
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Lessons from a Basic Long-Term
ChartMcDonalds
Figure 6-2 is one of my all-time favorite chartsan 11-year
chart of McDonalds from 1970 to 1981 from the Securities
Research Corporations Blue Book. It illustrates the basic chart
concepts very clearly, especially relative strength. Even more
important, it highlights the importance of sentiment in pre-
dicting future stock prices.To fully understand this chart, some background is necessary.
The big investing fad in the early 1970s was predictable
consumer growth stocks. At that time, the United States was
going through a time of unusually high inflation and unusu-
ally high interest rates, so companies found it difficult to bor-
row and expand. But approximately 50 giant consumer-goods
companies were growing so fast that they generated their own
cash needs and could finance themselves internally, so they
didnt have to go to the capital markets to raise operating cash.
They were fortresses in an angry sea. The inflationary seas
were raging around them, but these companies were so strong
that they could withstand the angry seas and still do nicely.
This group became known as the Nifty Fifty, and Mc-
Donalds was a leader among them.
McDonalds growth rate was phenomenal! It was 25 percentper year compounded. And that growth rate was steady and
unbroken throughout the decade. The Nifty Fifty investors
foresaw this in 1973 (three years into the chart) and paid 75
times earnings for the stock. And Putnam, where I headed the
Market Analysis Department, was one of the biggest of the
Nifty Fifty investors.
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Figure 6-2: McDonalds as a Nifty Fifty Stock.
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In 1973, every kind of fundamental analysis indicated that
the stock price would go even higher.
But look carefully at the chart to see where McDonalds
stock price actually went. (The earnings line is plotted on a
scale such that if the price line is at the earnings line, the stock
is selling at 15 times earnings. If the price line is above the
earnings line, the stock is selling at more than 15 times earn-
ings. If it is below, it is selling at below 15 times earnings.)
McDonalds stock price went from a high extreme of 75times earnings in 1973 to a low extreme of 7.5 times earnings
in 1980.
Well, 75 times earnings was, and is, a lot to pay for even a
predictable growth stock. But the most stunning thing on the
chart is that as the period of enthusiasm gave way to a correc-
tive process, the price/earnings ratio of McDonalds plummet-
ed from 75 times earnings to 7.5 times earnings even though
the companys compounded earnings growth rate was 25 percentthroughout the period and it never missed a quarter.
At Putnam, the fundamentally oriented money managers
were driven to tears. They had analyzed the company and
correctly forseen very good things. And those good things all
came to pass: Every quarter, McDonalds earnings would come
in at the expected 25 percent growth rate.
But the stock didnt do well. And it didnt do well quarter
after quarter after quarter, despite those fabulous earnings.
Why?
Heres what happened:
In 1973, McDonalds stock price increase had been driven
by euphoria, by a recognition of future earnings. This eupho-
ria pushed the stock price to an extreme valuation.
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But once the emotional peak was reached, in 1973,
the stock was all done. Basically, the market said, Hey,
McDonalds, youre a great company; you are going to do
fabulously well over the next seven years. But, at 75 times
earnings, Ive already anticipated that and paid for it, and Im
not going to pay more.
And so the stock price stopped going up.
After that, the only question was, How low was it going
to go?If in 1973 I had predicted that all the analysts earnings and
growth forecasts for the next seven years would come true and
that McDonalds, as a company, would do everything anyone
expected and more, but despite that, its stock price would be
lower in 1980 that it was in 1973, I would have been consid-
ered a lunatic.
But thats what happened.
McDonalds was unusually high priced at even 60 timesearnings. When it went to 75 times earnings, the risk was even
higher. Investors, of course, can never know ahead of time ex-
actly when risk will be perceived as too much. At some point,
though, the risk levels become high enough that the stock is
going to respond. So all a technical analyst can do with these
long-term charts is to say that risk levels are high or risk levels
are low and that the stock is in a position to respond negative-
ly to high-risk levels or is in a position to respond positively
to low-risk levels. Predicting exactly when this will happen,
though, is impossible. (John Maynard Keynes may have said
it best: Successful investing is anticipating the anticipation of
others.) But this gives you a long-term perspective, whether
you are in an enthusiastic period, where risk is way higher than
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usual, or you are in a period of pessimism, where risk is lower
than usual.
McDonalds actually turned out to be a happier case than
most. Its stock price was buoyed more than usual because its
earnings kept growing. In a more normal situation, earnings
would have been more sideways, and the price would have
been biased to the downside.
So the price didnt go down much. But it didnt go up ei-
ther, and people were not paying Putnam to own stockswhose prices went sidewaysespecially since a lot of other
stocks were going up during that time. Our competitors thus
got busy soliciting our clients and told them that Putnam has
McDonalds and it has gone sideways over the last few years,
and your account has gone sideways, whereas in our account
we have bought such things as US Steel at five times earnings,
and it is now at eight times earnings. And our accounts are
going up.But was McDonalds a bad purchase? It neednt have been,
not with some sensible longer-term timing and planning.
During its heyday, McDonalds went from 9 1/4 to 75 over a
period of 2 1/2 yearsand I can assure you that there were
some down days, some minor corrections, along the way. But
the stock price generally went up because investors anticipated
great earnings. The trick is to spot when the price stops going
up based on anticipation and its time to sell. Remember: No
stocks performance ever exactly tracks the performance of the
underlying company. And no stock goes up forever, no matter
what the companys earnings do.
And if the stock price is no longer going up, you have to
accept that it is going down and not try to get back into it every
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time there is a little upside correction. Keep your eye on the
long-term movements.
And what were things like at Putnam when McDonalds fi-
nally bottomed? Youll never guess: The following is the tran-
script of an interoffice memorandum exactly as it appeared at
Putnam in 1980.
AnecdoteThe Wall Street Week Memo
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AnecdoteThe Story of Baxter, US Steel,and John Maurice
This is from a special report I wrote and published on
April 9, 1999:
Back in the Good Old Days at Putnam (circa 1973),
when the Nifty Fifty were the only game in town and
the Putnam Advisory Companywhich was everybit as big a Nifty Fifty player as J. P. Morgans Carl
Hathaway, who got all the media coveragewas
bringing in new accounts almost daily, the advisory
managers used to make regular trips to the trading
room to deliver a stack of buy tickets for their Core
List stocks and a stack of sell tickets for the stocks
they had inherited.
One afternoon, John Maurice, the manager of the
Putnam Growth Fund, a card-carrying contrarian
and one of the best and most astute money managers
I have ever worked with, looked at the advisory man-
ager who had just brought in that days stack of buy
and sell tickets and said, Do you mind if I ask you
something?
Sure.
Do you ever wonder if US Steel, which youre selling
at five times earnings, might possibly be a better stock
than Baxter, which youre buying at 50 times earnings?
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No, came the instant reply. We were sold to ournew client as a growth stock manager, and a growth
stock manager we shall be.
But the deeply depressed US Steel wasa better stock
to buy in 1973 than the immensely exploited Baxter.
Not only that, the money that came flooding into
Putnam in 1973 and 1974 because of the sensational
past performance of high-quality growth stocks leftjust as quickly toward the end of that decade, due to
the underperformance of those growth stocks.
One final note: When I told this story in Boston, some-
one reminded me that the Nifty Fifty performance, which
crested in 1973, caused John Neff, the highly regarded value
manager of Vanguards Windsor Fund, to come within onequarter of being fired at the time. Neff stuck to his style of in-
vesting, though, and his fund subsequently performed so well
and got so big that it had to be closed to new investors 15 years
later. Carl Hathaways did not.
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