Technical Analysis Applied to a Stock Pick

Today, Barron's Online had an article (subscribers only) with a strong recommendation to purchase Texas Instrucments (TXN), the maker of computer chips for computers and cell phones. While I have no doubt that just this recommendation led many to run out and purchase TXN, persons who know the tools we are using in class would have held off. Clearly, the "fundamentals" of TXN are very good, so the stock passes and important test. But should one buy it when a recommendation occurs? For persons who don't believe in technical anaylsis, the answer is a resounding "yes." They would likely point out that as a long-term investor, if the stock should fall in the near-term, it will surely rise later based on its strong fundamentals. Let's look at an annotated chart of TXN (click on it to get an enlarged version).

The first thing to determine is how close TXN is to resistance. It is apparent that resistance is at 34 (from April). It failed a breakout above 34 in late April and early May. That resistance recently held as well. Note from the Relative Strength graph (bottom) that TXN has failed to outperform the overall stock market since mid-August. So purchasing this stock now is a wonderful illlustration of my handouts in class -- how persons often tend to buy when a stock is close to resistance (i.e., price is high).

Why not wait until (or if) TXN clears resistance, then purchase it, or better yet, purchase at support? That is what I would recommend. Consider the "fundamental" investor. Should TXN drop to $30 from $34, assuming they purchased it at $34, they would need to recoup a 13.3% loss just to break even (=$4/$30). What they won't do, and that I recommended that you would do, is to consider purchasing at support -- this is the equivalent of "buying low."

The motto of the story: I often see buy recommendations for stocks given at a time when the technicals of those stocks are not "right." Use technical analysis with stop loss orders to manage gains and losses, and don't just "resign yourself to fate" in terms of whatever the stock price does, as the fundamental investors do.

Enter economic analysis: Is it likely that TXN will test resistance or fall to support? (As practice for you: Where do you see support here? Where would you think of buying this stock?) Since stock price is largely determined by expected profits (and interest rates), what is likely to be true of future profits for chip makers? Will electronics and computer purchases slow down as the year ends or will this get stronger? THIS WILL BE DETERMINED BY THE MACROECONOMIC OUTLOOK. What a coincidence, that's what ECN 327 is all about!!! The products TXN's chips go into are part of discretionary spending, which is highly cyclical. So, if the bond market is correct, that a sharp slowdown is coming, prospects for TXN's stock price are not very bright, in spite of its present fundamental strength. If the stock market is correct, that we are headed for a "soft landing," then the prospects for TXN are brighter, and this might be a stock to keep track of. So, look at the graphs of cyclical stocks ($CYC) and discretionary goods (XLY). What is the real-time information from these graphs telling us? Is the Fed done raising interest rates? Will housing's fall not be sharp (due to falling 10-year bond rates, etc.)? These are the questions to consider.

Bond Market

Today we discussed the bond market in class and how bond prices and interest rates move in opposite directions. This can be seen vividly in today's news. Existing (median) home prices declined relative to last year, a rare event. This is bullish for bonds since it implies that inflation should come down a bit, and the inflation measures we use (like the CPI) will likely drop as well. Remember: bullish for the bond market means higher demand and higher bond prices -- which causes lower interest rates. You can read about this in an article from MarketWatch.com.

To further understand what is happening, remember our basic model of nominal interest rates (r):

r = f(expected inflation, economic growth, monetary policy)

Today, the news caused expected inflation (and actually expected growth) to moderate, causing nominal interest rates to fall. Remember: you can also explore this by using the ratio TIP:TLT in StockCharts.com, or take a look at the TIPS spread from Bloomberg.com (the link is: http://www.bloomberg.com/markets/rates/index.html ). You should bookmark this link.

When at Bloomberg.com above, page down to the graph. This is today's yield curve. Then, click on the tabs for different countries. Compare the interest rates (say 10 year) for the different countries listed.

Finally, oil prices bounced off support at $60 today. Graph $WTIC in StockCharts.com. Look to the left from today's values to see where support lies. You will see a $60 support point from early March of this year. Had this support not held, the prior support of just under $58 that I mentionned in class would be the relevant level. There was a bullish divergence in effect which makes today's move not entirely surprising. Oil price was falling while the RSI was making higher lows.

The question now is how long this upward move will hold. How far might it go? Resistance, remember?

Bearish Divergence As A Leading Indicator of Price Change

Cyclical stocks ($CYC) move in the same direction as actual or expected economic growth. As a market, this is itself a leading indicator. And, its changes contain real-time information on market expectations concerning growth.

As you know, yesterday (9/21), two indicators were released that caused markets to change sentiment -- reflecting the belief that the economy would weaken farther and possibly faster than was previously expected. On yesterday's blog post, I detailed how this affected the 10-year bond rate. That rate fell again today (to 4.6%). With the expectation of slower growth, cyclicals should also weaken. And they did.

