Stock Market for Beginners

One of my favorite technical analysis chart patterns is the hammer. The best hammer patterns happen at the end of a long downswing and on very high volume. The following graphic from Investopedia on the hammer explains the pattern well:

In essence, the price falls significantly from the open, and rises back to near or above the open to close for the day. The rationale behind this pattern is that after a long downswing, the selling climaxes in this one day. The hammer pattern exemplifies a final massive sell-off by the bears and then the bulls come sweeping in and bump the price right back up because they believe they are purchasing a bargain.

American International Group (AIG) has a textbook hammer in the making:

Stock Investing Notes For Beginners:

• Large sell-off prior to hammer
• RSI under 30 indicates oversold
• Very high volume relative to average volume

The key with hammers is to find as many indicators that confirm that a bottom has formed. Furthermore, I typically wait for a follow-through up day on the next trading day, which highly increases the probability of a true bottom.

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If you think Jamba Juice has some of the best smoothies in the world, then you’re in the same boat as me. I’ve been drinking a lot of Jamba Juice lately because I just had my wisdom teeth pulled and their smoothies offer great taste and nutrients. On the front door, I noticed a sign that said they were a publicly traded company under the ticker JMBA. I went home and checked out their chart and was pleasantly surprised to see that it looks great.

This find is a perfect example of how you can profit over the pros by simply keeping an open mind about what’s going on in your own backyard.

Key Investing Notes:

• Hammer and follow through signals a bottom
• RSI indicates oversold and is heading upwards through the 30 level
• Look for resistance at around 8.65

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In the last week, we’ve had a series of breakdowns through support levels. The previous lows of 1480s were tested and broken on Thursday and Friday. The market has entered a very volatile state, and you can expect it to remain this way for a while. Indecision from investors permeates the market at the moment.

On Friday, the market spent most of the day down very little and was almost unch at one point. The majority of the sell-off occurred in the last half hour of trading because many traders didn’t want to hold positions over the weekend. The selling capitulated in the last 15 minutes when technical traders realized the S&P was going to end the week below support. Furthermore, because the market was at support levels at the beginning of the trading day, there were many weak buyers looking for a quick rebound that were stopped out or forced to sell by the close because of their quick losses.

Stock Market Strategies for Beginners:

• Price is currently testing support at the previous high of 1461 in late February.
• If price breaks through there, look for further support at the 200-day moving average at 1448.
• If price falls through that as well, there won’t be any additional support until the previous low in March of 1363.
• Keep an eye on the RSI as it approaches the 30 level, which indicates an oversold market. You can see that the last time the RSI fell under 30 in March, the market rebounded soon after.

The weekly chart patterns ended very bearish last week because of the Friday sell-off and we need a major rally in the upcoming two days before the end of the month to have the monthly charts look better. But if I am right and the majority of the Friday sell-off was due to special circumstances, we should get most of that sell-off back within the next couple of days. If I am wrong and we have broken down in the weekly and monthly pattern in the S&P 500, we could have an extremely scary and volatile August.

In general, it seems that the underlying economy is still strong and can push this bull market up further. Look to buy upon confirmation of a rebound, especially if price bounces off support. Remember than in volatile markets like these, it’s crucial to practice solid risk management strategies.

<< Previous Stock Market Overview - July 22nd <<

>> Next Stock Market Overview - August 5th >>

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All of us have had difficulty selling stocks whether we’ve made a good profit or taken a sizable loss. Why do we doubt ourselves when we make the decision to sell?

Well, renowned Harvard psychologist Daniel Gilbert in Stumbling on Happiness offers an answer:

“Because experiences are inherently ambiguous, finding a ‘positive view’ of an experience is…simple…and research shows that most people do this well and often. Consumers evaluate kitchen appliances more positively after they buy them, job seekers evaluate jobs more positively after they accept them, and high school students evaluate colleges more positively after they get into them. Racetrack gamblers evaluate their horses more positively when they are leaving the betting window than when they are approaching it, and voters evaluate their candidates more positively when they are exiting the voting booth than when they are entering it. A toaster, a firm, a university, a horse, and a senator are all just fine and dandy, but when they become our toaster, firm, university, horse, and senator they are instantly finer and dandier. Studies such as these suggest that people are quite adept at finding a positive way to view things once those things become their own.”

I’m willing to bet good money that investors evaluate their stocks more positively after they have purchased shares than before they made the purchase. This psychological effect explains why we can’t let go and take profit on our shares of ABC after it has had a massive run-up because we think that it must go up more. This mindset also explains why we can’t let go and limit our losses on our shares of XYZ after it has taken a big hit because we think it must bounce back. (This psychological trick also explains why many Texas Hold ‘Em poker players can never fold pocket aces or kings even when they know that they’re beat.)

