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| Dear Daily Crux reader, This week we're continuing our new project: "The World's Greatest Investment Ideas." The project's goal is to conduct a series of short interviews that focus on the big ideas that form the foundation of what we know works in investing and trading... ideas like intelligent position sizing, owning World Dominating Dividend Growers, "bad to less bad" trading, and buying trophy resource assets. We're continuing our series this week with another interview with Brian Hunt on common sense technical analysis. Few investment subjects create as much confusion and controversy as technical analysis, often referred to as "chart reading." Many traders swear by its predictive value, while others regard it similarly to astrology or tarot cards. As editor in chief of Stansberry & Associates and a successful private trader, Brian has reviewed just about every type of technical analysis out there. He's distilled this complex subject into a few important ideas that can be a valuable to addition to any trader or investor's toolkit. Whether you're looking to become a more successful short-term trader or just improve your long-term investing returns, we guarantee you'll find some great ideas below. Regards, Justin Brill Managing Editor, The Daily Crux www.thedailycrux.com –––––––––––––––––––––––––––––––––––––––––– The Daily Crux Sunday Interview
Common Sense Technical Analysis, Part I The Daily Crux: It's often said that out of all the ways to analyze the stock market, none generates more confusion and criticism than the practice of "technical analysis"... also known as "chart reading." Before we get into the fine details, let's define our terms. Brian Hunt: As you said, technical analysis is often called "chart reading." It's the study of past market prices and trading volume in order to get an edge in the market. Some folks swear technical analysis is the "Holy Grail" when it comes to profiting in stocks and commodities. They'll tell you they've found chart patterns that regularly predict huge market moves. Some folks swear technical analysis is no different than using tea leaves and tarot cards to dictate investment decisions. They think it's all a bunch of B.S. There's a good reason to be skeptical of most technical analysis claims. Millions of books on technical analysis and millions of dollars of technical analysis advisories have been sold over the years... all marketed on the claim that certain gurus can predict the next big move in stocks or commodities. Just send 'em a check for $99 and you'll learn the secret. Many of these "secret formulas" are no better than flipping a coin to determine your trading direction. ---------- Advertisement ---------- A secret website Wall Street doesn’t want anyone OVER AGE 55 logging onto This 'underground' Internet site could help you collect as much as $653 per week in extra retirement income... Without touching regular investments... And without going through brokers and money managers ever again. ---------------------------------------- But over the years, I've found there are some useful "common sense" applications of technical analysis. They can help transform ordinary traders and investors into extraordinary traders and investors. These "common sense" applications don't try to predict the future. They simply help the trader gauge where an asset is relative to the big trend... and they help the trader see how an asset's fundamentals are affecting its price. Crux: That's the theory. Now let's cover some of these tools. Hunt: Let's start with the most important concept in technical analysis: what a trend is. Put simply, a trend is a series of price movements in one general direction. That's it. Since pictures speak louder than words, we'll use a lot of charts in this interview. We'll start with a chart that displays an uptrend. The chart below is the trend in gold prices from 2001 through 2009. You can call the price action here a "series of higher highs and higher lows." Each rally in gold takes it higher than the previous high... And each decline in gold ends a bit higher than the previous decline. That's all an uptrend is.
Let's also cover what a downtrend is. Below is the downtrend in the share price of newspaper giant Gannett, which publishes USA Today. This chart shows Gannett was in a downtrend from 2005 through 2008.
You can call this downtrend a "series of lower highs and lower lows." Each rally in Gannett's share price ends a little bit lower than the previous rally... and each decline takes Gannett a little bit lower than the previous low. That's the key concept in technical analysis... the trend. Crux: OK, let's move on to another concept I've heard you talk about – "respecting trends." How do you do that? Hunt: If you don't respect trends, you'll get killed in the markets. One of my favorite market analysts and investors of all time is Martin Zweig. Zweig's Winning on Wall Street book is considered one of the all-time greatest books ever written on the markets. He achieved fame and fortune in the 1970s and '80s with his Zweig Forecast market advisory. He's also a successful money manager. Located in the middle of Winning on Wall Street is this timeless quote:
In the early days of Wall Street, traders received updates by a machine that printed out prices on a roll of ticker tape. Even today, with the ticker tape machines long gone, traders still call market action "the tape." When Zweig says "Don't fight the tape," he's really saying, "Don't fight the big trend." Hundreds of thousands of traders have blown up their trading accounts by trading against uptrends and by trading against downtrends. Most of these traders were sure they knew something the market didn't... Maybe an uptrend was due to end in a big crash... Or a downtrend was due to end in a big rally. So, they bet on them ending. Again, this is called "fighting the tape." And as Martin notes, it's an invitation for disaster... for the simple reason that trends tend to last longer than anyone expects them to. Or as legendary investor Jim Rogers reminds us: "Markets often rise higher than you think is possible, and fall lower than you can possibly imagine." This is why you never want to bet against a major uptrend or a major downtrend. Trends can last a long time... and you must either trade with the trend, or step aside. But never stubbornly trade against it. From a general standpoint, you want to be long uptrends, and short downtrends. And unless you are trading for lightning-fast moves of just a few days, never short a major uptrend, and never buy a major downtrend. Or in Martin Zweig's words, "Never fight the tape." Crux: But you can make big money when a trend goes from up to down, and vice versa. How should a trader do it? For example, what if you find an asset that is a terrific value and has a great bullish long-term argument for buying it, but is still locked in a downtrend? You want to buy, but you don't want to "fight the tape." Hunt: This gets to another key concept... the art of finding tops and bottoms. Let's start by looking at an important chart. This chart displays a type of price move that has bankrupted hundreds of thousands of people. So please pay careful attention to it.
