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Picking the Right Stocks Using Charts

by Michael Kahn

Picking The Right Stocks Using Charts Splash image

Investors are always searching for ways to “beat the market,” and while naysayers abound, studies have shown that individuals can indeed produce superior returns in their portfolios. The best part is that it does not take advanced degrees and high-powered computers to do it.

If half the battle in the stock market is recognizing whether a bull or bear market is in place, then the other half is choosing the right sectors and the right stocks. This is the basis for relative strength or relative performance investing. Find the sectors and stocks that are outperforming the market, ride them until they stop outperforming and then find the next leading area. Indeed, relative performance is represented by not one but two letters in William O’Neil’s CAN SLIM stock selection methodology. “L” stands for leader or laggard versus other stocks, and “M” stands for leader or laggard versus the market.

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Michael Kahn CMT, writes the twice-weekly Getting Technical column for Barron’s Online (www.barrons.com) and the daily Quick Takes Pro newsletter (www.quicktakespro.com). Kahn will be speaking at the AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
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They Keep Going and Going…

It is not difficult to uncover the leaders in the market, but that tells us what has already happened. Fortunately, the stock market has inertia, a term borrowed from physics stating that bodies in motion tend to stay in motion. Leaders tend to keep leading and laggards tend to keep lagging. Charles Kirkpatrick, a certified market technician, has shown that this simple concept, combined with relative earnings growth, beat the market for a period of over 17 years. His research served as the basis for a stock screen highlighted in the November 2009 AAII Journal (“Building Stock Screens Using the Kirkpatrick ‘Relative’ Approach,” by Wayne A. Thorp, CFA).

There are two basic methods of finding the current leaders. The first is to rank the individual performances of all stocks over a specified period of time. Of course, we can weed out undesirable stocks using such criteria as earnings growth, trading volume, market capitalization and price, but the goal is to produce a manageable list of strong candidates for further analysis. The second method, which I will discuss momentarily, is to look for good sectors first.

AAII provides the ability to rank stocks based on price momentum and other criteria in its Stock Investor Pro fundamental screening and research database program, so I won’t spend time describing how to rank stocks here. What is most important is that one ranking list can alert you to any stock that is strong regardless of its sector: Whether a stock is in healthcare, mining or technology, a ranking does not discriminate.

Bottom Up Versus Top Down

I want to step back from stock selection for a moment to add some context. You may have heard the term “bottom-up investing.” This is part of the process where you find good stocks, determine whether they cluster in any sector and then apply what you have learned in forming an overall market opinion. Are you finding an above-average number of retail stocks? That tells you a bit about the overall market health. How about gold stocks? Perhaps that is a precursor to inflation, but I don’t mean to stir the pot on one of the more hotly debated arguments of the day.

Of course, there is more to it, but it starts at the individual stock level—at the bottom of the market pyramid, to invoke a visual representation.

Conversely, a “top-down” approach starts with a market opinion and then moves down to the sector and stock levels. While rankings are also appropriate, I find that graphical comparisons using charting software can quickly hone in on the strongest sectors and stocks. They also add a good deal of flexibility in that they are not locked into a fixed look-back period. The user need not determine a precise period in advance and can just let his or her eye assess the appropriate span. One look can quickly determine if one sector is outperforming another over a variable period of time.

In other words, a chart displaying three months of data for Google (GOOG) versus the Standard & Poor’s 500 index could show the stock lagging the market for many weeks and only recently starting to emerge as a leader. This would not show up on a three-month ranking list, for example, when a stock such as Priceline.com (PCLN) has been beating the market for months on end.

But looking at a chart, your eye would see the change immediately. And the sooner you see it, the more time you have to do further research to back up what the chart indicates. Did the company just report good earnings news or a new product? The market reacts quickly to such events, even if they do not flash across your favorite investing website’s news feed.

The drawback, of course, is that we cannot analyze more than a few stocks at a time. This is why charts are better suited to hone in on winners like bloodhounds, rather than finding “the” next big winner. Using charts to find the next big winner is akin to looking for a needle in a haystack.

It also becomes an issue of style. Are you more comfortable with numbers or pictures? Do you prefer knowing the market’s mood first or do you believe that good stocks will perform no matter what else is happening, extreme events such as war and nuclear meltdown excluded?

