As the market has suffered very ugly corrective action over the past six weeks we hear quite often that 'charts look bad'. When support levels are broken and downtrends develop there is little choice but to dump positions and move to the sidelines. However, just because a chart looks poor in one time frame doesn't mean it isn't favorable in a different time frame.
Jim Cramer commented this week that he keeps hearing from technical analysis 'experts' that keep pointing out that the charts of the FAANG stocks look bad. Of course they look bad. That isn't any mystery but they are not going to trend down forever. At some point they will find support and bounce or maybe begin another sizable uptrend.
The fact that a chart looks bad doesn't mean a stock is dead forever. It is just part of the normal cycle of the market. Many of these stocks will recover and will move to new highs once again. Back in 2002 and 2008 it was impossible to find a 'good' chart. Virtually everything had broken key support levels and were in downtrends. If you listened to many technicians you would tend to believe that things would never recover.
The dilemma for most technicians is that they use trend following. The foundation of their trading is that the trend will continue into the foreseeable future. Not that Apple (AAPL) and Facebook (FB) have broken support and started to trend then we should expect them to continue to do so. They are 'bad' charts.
However, the nature of the market is that the cycle will turn. Those 'bad' charts will reverse just like the 'good' charts always do. Some stocks never recover and some stocks will trend up for many years but, in general, any stock with decent fundamentals will go through the cycle of ups and downs.
Rather then think of charts as 'good' or 'bad' it is better to view them as a strategic tool that may help us determine when a turning point might take place. In doing so here are some key considerations to keep in mind:
- Trends tend to last longer than you think possible. Some technicians employ tools like Fibonacci levels and stochastics to try to predict when a stock is oversold are at a natural support level but these logical constructs don't take into account how emotional selling can be when it takes hold like it has recently. It is good to have a framework in which to consider how 'oversold' a stock may be but there is an old saying that oversold stocks can become more oversold.
- There is no glory in catching the exact bottom in a downtrend. Traders like the idea of being the genius that predicts the exact moment when a stock hits its ultimate low but the process of playing that game creates a strong tendency toward jumping in too early. You can only predict bottoms prospectively and not retrospectively which means you have to buy into weakness in order to catch the exact low.
- The best entry points occur after a stock has hit a low and bounced. One of the big advantages of buying after a stock has turned up is that it gives you a natural stop out point at the prior low. It is much easier to manage a trade if a stock is no longer in free fall. If you are stopped out, you can step aside, regroup and then try again. It actually can be a very good strategy to take multiple small losses on a stock as you wait for the shift.
- The goal of buying stocks at a low is to catch a trend. There can be some good, quick trades as counter-trend bounces occur but the big money is made by riding a new trend as it develops. A good trend will last weeks or months and the best way to benefit if you catch one is to build your position as the stock strengthens.
- Don't let the fundamental arguments make you blind to the price action. One of the easiest mistakes to make when trying to catch a stock that is trending down is to believe that it is a 'good' company that is being mistreated by an irrational market. That might be the case but as the saying goes the market can remain irrational longer than you can remain solvent. If you like the fundamentals of a stock that is acting poorly, follow it closely and make some buys as it develops but be relentless in cutting them when they don't perform.
There are a lot of terrible charts out there right now but many of them will offer great rewards down the road. The key is to develop an effective trading strategy that can capture the inevitable shifts in the market cycle.