So how can we combat our natural instincts in order to make better decisions in the stock market? A good method that many professionals use is to remove yourself from your “ownership” position. Pretend for a moment that you did not own shares of the company and ask yourself if you would purchase the stock then. If the answer is yes, then you might consider holding onto it. If the answer is no, then by all means sell your shares.

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The CBOE Volatility Index (VIX) is a great way to figure out when it is safe to put money into this volatile market. The VIX measures the market’s expectation of short term volatility conveyed by stock option prices of the S&P 500. Because volatility means financial turmoil, the VIX is often referred to as the “investor’s fear gauge.” At the CBOE website, you can learn more about the VIX and how it’s calculated.

Why is it important to be able to gauge the amount of fear in the market? Because fear historically means lower prices and the lack of fear means higher prices. As a good investor or trader, you should be buying when fear is high and prices are low and selling when fear is low and prices are high. So, by tracking the VIX, it can be determined when fear is at extremes signaling opportunities to buy or sell.

Presently, the VIX is high if you compare it to its average for the past three years. The VIX closed at 20.74, its highest level since we had the low in the S&P 500 in March and higher than the levels we reached last summer. The last couple of times the VIX reached these levels, it signaled a buy for the market because fear and selling was at extremes. You can see from the VIX and S&P500 charts the correlation between VIX tops and S&P bottoms. It is hard to say that the market is a buy right at this moment, but if history repeats itself, we could well be near a bottom.

When using the VIX as a buy signal, it is safer to wait for the VIX to show signs of turning downward and volatility expectations to decrease before you start to buy the market. Trying to pick the top in the VIX and a bottom in the market can be very dangerous. Some people refer to picking bottoms as “trying to catch a falling knife.” Experienced investors know it is safer to commit your money after a bottom has formed.

It is hard to say that today was the top in the VIX and the bottom in the market, but if you keep tracking the VIX, it will give you signs of the ultimate bottom.

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If you haven’t heard of Facebook, then you’re obviously behind on the times. Facebook is the second most popular social networking site - next to MySpace - in America with over 30 million registered users. Of course, Facebook seems to offer much more potential than MySpace for the following reasons:

• Clean user interface
• Middle to upper class user base (as opposed to MySpace’s lower to middle class user base)
• Facebook application platform
• Parakey acquisition

In recent news, Facebook could be sold for as much as $10 billion. Potential companies looking to acquire Facebook include Google (GOOG), Microsoft (MSFT), and Yahoo (YHOO). I don’t think that this valuation is as ridiculous as it sounds. It might be on the high end, but I definitely think that a $5-7 billion buyout is very possible. Last year, Yahoo made a bid for Facebook for $1 billion and was turned down by the aspiring founders.

It seems like they’re placing themselves back on the trading block with more money in mind. I wouldn’t be surprised, however, for companies to continue to underestimate the power that Facebook will offer in the future. Facebook recently acquired Parakey, which has yet to launch their “web operating system.” Combined with their new application platform, Facebook is attempting to be THE destination of the web. It is not inconceivable for Facebook to be the next Microsoft. Many are already comparing Facebook founder Mark Zuckerberg to Apple’s Steve Jobs.

There has been much hype and talk about over-valuation of social networking companies, but they have proved time and time again that analysts and naysayers are wrong. MySpace recently has been estimated to generate $1 billion in revenue for 2007. This more than compensates for News Corp’s $580 million purchase price for MySpace. In fact, at the time of purchase, most of Wall Street could not believe the price tag. Now, it seems that the purchase was a steal for News Corp (NWS).

Stock Market Implications

So what does this all mean for you? Well, if Facebook is purchased by a Google, Microsoft, or Yahoo for a near $10 billion price tag, then it’s very likely that Wall Street will cry out again in outrage just like it did in the News Corp deal. This could likely bring the purchasing company’s stock down temporarily. That will be the perfect opportunity for you to come in and snatch up shares on the cheap. You can then expect Facebook to prove the naysayers wrong again when they prove to the world that they could potentially become the world’s next Microsoft.

Of course, if Facebook doesn’t like any of the offers they get, you might just see a Facebook IPO (you can actually see on their website that they’re looking for a stock administration’s manager)!

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I’m sure you’ve heard of the subprime crisis and how that’s affecting the stock market. Well, keeping an eye on the iShares High Yield Corporate Bond Fund (HYG) can give you an advantage and insight into where the stock market’s headed.

