Continuing on in our series on Point and Figure charts I would like to quickly do a recap of what we have learned so far.
P&F Basics - here we started with the history of P&F and explained:
P&F Support and Resistance - we built on the basics and learned how to draw and use the:
P&F Formations - we investigated when a P&F chart gives a buy or sell signal using:
P&F Price Projections - gave us an idea of how to calculate the number of points a P&F buy or sell could go with the caveat that price objectives should only be used as a guide for how much you could make out of a trade or a place where you should be thinking about taking profits. Frequently stocks will trade past these projections and also frequently not make it all the way to the projection. P&F charts are not crystal balls they are just very handy tools. The tools we learned were called:
P&F Relative Strength - getting a little more sophisticated now we learned how to compare a stock to an index and:
P&F Bullish Percent Index (BPI) - was the granddaddy of all P&F charts and all analysis should start here. In this article we learned:
Now we will try and put this altogether and see if can make some sense of this thing they call the stock market.
We will begin with the BPI because that tells us if we should be concentrating on shorts, longs or flat.
We start with the BPI to determine the overall state of the market and, using the same image I showed in the in the BPI article, I would be short this market. (This is also a good time to move your 401(k) money to a money market). That was simple wasn't it? But does that not beg the question short what? How do I find the best short candidates? This is where the things get a little more difficult. Let's start with looking at which of the indexes are the weakest.
If you have read any of my market wraps lately you probably have seen that the SPX is the strongest. Let's see if that is still the case.
In the March 31st Market Wrap I stated "The bad news is that if SPX were to trade to 1160 and give what I consider a weak P&F sell signal, it would translate into a nasty break of a double bottom on the bar chart. Then add the fact that the double bottom was met with a lower low on the MACD and you can see that the sell signal on the P&F chart becomes a little more ominous." The reason I said it would be a weak P&F signal was because the P&F chart is still above its blue support line and as you can see it still is.
Now let's look at the DOW. Here is what I said in the March 31st Market Wrap, "The DOW has added a few Os to the last column but not enough to break the blue support line. This chart gave a sell signal back at 10600 so it is weaker than the SPX, which has not yet given a sell signal."
Here is how the DOW looks now.
As you can see, it has now broken the blue support line and then some. The support line break back at 10350 was also a triple bottom break so this index gave you two reasons to be short.
Let's now look at the Nasdaq composite. Here is what I said in the March 31st Market Wrap, "the red resistance line as started to form and the blue support line has been broken. It has even had its required bounce and made a small column of Xs setting up a picture perfect short entry below 1970."
Did you short this market when it broke 1970 back on April 14th? That's Ok neither did I and what a shame.
So looking at the above P&F charts your short candidate would not be the S&P, it should have been either the DOW or the Nasdaq.
But what if you didnt want to short an index? What if you are more comfortable shorting individual stocks because you feel there is more potential for profit with one stock than with a group of stocks. How do you find those individual stocks? This is where your Relative Strength charts become extremely useful.
Let's use the DOW because there are only 30 stocks to look at. To find the weakest stock in the DOW Industrials, I will look for Relative Strength charts that have broken their blue support line, have formed a red resistance line and on P&F sell signals.
I went through all the Dow charts and found the strongest (for comparison) and the weakest. Which one of the following stocks would you pick for short candidates?
Here is Boeing (BA) compared to the Dow Industrials.
Would you short this stock even thought the market as a whole is bearish? This Relative Strength chart is above the support line and on a P&F buy signal.
How about Altria Group (MO)?
This Relative Strength chart is also above the support line and on a P&F buy signal. Not a good candidate for shorts.
Now look at Walmart (WMT).
The Relative Strength P&F chart for WMT is below the Red Resistance line and on a P&F sell signal.
Here is International Business Machines (IBM).
The Relative Strength P&F chart for IBM is also below the Red Resistance line and on a P&F sell signal.
One last RS chart - here is Coca Cola (KO).
This chart is also below the Red Resistance line and on a P&F sell signal.
Now that we have three short candidates the next step in our analysis is to see how these three compare to their sectors.
First of all WMT is in the Retail sector so lets look at how well it is doing in comparison to its sector. I have used the AMEX Retail Holders Index $IRH for this comparison.
Sometime in October 2005 (red A) this Relative Strength chart gave a double bottom sell signal and it is now well below the resistance line. So far WMT is holding up as a short candidate.
Next let's look at IBM compared to the Hardware Sector represented by the GSTI Computer Hardware Index $GHA.
Between September 2004 and October 2005 this Relative Strength chart gave a double bottom sell signal and it is now well below the resistance line. So far IBM is holding up as a short candidate. .
Next let's look at KO compared to the Consumer Staples index represented by Morgan Stanley Consumer Index - $CMR.
Back in September of 2004 this Relative Strength chart gave a double bottom sell signal then another double bottom sell between November 2004 and February 2005. It is also well below the resistance line. So far KO is holding up as a short candidate as well.
All three of our short candidates are weak in comparison to the market and to their respective sectors. Now it is time to drill down even further and see if we can nail a good entry. For that we will use the plain old basic P&F charts.
Here is the P&F chart for WMT.
WMT has broken its support line and has formed a resistance line. But the thing that jumps out at me is the triple bottom break at $50, which would have been a good entry however; there are other things we need to consider. Firstly of we cant come up with a price projection yet because we dont know when the column of Os ends, we have to wait for the next column of Xs to start. Here is how we do price projection:
1. Find a buy signal. That was in November of 2004 (the B in the last column of Xs.)
The second item we need to consider if your stop loss. If you were to short WMT here, or even at the triple bottom sell signal, your stop loss is a print above $58, which is a wide stop. Therefore, you may want to wait for WMT to retrace, build a column of Xs and sell at your next sell signal. This would serve two purposes; you will be able to calculate your price objective and hopefully give you a lower stop loss.
Here is the P&F chart for IBM.
IBM is in a similar situation as WMT. It gave a sell signal below 85 but has not retraced so we can calculate the price projection. Also if you were to short here your stop is all the way up at $100, too far for my pocket book. So you will need to be patient, wait for IBM to retrace and build a column of Xs so you can calculate your price objective and lower your stop loss.
Here is your basic P&F chart for KO.
KO gave a sell signal back at $48 in July 2004 but it was above the support line so it was a weak signal. However, since then KO has broken its support line and has retraced into a column of Xs giving us a very clear entry below $39 and a price objective:
1. Count the number of Os in the last O column = 13.
When/if KO prints below $39 short KO and look for a price projection of $25. Place your stop at the next buy signal.
Did you see how we started at the top and used the BPI charts to determine if you should be positioning yourself short, long or flat? Then you drilled down to the RS charts to find your individual stocks to buy or sell. Then used the RS charts to see if they were exhibiting any kind of strength/weakness compared to their sector - remember 80% of a stocks movement is related to the market and its sector.
Then once we assure ourselves that the stocks were indeed good short candidates we use the basic P&F charts to nail a good entry.
When I first heard about Point and Figure charts I thought they were called Point Your Finger charts. You just point your finger and the chart will tell you where to buy and where to sell. Maybe P&F charts arent quite that easy but darn near.