In the handouts on technical analysis, I detailed what is called a bearish divergence: price action moving higher but the RSI not experiencing higher highs. This is a leading indicator of a downward move in price in the near term. Note this is not 100% accurate, but it has a fairly good track record.

I have included a graph of cyclical stocks where such a bearish divergence is evident (and marked). Click on the chart to enlarge it.


Based on this bearish divergence, one should have expected some decline in cyclicals, and thus the perception of a weakening economy gaining traction. THIS DOESN'T MEAN THE ACTUAL ECONOMY WILL NECESSARILY WEAKEN -- JUST THAT THE EXPECTATION OF THE MARKET IS THAT IT WILL WEAKEN.

To earn extra credit, get the chart of cyclicals and using weekly data for the past two years, annotate the chart, drawing lines and adding comments. Determine if a bearish divergence occurred. Also, draw the support line for weekly data and a possible support line for the Relative Strength indicator. This will be accepted no later than the beginning of class on Monday. No pencil or pen lines will count.

The next test is to see if the support line (indicated in the graph) is broken next week. Note that cyclicals have been underperforming the overall market (based on a declining Relative Strength (below the graph) since early May. It is also possible to draw a support line for the Relative Strength indicator.

Soft Landing?

The economic indicators released today raised serious questions about how rapidly the overall economy is slowing. Prior to today, the consensus view was that economic growth would continue to slow, but not by enough to seriously crimp profits. Along with this, the Fed would be done raising rates, and might even begin rate cuts by the middle of 2007.

Two reports in particular, the Philadelphia Fed's Economic Activity Index was a negative value, well below the concensus (of around 13). Also, the Conference Board's Index of Leading Economic Indicators fell for the fourth time in the last five months. Hardly an endorsement for future economic strength. Read about these developments in an article.


















This percieved future loss of economic strength affected interest rates. The benchmark 10-year government bond fell by 8 basis points. Furthermore, by the end of the day, this rate had fallen to its support level from mid March. I have provided a chart using StockCharts.com (click on the graph to enlarge it). Note that at its present level, the 10-year is only slightly overbought and that short-term resistance is not the 200-day moving average. (NOTE: divide the right-side scale by 10 with this interest rate)

Is the Market Headed Higher?

We discussed technical analysis a bit in class today along with sector rotations. When the economy is slowing, you will observe a rotation from sectors that do well with a strong economy (like cyclicals ($CYC) and discretionary spending (XLY)) toward more defensive sectors like consumer staples (XLP), telecommunications (IYZ), and public utilities (XLU).

A good article dealing with this by Michael Kahn of Barron's discusses this. It provides more practice as you learn the material from the handouts today. He points to relative strength as an indicator (recall this is a symbol or index divided by the overal S&P 500). When the relative strength graph is upward sloping, that market is outpeforming the overall stock market. For XLP, that has been the case since mid April.

Finally, note how you can apply lines to other measures such as advancing issues versus declines, or as Kahn's article shows, advance volume vs. decliner volume.

CLASSROOM and Practice Exercise

Today our classroom permanently moved to CHAFEE 219. Please note this.

As you read your technical analysis material, go to StockCharts.com and practice by working with the graph for oil (symbol $WTIC). Where is the trend? As people ask where oil price is likely to go, you can use the chart and see the past levels of support. When a price graph is falling, LOOK TO THE LEFT and find a previous level of support. What price is it? Annotate the graph. My handout says how to print this if you want to keep a record of this.

Note that on StockCharts.com, you can use either daily or weekly time frames. Perform the above analysis on the daily chart, note past support, then switch the frequency to weekly. Do the same thing. Where is weekly support?

Technical Analysis Practice

You should be reading Stikki Stock Charts (finish it for class Wednesday). Let me refer you to a free article from Barron's Online by Michael Kahn -- someone I will be referring to throughout the semester.

His most recent article, Will September Be the Cruelest Month , contains several technical formations and tools that we will be discussing all semester. These are introduced in Stikki. Feel free to read though the archives of Mr. Kahn's column as well.

You should visit StockCharts.com. I have a set of downloadable notes on the online syllabus that detail how to use this site. Try it. It's actually quite easy, and you have the entire semester to gain proficiency with it.

Assigmnent #3

A number of persons had incorrect answers for the first two questions in Assignment #3.

1. As Md = f(r) but not a function of Y => Md is downward sloping but it does not shift for changes in Y. Thus, there is only one equilibrium r, no matter what the level of Y is. Therefore, the LM curve is horizontal.

2. You need to read the chapter on AD - AS for this. Yf is obtained when labor market equilibrium occurs (where labor demand = labor supply). This gives L*, which when plugged into the production function gives Y* (or Yf).