This is a chart of crude oil from early 2007 through late 2008. See that huge, sharp decline on the right-hand side? That's a market in crash mode. Some traders call this kind of move a "falling knife" or a "falling safe." A market in such a sharp decline is nearly impossible to trade successfully. But that doesn't stop all kinds of people from trying to do so. Many people see this kind of fall and think, "It's getting cheap. It's due for a big rebound... and I'm buying." Many traders get a thrill from trying to pick the exact bottom or top of a runaway market. They perform the necessary fundamental analysis to realize a market is cheap after a big fall... or expensive after a big rise. Armed with this valuation knowledge, they go for the glory and start buying... and lose a bundle. Here's why: A huge move like the 2008 oil crash generates a lot of emotion in the marketplace. It catches most people off-guard. It causes big swings in their account values... both up and down. All that emotion produces wild markets with little concern for fundamentals. Whether an asset is overvalued or undervalued simply doesn't matter during these moves. So saying things like, "This stock is just so cheap" is only going to get you and your money in trouble. It's going to get you into risky trades. Instead of letting that sort of thing run through your head, remember that quote from Jim Rogers:
Markets are just big groups of people. People are irrational... even more so when their money is on the line and account values are jumping around like crazy. This makes trading against runaway trends – fighting the tape – a high-risk activity... There's a much lower-risk way to trade these moves. It's a lot easier on your blood pressure... and more profitable. Let's again consider advice from Marty Zweig. Zweig says trying to buy an asset in freefall is like trying to catch a falling safe. You'll always get squashed. His alternative is amazingly simple and profitable. Don't try to catch a falling safe. Wait for it to hit the ground... Then just walk over and pick up the money. Let's look at crude oil again. Instead of trying to catch the falling safe by going long crude oil in October 2008 when the chart looked like this...
...the smart speculator waits for the safe to hit the ground. He waits for the chart to look like this...
See that price action in late 2008? Traders who bought oil at $70 in October got a 50% "discount" from July's high of $140. They also lost half their money as the safe kept falling and falling. It eventually hit the ground at $35 in December. Few market players imagined this stupendous decline could happen to crude oil. But remember Jim Rogers: "Markets often rise higher than you think is possible, and fall lower than you can possibly imagine." The safest time to go long crude oil and oil stocks came in February 2009. It was during this time that oil "carved out" a bottom. After hitting a low of $35 a barrel in December, oil rebounded into the upper $40 range. The oil bears countered this rally and tried to drive prices back down to the low several times. Each time, oil refused to reverse. As traders would say, oil "tested" its bottom. At this point, it's much safer to buy oil than it was in October 2008. Anyone who went long back then was buying into a sharp decline. Traders who waited on a bottoming out process – and waited for the safe to hit the ground – made a bundle as oil went onto rally into the $70s and $80s in 2009. They waited for the trend to get exhausted... for all that emotion to get wrung out of the market. This "wringing out" process takes time... And it produces a "round bottom" like you see here:
This strategy of avoiding sharp declines while trading round bottoms works for all stocks and commodities. It allows you to stand safely aside as the safe hits the ground and spills out its contents. This line of thinking also works at market tops... and allows you to make money when assets fall. Have a look at this chart. It's one of the great moves of the 2003-2007 stock rally.
This chart shows the gigantic move Potash enjoyed from 2006-2008. Potash is the world's largest fertilizer company. In 2006, grain and farm prices went through the roof... So fertilizer producers went through the roof as well. Potash shares increased 600% in less than two years. After fertilizer shares ran up hundreds of percent, the investment public caught on. The news was everywhere: Fertilizer prices are skyrocketing! Wall Street and Main Street went wild. People were so bullish on fertilizer shares, they were willing to pay between 40 and 60 times earnings for these stocks. That's a crazy price to pay for any company... let alone for one that produces boring crop fertilizer. So... you had two big "red flags" here. You had 1) a wildly overpriced stock, and 2) rampant bullishness from the investing public surrounding shares. Time to go short? No way. Look how sharp that rise is again. Sure, Potash is super-expensive and "should" suffer a big correction soon... but remember Jim Rogers: "Markets often rise higher than you think is possible, and fall lower than you can possibly imagine." Potash shares were still rising. The stock was a rocket ship with plenty of momentum. It was too risky to trade. At that point, the right thing to do was place the stock on your watch list and wait for the flame at the bottom of the rocket ship to sputter out and turn cold. Here's what that "flameout" looked like:
As you can see, Potash peaked around $240 in June 2008. It entered a perfectly natural correction at the end of the month... Then the bulls tried to push it skyward again. That rally couldn't push it above $230. It failed the "test." The flame was sputtering. Potash's chart had changed from a sharp uptrend to a round top. It was time to bet on the short side and let gravity do the rest. Here's what happened over the next four months:
Gravity really worked Potash over. The stock fell 75% from its high. Short sellers made a fortune. So, to sum things up, this common sense technical concept tells us to never buy assets in freefall and never sell short assets in rocket flight... to never fight the tape. Instead, look for round tops and bottoms. Editor's Note: We'll publish Part II of this interview next week, where Brian explains two simple ways to discover and profit from important trend changes, and reveals how the world's best investors use trading volume to greatly swing the odds in their favor. |
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