What It All Means

Let’s dive a bit more deeply into the graphical representation of relative strength. The formula is a simple ratio of one stock or sector divided by another stock or sector, and the result is plotted on a chart. Standard technical analysis tools can be applied, but the most important indicator is the trendline. When the trend of the relative strength ratio is rising, we know that the first stock or sector is outperforming the other. Conversely, when the trend is falling, the opposite is true.

Graphical relative strength analysis starts with determining which sectors are strong relative the market and which are weak. Since there are only a limited number of sectors, such as consumer discretionary and financial, it does not take long to create ratios of each to the S&P 500, or whatever benchmark index you prefer. I like to start with something easy—say, the nine Standard & Poor’s sector exchange-traded funds (ETFs).

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For example, a chart of the Technology Select Sector SPDR (XLK) divided by the SPDR S&P 500 (SPY) from August 2010 through March 2011 shows two distinct phases of relative performance (see Figure 1).

From September to early November, the technology sector outperformed the market by 6%. Investors owning the tech ETF beat the market over that period of time.

However, it is clear that the relationship changed in November and technology lagged the market by the same percentage through March. Where did the money flee? Relative strength charts of industrials and energy began to rise at just that time.

Wouldn’t it be worthwhile to know when this sector rotation was happening in its early stages? Of course, the answer is yes.

At the time this chart was produced, the trend for technology performance was still down. Inertia, as mentioned, suggested that technology was still not the place to be.

One sector that began to outperform when this article was originally written in late March 2011 was gold and silver mining. It is no surprise to anyone with even a remote interest in investing that gold and silver prices have been soaring. In such an environment, mining shares tend to outperform. But don’t take my word for it. Let’s look at the relative strength chart of the Market Vectors Gold Miners ETF (GDX) relative to the SPDR S&P 500 (SPY) (see Figure 2).

In December of 2010, gold was still trading above $1,400 per ounce, yet the relative strength of the gold miners ETF started to fall. It moved below the short-term rising trendline that had guided it higher for most of the year and it signaled that investors were moving money out of gold stocks. But in January 2011, even though gold itself had not yet found a bottom, the relative strength of gold stocks began to climb. Investors were back.

Sure enough, gold turned higher and gold stocks started to climb. We cannot say that investors cleaned up on gold stocks, but those who went back into the metal rode it to a fresh new high. However, even though the absolute gains were muted for the stocks, they still beat the market for the first quarter of 2011 and continued their outperformance into early April. Relative strength for the Market Vectors Gold Miners ETF broke down on May 2, 2011. This was an early warning for investors, as the ETF declined in price the following day.

Step by Step

I recommend that investors form a major market opinion first. Is it a long-term bull market or bear market? Bear markets should not deter investment, but being aware of them is important in order to determine how aggressive you should in order be and how much leeway you should allow for stocks with less than ideal characteristics. Bull markets can hide the flaws of many stocks, but bear markets are merciless.

Next, look at major sector indexes or ETFs versus the S&P 500; you can easily get by with just a dozen or so comparisons. Further, if you set the securities and indexes up and save them in your favorite software package, you will be able to quickly page through the figures once a month to see if anything has changed.

If you are curious to learn more, compare the Russell 2000 to the S&P 500 as well to get a feel for which market capitalization group is leading. Knowing that small-cap technology is leading and big-cap consumer staples are lagging, for example, can quickly point you to the strongest corners of the market.

Finally, when you have found the one or two leading sectors, drill down into their respective industry groups. Most have dedicated indexes, if not ETFs, to make this relatively easy—semiconductors and software in the technology sector, for example, or pharmaceuticals in the healthcare sector, or retail in the consumer discretionary sector.

Many investors will find this level to be deep enough, as they prefer to use ETFs in their strategies. Others will want to drill down to the company level to find the best hotel company in the travel and leisure industry, or to find the best railroad firm in the transportation sector.

Once you have found your candidates, and they have passed all the fundamental and technical screens you wish to use, save their relative strength charts so you can look at them weekly or even daily to know when it is time hold or time to move on.

Michael Kahn CMT, writes the twice-weekly Getting Technical column for Barron’s Online (www.barrons.com) and the daily Quick Takes Pro newsletter (www.quicktakespro.com). Kahn will be speaking at the AAII Investor Conference this fall; go to www.aaii.com/conference for more details.