3. The data you obtained was for the nominal interest rate (the 10-year constant maturity rate) and the real interest rate (the Treasury-Inflation Indexed note). The basic formula to relate these is:

Real r = Nominal r - expected inflation

Solve this for expected inflation:

Expected inflation = Nominal r - Real r

The result is what is referred to as the "TIPS spread." It provides a real-time measure of the value of inflation expectations for the next 10 years (in this case). REFER TO THIS IN THE FUTURE AFTER YOU COMPLETE THIS COURSE -- IT IS VERY IMPORTANT AND OFTEN REFERRED TO.

THIS WEEK - WHAT TO WATCH

The big story, which we discussed in class this past week, is the rise of long-term interest rates. The 10-year ($TNX) has risen past two resistance lines over the past several weeks, and is now above the psychological 5% barrier. Next resistance is around 5.3% (I was kind in class when I used this, the preferable point is more like 5.45%). Note the recent trends surrounding this: mortgage rates rising; the dollar gaining strength; expectations for a slower pace of economic activity in the second half of this year are being reinforced.

This week, there are several critical reports to watch. There will be both a CPI report and a PPI report. Also, the minutes of the last Fed meeting will be released. All of these contain important and market-moving information. If you want a real-time indicator of inflationary expectations relevant to the 10-year bond, view the behavior of Treasury Inflation Protected Security prices (TIP) relative to bond prices for longer duration (TLT). To evaluate this, try viewing the ratio TIP:TLT on StockCharts.com. Switch from candlesticks or OHLC bars to lines, and add RSI(9) as usual. IN REAL-TIME, what are markets saying about expected inflation? How is this different from what the reports are saying? Also, check to see how this changes after each report is released.

Also view the yield curve. You can see this either from Bloomberg.com (under Market Data and rates) or Bondheads.com. If you use Bloomberg.com, click on the tabs to see the yield curves for other countries. Want to see a really strong positive yield curve? Try Japan. Interestingly, the British Pound has been appreciating relative to the US Dollar lately. Check out their yield curve. What does that say about their economy in the coming months? What about Pound strength relative to the US dollar going forward? Hmmmm.

We'll talk more about all this during class. But you should begin to follow trends like these and different variables to understand how the economy is performing now, or how things will likely change in the future. THIS IS ESPECIALLY USEFUL FOR YOUR FORECAST PAPERS!!

Dollar Strength

The strength of the US dollar is something that has been hotly debated of late. If you follow this measure each day, you see "ups" some days and "downs" on other days, but no dominant pattern (at least if you follow the financial press).

How should you follow the dollar? The dollar index ($USD) measures the strength of the US dollar against its major trading partners. It is not a bilateral exchange rate. Think of the dollar index as an equilibrium price -- in this case for the dollar. How is this price determined? Simply by supply and demand. So, you can use the supply and demand for dollars by the US and its major trading partners to model this variable. I will also refer you to my handout on Flexible Exchange Rates.

At the present time, it appears that relative US interest rates are the most important driving force for the Dollar Index. The Fed's indecision about whether it is done raising interest rates (at least in its post-meeting statements) has lead to recent market uncertainties and dollar "bounces." This is critical in light of recent slowing by the housing sector which has done much of the "heavy lifting" for our economy the past few years (an article about this).

In the last few days, the 10-year government bond ($TNX) has gained significant ground, breaking through resistance, finishing the day at 4.85%. This is NOT a good time to have money in bond mutual funds (see article).

How high will the 10-year go? To answer this, first examine a chart of $TNX and find support and resistance. Where is the next resistance? Are we close to that now? For extra credit (part 1), graph the 10-year bond using weekly data for three years in StockCharts.com. Change the moving averages to 10 and 40 periods (this makes them comparable to daily values of 50 and 200). Annotate this graph going back as close to the beginning of the three-year period as is necessary and draw relevant support and resistance lines. Print this out in a Word document. (do not hand draw the lines).

The other relevant question is how tied to interest rates the US Dollar is. According to economic theory, it is very tied, for reasons outlined in class and on the handout for Flexible Exchange Rates. For extra credit part 2, make a graph of the US Dollar Index ($USD) as a dotted line, remove the moving averages, and select Price as one of the indicators -- use $TNX -- and place this behind the dollar graph (this is done by changing the box from "below" to "behind price." Past this into the Word document and in one paragraph discuss how these two variables are related. Is it what theory leads us to believe? Bring this to our next class. It is due at the beginning of class on Tuesday.

In order to determine whether the 10-year bond might break beyond current resistance, you can use the model of interest rates we developed in class at the beginning of the semester. A forecast by you would allow you to make an "educated" guess as to whether we will break through the next resistance.