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Amazon.com had risen far enough that many investors were not able to justify new purchases in the stockTools There are many dozens of tools available to the market technician and many different schools of thought practiced under the definition of technical analysis. This includes the use of different types of charts like point and figure, candlesticks, and bar charts as well as different theories on market behavior such as cycles and Elliott Wave analysis. Most go well beyond the scope of what I wish to accomplish here. For this chapter, I have chosen a few specific tools for their ease of use as well as their effectiveness. When analyzing any investment, I prefer to divide my analysis into three categories: tools that are leading indicators, coincident indicators, and lagging indicators. Leading indicators help warn us of a potential change in trend. A coincident indicator tells us when the trend has changed, and a lagging indicator confirms that the investment is firmly on a new trend. This effective methodology is no different from what we would expect of an economist or fundamental analyst. The analytical thought process is very much the same. Leading Indicators of the most reliable leading indicators in technical analysis is volume. If we break down the rise and fall of any stock price into the simple components of demand and supply, volume is one of its best measures. The volume of any stock is simply the number of shares traded in a particular amount of time. It may be a day, week, month, or even intraday periods. For an index, volume is the sum of the shares traded in all of its components. To best understand the value in using volume, we have to first understand that the deciding factor for whether a stock rises or falls today, tomorrow, or next week is simply the ratio of supply and demand. If more shares are being purchased (demand) than sold (supply), the stock will rise in price. If more shares are being sold than purchased, it will fall in price. However, because supply and demand is a ratio, a stock can rise if demand (buying) stays the same but supply (selling) falls. The converse is also true. If the amount of shares being sold remains the same but the amount of shares being purchased declines, the stock can fall. This concept is important because in order for a stock to have a sustainable uptrend, it must have increasing demand. As a matter of fact, there is an old Wall Street saying I use when I teach basic analysis: A stock can fall of its own weight, but it takes volume to rise. In other words, when a stock can begin a major decline without increased volume, it falls of its own weight. But for a sustainable uptrend we must see an increase in volume, an increase in demand. As a rule of thumb, a stock that is rising on higher volume is rising on increased demand, a healthy sign. A stock that is falling on increased volume is falling on increased supply, an unhealthy sign. A stock that is rising on lower volume is probably rising due to lower selling pressure instead of increased buying. This usually leads to lower prices. When a stock is falling on lower volume, we must use other tools to determine the nature of the decline. A classic illustration of volume can be found in Figure 11.4, a weekly chart of Amazon.com (AMZN) from 1997 to mid2004. Clearly the advance during 1997-1998 is on dramatically increased volume, pure rising demand. The peak in volume in late 1998 preceded the peak price in the stock by nearly a year, a strong leading indication that demand was drying up. Thus Amazon.com continued higher from late 1998 to mid1999 on lower volume and then revisited the mid-1999 high later that year on still lower volume, all a sign that buying enthusiasm was falling but selling had not yet increased. Because AMZN had risen so strongly and consistently for several years, investors expectations were for a continued rise in price. Thus few were willing to let go of their holdings. At the same time, Amazon.com had risen far enough that many investors were not able to justify new purchases in the stock. The stock was no longer rising due to increased demand. It was rising because so few investors wanted to sell. After the final peak in late 1999, Amazon.com began what was to become a severe bear market. It did so with declining volume in early 2000. If an investor was looking for rising volume during the decline to confirm that AMZN was in trouble, they would have missed their opportunity to exit at a high price. Amazon.com bottomed in late 2001 and began to rise on significantly higher volume; demand was increasing again. The astute market technician would have recognized that the landscape had changed and the trend was likely to change as well. Higher volume continued for about four months, long enough to pull AMZN up from near $5 per share to nearly $15 per share. Volume then returned to more normal levels with a mild bullish rise, reflecting increased demand. In addition to volume itself, there is an indicator based on volume that I find to be an invaluable tool. This indicator, developed by Joe Granville, is called On Balance Volume (OBV).