Why You Need to Learn to Read a Stock Chart

In early February I profiled a company called Adelaide Brighton [ASX:ABC] for one of my stock updates. You can find this and many other excellent stock updates here on the Markets and Money website.

In doing some research on the company I came across a report that stated that the company was ‘overvalued’ based on fundamental analysis.

Now this is interesting.

You’ll often hear equity analysts talking about a certain company being, ‘undervalued’ or ‘overvalued’ based on fundamental factors like its cash in the bank, price earnings (PE) ratios and book value.

Essentially, with fundamental analysis you’re trying to find out what the stock is really worth as opposed to the price it’s trading at in the stock market.

Today I’ll show you what the analysts who take this approach don’t tell you…

How the market really works
Below is the weekly chart of Adelaide Brighton. The arrow you see is to note the timing of the ‘overvalued’ recommendation in late January.

In Late January Adelaide Brighton Said
to Be ‘Overvalued’
 


Source: STEX

The fundamental analysis that stated Adelaide Brighton was ‘overvalued’ was indicating that you shouldn’t buy the stock at that price.

However, it was clear to anyone with some basic chart reading knowledge, that by early February, this stock was growing revenue. That’s because the price of the stock went over a key technical point.

All easy to say in hindsight I know, but I’m on record as saying so at the time. So in this instance, how could the fundamental analysis get it so wrong? And furthermore, why would anyone pay more for a stock than it is actually worth?

The reason is this. Fundamental analysis is based on what is already known. Fundamental analysis is all based on the known cash flows. In other words, it’s common knowledge.

But the market simply doesn’t work like that. The market is always looking ahead and is already pricing in improved or worsening conditions months ahead. You must come to this understanding, because you will never get to grips with the market if you don’t.

The market is a great predictor of what is coming. This is why it is so important to develop some basic chart reading ability. To get at information not known to the general public requires some chart reading ability.

A real bargain
Let’s consider a hypothetical example. Let’s call this listed company XYZ Ltd.

Let us further hypothesise they make some sort of medical implant. All is going to plan and the company is trading at its fundamental value of $2.00.

You and I are watching the chart of the stock.

Over a number of weeks the company makes a series of lower tops and bottoms on no news. That means the chart is going down but there’s no public information to say why. It falls to trade at a $1.50 per share. At this point a broker will come out and say this company is undervalued on fundamentals and a real bargain.

But during all this time, behind the scenes that you and I never get to see, there are now some concerns being expressed about the medical implants. Initial reports reveal patients are experiencing complications.

Further and comprehensive testing is done as a matter of urgency. The results take some time to come back, but eventually reveal that there are potential concerns from one of the components of the implant, which may be leaching a toxic substance.

This sort of information will not show up in your fundamental analysis, but you can be absolutely certain that information will show up on a chart. And the simple reason is this.

When people have money in the market, they will act. Perhaps a friend of someone in the company hears something. One of the suppliers knows about the problems. Some way, people closest to the company will know before you and I ever will.

This is why the chart will tell you the truth of the situation.

Start listening to the market
You can use that insight to your investment advantage, or stick to the fundamental analysis approach. It all depends on the type of person and investor you are.

I urge you to be someone who listens to the market and can compromise. I have found this charting approach very helpful in avoiding losses.

In the latest issue of Cycles, Trends and Forecasts, we go to some length to emphasise why this is actually the most important component in investing and trading.

I urge you to develop the ability to read a chart and start to listen to what the market is telling you. You can get some basic chart reading knowledge here. You will find it of immense value, I can assure you.

Because if you take a ‘fundamentalist’ attitude to the market, ignore what it’s telling you and continue to defend your position, then you risk getting absolutely hammered.

Regards,

Terence Duffy,
Researcher, Cycles, Trends and Forecasts

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