It is well known to most investors that the stock market pales in comparison to the size of the debt market (also known as the bond market). Because of its shear size and potential for huge profits, the debt market attracts some of the most talented people to manage money. When people talk about smart money, the smartest money is usually managed by debt managers.

For example, when Enron was rumored to have accounting issues and the stock was spiraling downward, equity traders looked at the price of Enron’s bonds to determine if the rumors were true or not. When Enron’s bonds started to really decline, the equity traders sold. The price of a companies bond is very telling because they act like a canary in a coal mine. When the price improves it means good news is probably pending but if it declines it usually means something bad is coming down the pipe. Bond prices usually lead equity prices.

The subprime problem the market is trying to work through right now is causing bonds to go down in price, which is spooking the equity market. Because no one really knows how big a problem these subprime obligations may eventually be, smart money managers and hedge funds are looking to the corporate bond prices to give them a forewarning about a looming crisis. At this point in time, these prices have fallen but they have not collapsed to a point where stock investors feel they need to sell in size. The prices of corporate bonds have been going down steadily and slowly with no end in sight yet. They have not yet collapsed though.

Corporate high yield debt is the most sensitive to bad news because they have the highest risk of default. The HYG is an ETF holding a basket of high yielding corporate debt. Take a look at the HYG chart and you’ll see that these bonds have been selling off ever since Bear Sterns announced their hedge fund problems. Technically speaking, HYG has not formed a bottom yet, and the sell off in price has slowed. Whichever direction this ETF goes, the equities market will follow.

In summary, track the HYG if you want to be ahead of everyone else about the fate of this subprime issue. I just gave you a canary for the stock market.

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Dorsey Wright offers a technically managed PowerShares ETF (PDP) based on relative strength that you can purchase right on the market. As you can see in their index performance chart, they have outperformed the market significantly. You can see that the correlation between the two portfolios is very similar. Dorsey Wright, however, has done a very good job of magnifying reward while minimizing risk. Specifically, you can see the enormous run they had in the last leg of the internet bubble.

If you’ve been reading my stock market overview articles, you’ll know that it’s a strong possibility that we could be approaching the last leg of this bull market. Of course, the last run-up of most bull markets can promise significant gains. With the international and commodity boom currently in place, PDP is in a prime position to outperform the market. Investing in this ETF is like being a technical trader without doing all the work. If you want the potential for exponential returns using a strategy that has been limited to institutional investors and the smartest money managers, you should strongly consider PDP before it goes parabolic.

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Oil is too close to last year’s highs right now to not trade there. With oil currently at around $75, it will most likely head to $80/barrel before hitting $70/barrel. When commodities move one way, they typically stay that way until some type of technical break down or exhausting buying climax reverses the trend. When it comes to commodity or oil trading, especially in the short term, it seems that technicals drive price action and fundamentals take a back seat. Right now, we have oil inventory above the five year average, which means we have plenty of supply; yet, oil continues to want to go higher.

The main reason I believe oil will go to $80 before $70 is because last years trading and closing highs were just under $80. As a technical trader, you don’t want to sell until the next strong resistance level, which now happen to be last years high at around $80/barrel. Most money managers and oil investors are still bullish and will remain so until oil tests its previous highs. That means there’s a lack of selling pressure.

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Last week, we found that the market technicals looked bullish. This week, however, we had some indecision in the market. Investors have been hesitant about putting more money into the market at its all-time highs. This is a good sign as the hysteria that is so typical of the last leg of a bull run doesn’t seem to have hit us yet. See my crowd psychology series for more detail.

Stock Market Strategies for Beginners:

1. A new resistance level has formed at the 1560 level. This barrier was tested four times.
2. RSI is falling back to the 50 level. Look for a bounce off 50 and a healthy run up in the market. If not, we could be in for more losses.
3. We have support by both a trend line and the 50-day moving average at 1520.
4. Further support lies at the mid 1480s.

It seems as if we’re entering a critical junction in the market. The market showed it’s indecisiveness this week and could be ready for a big move in either direction. Here are a few insightful articles on the state of the stock market:

• Cracks in the Market Foundation - Brett takes a look at an increasing number of stocks with new lows being formed.
• Stock Market Trading Review Video - Brian narrates an excellent video on technical analysis and the current state of the stock market.
• Technical Market Report - Mike offers his short term and intermediate term technical analysis. He also goes into some Presidential Cycle analysis.
• The Bull Market Fights to Stay Alive - My own take on some reasons the bull market still has some fight left in it.

The common theme among these articles is that we need to be using proper risk management. While the market doesn’t seem to have reached its peak, we’ve entered a very volatile period where we could have a large sell off.

<< Previous Stock Market Overview - July 15th <<

>> Next Stock Market Overview - July 29th >>

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