* On Balance Volume is a popular indicator available in virtually every technical analysis software package and every technical analysis web site I know of. The calculation for OBV is simple. It assumes that all the volume for any day that closed up was positive volume. All the volume for any day that closed down was a negative. We then add the positive and negative volumes to reveal the indicator. When the On Balance Volume line is rising, it means that the volume on the up days is higher than the volume on the down days, a sign the stock is being accumulated. When the OBV line is falling, it means that volume on the down days is higher than volume on up days, a sign the stock is under distribution. Often, we will see the On Balance Volume rise to new highs or fall to new lows ahead of the stock, making it a very useful leading indicator. A good example of the use of On Balance Volume can be seen in Figure 11.5, a weekly chart of Nextel Communications (NXTL). For the seven months from October 2002 through May 2003, Nextel was caught in a sideways consolidation. The stock was not strong enough to move higher or weak enough to fall. For a while, the OBV was also range bound. Then in March 2003, the OBV indicator broke to a new high ahead of the stock. Even though Nextel could not move higher, the volume indicator was telling us that there was more volume on the up days than on the down days and that the stock was under accumulation. Three months later, NXTL broke out from its consolidation pattern and doubled in price within six months. As an aside, it is also worth noting that volume began to decline in October 2003, nearly three months ahead of the most recent high. Insider buy signals can add value to technical indicators such as On Balance Volume. For example, in Figure 11.5, we see two instances where insider transactions resulted in buy signals. The first was in April 2002, when at that time Nextel was still declining and still in a bear trend. Volume was contracting but the On Balance Volume was just beginning to create a positive divergence with price. A positive divergence is when the indicator rises, making higher lows or higher highs, while the price is still declining. The insider transaction buy signal was a great leading indication of the coming change in trend. Volume began to increase in July; then, in August, the stock broke above its 200-day moving average signaling the downtrend was complete. The second insider buy signal was in March 2003. This was at the same time the On Balance Volume also provided a leading indication of Nextels coming advance. In both cases, adding the insider buy signal to our list of leading indicators strengthened our confidence in the analysis and our conviction to take action. Another good example of On Balance Volume is seen in Figure 11.6. In the early part of 2000, Micron Technology (MU) had advanced sharply from $30 per share to nearly $100. In spite of such a strong advance, the OBV was unable to make a higher high. The On Balance Volume was no stronger at Microns peak price in July of 2000 than it had been at the lower peak in March of that year. We call this a negative divergence, when the price of the investment makes a higher high but the indicator does not. This negative divergence was a leading indicator warning. In addition to the warning from On Balance Volume we can see that volume itself contracted as MU made its high in July and then contracted again as the stock made a second high in August. All of these signs together are a clear warning that Micron was losing its strength and might soon lose its up trend. Sure enough, MU broke below its trendline below a previous low in September of 2000 on increasing volume. For Micron Technology, the insider transaction sell signal came as the stock was making new all time highs. This is a point; most investors would never consider selling because their fear of missing out on the upside is greater than their fear of loss. But when we add the insider sell signal to the signals we saw in our volume indicators, we see strong reasons to step aside or take a more cautious stance. Although the On Balance Volume has a strong tendency to lead the price of a stock, there are times when this indicator does not lead or leads by very little. In Figure 11.7 of Micron Technology, we can see an example of a very short lead time between On Balance Volume and the stock price. In early 2003, Micron Technology was still in a severe downtrend. The stock had collapsed from nearly $100 per share only a few years earlier to just above $5 per share. In mid-March of 2003, the On Balance Volume indicator broke above its declining trendline showing potential accumulation even though volume was contracting. When insider buying precedes a break above a downtrend, the chances of a whipsaw or false break put is dramatically reduced. The price of Microns stock broke above the downtrend line that had served as resistance. With volume still declining, the stock was unable to build on the positive trendline break until May, when volume began to increase notably and the OBV indicator began to rise steeply. Then in early June, the price followed the indicators higher. Insider buying prior to a technical breakout clearly adds validity and increases the chances of success. see Webmethods (WEBM) from the beginning of 2000 to 2004. From 2000 through 2002, Webmethods was in a severe down trend having fallen from a high of $336 per share to a low under $5 in late 2002. For our example, I want to focus on the low in September 2001 and the bounce that followed. |
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