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An Explosion Waiting to Happen
There are two key methods of stock selection used by stock market traders and investors – fundamental analysis and technical analysis. Some investors and traders, of course, use a combination of both methods.
Sadly, fundamental analysis has a major flaw – it does not take into account the timing of the stock purchase. A fundamentally undervalued stock can fall for years before starting to rise again. Purchasing such a falling stock, regardless of how undervalued the stock may be, is very unwise indeed. There are no guarantees that undervalued stocks will ever rise.
Technical analysis, including behavioural analysis, on the other hand, can be used for both stock selection and the timing of the purchase. Many astute investors and traders, having selected a stock using fundamental analysis, then use technical analysis to confirm that the stock is strong from a technical perspective, and that it is a high probability time to purchase the stock.
Some fundamental analysts think of technical analysis as a form of voodoo where one studies chart patterns. This is sad, because the study of chart patterns is a very small part of technical analysis, and by trying to categorise it in this way, they are closing their minds to its enormous power.
Technical analysis includes the application of Dow Theory, an objective method of determining whether or not we are in a bull market; cycle analysis (did you know that the stock market has always risen in the fifth year of the decade); a study of support and resistance in markets (knowledge which is valuable when purchasing stocks and placing stops) and powerful stock selection methods such as comparative relative strength and breakouts from congestion patterns.
Technical analysis today is a highly respected and widely applied method of stock (and commodity) analysis. The Australian Technical Analysts Association (A.T.A.A.) has as many members as the Australian Investors Association (A.I.A.), for example, with branches in every mainland State capital city, plus Canberra, Newcastle and Toowoomba. It also enjoys an excellent relationship with the A.I.A.
In this article I will outline an example of the application of technical analysis to stock selection. Specifically, I will examine a breakout strategy often described by the highly respected analyst David Fuller as “an explosion waiting to happen”. David Fuller is an American who runs his highly successful analysis company from London. He is considered to be a world expert on the behavioural analysis of financial markets.
Breakouts From Long, Narrow Congestion Zones
Often stocks form a large base during the accumulation phase. This is a phase where the professionals are slowly accumulating large quantities of stock. The market moves up and down in a fairly narrow range during an accumulation pattern.
Each time the market reaches the tops of this range, renewed selling takes place. The accumulation phase is the phase when ‘weak’ sellers finally dump their stock out of sheer frustration and disillusionment. Similarly, traders carrying losing positions tend to sell during any rise at previous tops as this is where the market usually gives them a chance to get some of their money back. If these losing traders sell during the accumulation phase, ‘strong’ buyers, who will be in profit at higher prices, will replace them. They will not be under any strong psychological pressure to sell when the market reaches old tops.
The longer the base and the stronger the base, the bigger the move that should occur once the market successfully breaks clear of the base. Should we buy at this time, we have a high probability of a very profitable trade. David Fuller likens the situation when a market is in a narrow, long (in time) congestion pattern to a spring coiling tighter and tighter. It is “an explosion waiting to happen”.
Old tops are points where much selling takes place, and hence a stock breaking above these tops has proven its strength by overcoming this resistance caused by the selling. It should now be free to move strongly upwards without the risk of it forming another top that is level with the earlier one(s).
W. D. Gann confirms the wisdom of this strategy by advising the trader to … buy … a stock as soon as it gets active in new territory. (Gann, W.D., Truth of the Stock Tape, Lambert-Gann Publishing Company, Inc., Pomeroy, WA, 1927, page 64.)
Chart One – Amity Oil Limited
In Chart One, it can be seen that Amity Oil started to move in a narrow sideways range in late September 1999. It broke above this range for the first time in July, 2000. As a rule of thumb, we like to see a stock in a narrow sideways range for at least 30 periods. As this is a weekly chart, we would look for the pattern to have lasted for 30 or more weeks. Although volume is not shown on this chart, a huge increase in volume when the strong upward move commenced is a very good sign as rapidly rising prices on high volume indicates that large numbers of buyers are prepared to pay higher and higher prices for their shares.
Chart Two – Coles Myer Ltd
In Chart Two we can see Coles Myer in a multi-year sideways congestion pattern. Many traders and investors made handsome profits by purchasing the stock when it broke clear of the sideways congestion range.
Conclusion
Technical analysis is only tea leaf reading in the minds of those who do not understand it. As can be seen in this article, it can be used as a stand-alone trading and investment tool, or combined with fundamental analysis to help time the purchase of stocks that are undervalued from a fundamental analysis perspective.
DISCLAIMER:
No part of this article is intended to give trading or investment advice, or is intended to be an invitation to trade. The examples used were deliberately chosen to be outdated and therefore to be of no assistance in making trading or investment decisions in those stocks in the current market.
[This article was first published in the Australian Investors’ Association’s (AIA’s) Equities Newsletter, Issue No. 5, January 2004. Repreinted with permission of the AIA.]
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