A Brief Series on Stock Chart Reading

 

A Brief Series on Stock Chart Reading

Stock Charts Lesson One

A Stock with a Monstrous-Volume Breakout

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Writing Cabot Wealth Advisories is generally a fun task—it allows me (and the other analysts) to “write outside the box” a little bit, allowing us to opine on some investment topics that have been on our minds but aren’t necessarily 100% relevant to a particular advisory service.

That said, all of us around here write so much that sometimes we get good old-fashioned writers block. That hit me between the eyes this week, so I asked writing aficionado Paul Goodwin for a few ideas. And amazingly, he had one good one! (Just teasing, Paul.)

Paul thought it would be good if I wrote a brief series on stock chart reading, something that’s key to my growth stock methodology, but something few individual investors (and, according to my conversations, even professional investors) understand too well. That seemed like a good idea to me.

This isn’t going to be a full-fledged “Read Charts the Mike Cintolo Way!” type of series, and I’m not going to simply go over the basic chart stuff like support and resistance. (Google that if you want to get a primer on those topics.) Instead, I want to present a handful of tidbits that you can actually use when looking for entry points, or for identifying abnormal action. I’ll probably end up highlighting six or seven “rules or tools” I use over the next three of four Wealth Advisories. Sound good?

Let me start with three very brief points. First, if you’re looking for a great free charting service, I suggest www.stockcharts.com; we use it at Cabot all the time. Second, I tend to keep my charts very clean—price, volume, a couple of moving averages (25-day and 50-day usually) and maybe a relative performance line. Honestly, many times, I feel like I don’t even need that much.

Lastly, my universe basically revolves around well-traded, institutional-quality stocks. Most aren’t “big-cap” per se, but they almost always trade at least $50 million in volume every day, and often $100 million or more. Chart analysis of thinly-traded, lower-priced names isn’t nearly as reliable.

OK enough with the preamble—let’s get to my first stock chart lesson.

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The way I think of stock charts isn’t in much-talked-about patterns—triangles, pennants, flags, etc.—but more in supply/demand terms. Specifically, liquid stocks move around because big institutional investors are buying or selling. You or I might buy 300 shares, but if Fidelity is trying to unload 450,000 shares, guess who’s going to move the stock?

Thus, what counts most for me is price and volume; just using these two inputs, you should be able to identify good buy and sell points.

Let’s start on the buy side with one of my favorite buy set-ups:

When you see a stock stage either (a) a huge gap up on big volume on meaningful news (often earnings), or (b) many days in a row of huge-volume buying that takes the stock to new highs, that “volume area” will often provide support during the next few weeks. And that means dips into that area represent low-risk buy points.

Let me show you what I mean. Here’s a chart of Apple (AAPL) back in 2004 when we originally added it to our Cabot Market Letter Model Portfolio. The market was in a multi-month correction during the middle of that year, as it digested its big 2003 gains. But thanks to a burgeoning music business, AAPL gapped up on earnings in mid-July—you can see the huge volume clue as the stock popped higher.

However, the market itself wasn’t ready to run, so AAPL backed off. And where did the stock find support? In that gap area, as all the institutions that were trying to buy AAPL the day of the gap built positions as the market pulled it down during the next month.

We saw another example of the “volume area” support just a few weeks later. AAPL zoomed to 17 in late August on big volume, and during the next couple of weeks, that big volume day effectively contained any pullbacks. I should know—we bought it during that timeframe and enjoyed the stunning advance during the next couple of years. 

This “volume area” theory works on the downside, too. If a stock’s had a big run and then BOOM!—it sees a few days in a row of heavy selling (or one big earnings gap lower), the next couple of rallies are usually repelled.

Chipotle Mexican Grill (CMG) back in April 2011 was a classic example—look at how right off the top at 440, the stock fell to 400 on four straight days of big volume. It tried to rally three different times during the next two months, but the 420 area provided resistance each time ... right in the heart of that “volume area.” The wheels really came off later, when the stock dipped below 250.

The brief lesson here is that big volume clues that coincide with meaningful moves in a liquid stock are invaluable—they often point to a new uptrend getting underway, or the end of a prior move. As I wrote above, these huge-volume moves are caused by institutional investors ... and once institutions start buying or selling, they rarely stop in just a couple of weeks.

By properly identifying this kind of volume, you can literally buy when the big boys are buying, and sell when they’re selling! This one tool has helped me immeasurably over the years—like everything in the market, it’s not foolproof, but it works a good percentage of the time.

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So how about a current example on the buy side? One name I’m watching is Freescale Semiconductor (FSL), a huge chipmaker that produces chips for a variety of end markets (although auto is its largest). This is not a classic growth stock—it’s a good-sized company ($4.2 billion in revenue) that went private years ago, but came public again in 2011 loaded with debt and with business entering a downswing. Thus, FSL is more of a turnaround play ... but it’s one I think could have an outstanding run.

Shares did a whole lot of nothing for years, but just a month ago, the stock exploded out of a nice-looking consolidation. The catalyst was initially better-than-expected earnings (sales up 13% was the fastest growth rate since early 2011, and Freescale now has three straight big quarters of earnings), and then, a successful share offering that will dramatically cut its debt load and interest expense. It also helps that management was very optimistic, telling analysts that profit margins and the firm’s market share should continue to expand.

The end result is that FSL has great earnings estimates ($1.37 per share this year, up 204%), and $1.87 in 2015, up 36%) and staged a monstrous-volume breakout and advanced from 18 to nearly 24 in just four weeks. Now the stock is at least calming down, though it hasn’t been able to pull back much.

Given the volume on the advance, my guess is that, barring a market meltdown, FSL will have trouble pulling back farther than 20 or 20.5, which is where that huge volume gap occurred in mid-February. Thus, I view any weakness as buyable, and given that the stock only recently exploded out of an initial-stage consolidation, FSL could have a healthy rise for many months (again, market dependant).

Sincerely,

Michael Cintolo
Chief Analyst of Cabot Market Letter
and Cabot Top Ten Trader

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Michael Cintolo can be found on Google Plus.

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