I know some people aren’t into charting, or technical analysis. I never used to be, either. But then I took the time to learn about it and understand it more deeply.
Now I consider it to be a hugely valuable investment tool.
You see, charts are simply an illustration of the psychology of investors. Charts of individual stocks and indices produce patterns that repeat over and over again.
These patterns are the same because investor psychology is always the same. Once you start to recognise these patterns, you have a powerful investment tool at your disposal.
Managing Emotions is Important
The other thing charting analysis helps you with is in managing your own emotions. It enables you to test your idea before you put your hard earned money into it.
For example, say you think Telstra [ASX:TLS] is a good buy right now. It’s down 40% from its peak in 2015. It trades on a dividend yield of more than 7% and a price-to-earnings ratio of around 12 times.
That sounds like a stock that’s worth buying, especially a dominant blue chip stock like Telstra.
But before rushing out and buying, I suggest having a look at a chart first. Here’s the chart over the past 12 months. What’s the first thing that you notice?
That’s right, the share price has been going down…relentlessly.
[Click to enlarge]
What makes you think that you’re going to pick the bottom? You might get lucky, of course. But the stock could continue to fall. Then you find yourself holding a stock that is going down and is in all sorts of problems.
Generally, price moves ahead of the news. That means a stock price will make a move BEFORE you really understand why. In this case, Telstra’s share price might take another leg down. Only in hindsight do you then find out that it’s because of increased competition in the mobile phone sector, which is going to hurt its profit margins.
Or maybe it’s because the rollout of the National Broadband Network (NBN) continues to cut the margins of all the Telcos.
Whatever the reason, it doesn’t really matter. By the time it’s in the news, it’s in the price.
But because Telstra’s share price has fallen so far, and there is an argument that it looks like good value here, it’s getting more attention as a good long term investment.
Before jumping on board, consider what the chart is telling you.
Have a look at the chart again. As the yellow and blue lines show (the 50 and 100 day moving averages) the share price is in a clear downtrend.
One of the key rules of my investment advisory, Crisis & Opportunity, is to never buy into a downtrend. The odds are simply against you.
Investing is About Probabilities
There are no guarantees in investing. It’s all about probabilities. Good investors make sure they have the odds on their side. Avoiding stocks in a downtrend is one way to do this.
In the case of Telstra, the first thing you want to see is for the price to find support at $4. This is where the stock fell sharply to in April. But strong buying support came in at that point, and the stock bounced back quickly.
But the downward trend has since reasserted itself. It’s approaching $4 again. If it breaks through here, that’s a signal to stay away. It’s the market’s way of saying that the business is under pressure, for whatever reason.
It might be more mobile competition or reduced margins from the NBN.
Whatever it is, it doesn’t matter. The price will tell you before it happens.
If, on the other hand, the price finds support at $4, then you can start to get interested. You can take this as a sign that the stock is trying to find a bottom.
You may decide to take a small position at this point and see what happens.
However, I would rather wait for evidence that the trend has turned before buying in. This is a way to increase the odds that you have got the call right.
How do you know when the trend has changed?
Put simply, you want to see the stock making higher highs and higher lows.
So in this case, a rally off $4 to a new multi-month high above $4.50, followed by a correction and a ‘higher low’ around, say, $4.20, would be a pretty good sign.
That would tell you that the worst could be over for Telstra, and that the chance of a continuing downward trend is diminished.
Until that happens though, I’ll be staying away. Who cares how good the dividend looks.
Being a fan of charting analysis doesn’t mean I ignore the fundamentals. In fact, having an idea of the company’s strengths and weaknesses and the industry dynamics, allows you to enhance your interpretation of the charts.
In Telstra’s case, we know that the rollout of the NBN damages profits margins across the board. This makes Telstra’s impressive mobile phone margins even more attractive to competitors.
As a result, rivals boost their investment in mobiles in the hope of capturing some of Telstra’s market share. This forces Telstra to respond with its own investment plans, which absorbs cashflow and in turn could threaten the dividend.
That’s what the falling share price is telling you. That competition is tough, squeezing margins and earnings across the board.
And that’s why you should avoid Telstra (and other telcos for that matter) until the charts tell you that coast is clear.
Editor, Crisis & Opportunity