Discussion

Bruce from CO posted over 3 years ago:

I like your article. Please tell us where we can find the data and software to create the ratio charts for the top down analysis.
Thanks, Bruce


Charles Rotblut from IL posted over 3 years ago:

Bruce,

Joe Lan wrote a column in this issue listing several charting websites and software programs.

Here is a link to it:
http://www.aaii.com/journal/article/analyzing-stock-and-sector-price-momentum

-Charles


Walter from TX posted over 3 years ago:

Bruce, I like the sector SPDR charts. Go to
http://www.sectorspdr.com/sectortracker/?do=htmlsectortracker. I think you will find this very usefull. Walt


David from PA posted over 3 years ago:

Would using Stock Investor Pro be the software to use to produce these charts? or would we be able to produce them with any good, free stock screen software?


James from OH posted over 3 years ago:

This is a good introductory article on Relative Strength.

In the past year, correlations have been fairly high (as reported elsewhere). I suggest that when that is the case, an investor might as well put his/her money in the investment that is rising the fastest.

However, one needs to always bear in mind that, just because its Relative Strength is rising, it doesn't mean the price of an investment is rising. It could be that the investment one is comparing to is falling much faster. After finding an investment with rising Relative Strength, one should always look at the price of the investment to make sure it is rising, too. - - - When the market has been losing 30%, an investor should never find it satisfying that he/she outperformed the market by losing only 20%.

Which brings me to the one statement in the article that I have a major quibble with, "Bear markets should not deter investment." There may be long term investors who want to invest their money and never pay attention to it for 10, 20, 30 years. - - - The rest of us are doing what we can to avoid bear markets / big losses. If you were one of those rare people who had invested in the 5% of the stocks that rose in price during the bear market that started in late 2007 and carried through early 2009, then you probably don't need to be reading articles on investing.


Russell from MO posted over 2 years ago:

need more information on how to divide one stock by another.


Gil from LA posted over 2 years ago:

I may sound like a walking Fidelity.com commercial, but I swear I have no stake in them.
I just used them for twenty years or so, and have no intention of changing.

Any person who opens an account with Fidelity, even a very small one, has immediate access to a enormous number of features.

My favorite feature is that I can enter or click on the symbol for any stock or fund and get a quote. If its a stock I can just click on the little graph and up pops a snapshot graph that is more sophisticated. At the bottom I can choose a period of time anywhere from one day or two days, a week, one month, six months, a year, two years, three... or on the whole life of the stock. I can click at the top on any index box, but I just click on NASDAQ because the other two come so close to walking in its tracks, over any extended period, that it tells me, in a sense, what "the market" is doing. The graph of the stock I'm evaluating is boldly displayed and, at this point, I can see how its price has performed in relation to the NASDAQ. Then, I like to have in mind a couple of stocks I know have been beating the market and, in recent months the two I like to compare any and every other stock to are DLTR and AAPL. It's hard to find any other stock in the past month, six months, year, two years... that has beat them. But I'm interested in looking farther into any stock that over any of those speans of time has come anywhere close to measuring up to them. These two, also, have been relatively less volatile than most other stocks, and have tended to ride over slumps better... so there's another comparison, as instantly visible as can be.

If there are other brokerages that offer anything better, go for them. I'm just sharing how simple and easy it is with this particular brokerage service. There are other brokers that charge less in buy and sell fees but, so far as I know, they don't offer all the free features I use on a daily basis.

With practice, you can go down a list of stock symbols, clicking on the symbol, then clicking to go to snapshot mode, and know a large proportion of all you need to know to cull out a stock, or know whether it is worth doing some really nit picky analysis of.

If others have a brokerage, or some software, or some other kind of source for getting so very much valuable information in a minute or two, more power to you.

I just wanted to let you know about the one I really, really appreciate and use many times each market day.


Richard l. Huitema from IL posted over 2 years ago:

The article doesn't mention that a Relative Strength measurement implies a time interval, since it is a ratio of performances, each of which is the difference between the current price and a former price.

FreeStockCharts, one of the sites Charles mentioned Joe Lan wrote about, gives RS charts with user-specified intervals; on a chart, click Add Indicator to select Relative Strength and Daily to change the interval. The URL is:

http://www.freestockcharts.com/

Or, get 52-week relative strength charts from S&P for all nine sectors (plus a few more) at:

http://www.sectorspdr.com/shared/pdf/sectorResearch/Sector_Charts.pdf

Dick


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