Thursday, August 25, 2011

Thoughts on Following the Stock Market

As this is a blog about economics and the Rhode Island economy, it's time for me to discuss some basic economics. As you are no doubt aware, the stock market has been correcting of late and it has become extremely volatile on a day-to-day basis. This has inevitably lead to both panic and confusion for the everyday investor. What should you do? How can you better understand all the things that are going on?

These are very important questions, ones that clearly need to be addressed. In this post, I will make a few recommendations on reading material, and introduce a several concepts that will help you navigate your way through all of this.

First, let me recommend an excellent book that will provide you with a basic framework for following the stock market in general: Fire Your Stock Analyst (2nd edition) by Harry Domash. I suspect this will be the best $20 you spend in a long, long time. It is not one of the all-too-plentiful "how to make $1 million" books. I find those to be totally worthless (except to the authors)! Domash's text will provide you with a foundation you can build on, by providing a meaningful basis for you to begin understanding how stock prices are determined and how they change.

I also recommend that you use some website or brokerage site that will allow you to graph any stock (or ETF or mutual fund) that you own, or are considering purchasing. For stocks that you already own, look at its chart on both a daily and weekly basis (different time frames are important for perspective). If you are also able to generate monthly charts, all the better.

This leads me to a second book recommendation: STIKKI Stock Charts. Yes, the spelling is correct. This book, which costs $12,will open your eyes to another dimension of following the stock market: don't just focus on closing prices. Over a single time period, whether it be a day, a week, or a month, price will vary over a range. Therefore, information is available on not only the closing price, but on the opening price, the high over that period, and the low. STIKKI Stock Charts illustrates this effortlessly, providing you with numerous examples, so that in about an hour, you will see that there is a lot more going on than you had been aware of before.

Beyond these reference books, there is a pair of very simple concepts, frequently discussed in the media, that you need to know and understand. I am referring to support and resistance. What is interesting about all of this, is the fact that market prices are determined by supply and demand. There is nothing mythical in any of this.

SUPPORT: when stock prices fall, they almost never fall to zero. They generally move to a level where people collectively believe they are unlikely to fall much farther. At this lower level, the stock will often become viewed as being reasonably priced, or even a bargain. Once this lower price is reached, buying pressure, or demand, begins to overpower selling pressure, or supply. The result, is that price stops declining and may well begin to increase. This lower-level for price is referred to as support. You should use lows as the basis for determining support.

RESISTANCE: when stock prices rise, they eventually move to a level where the stock is viewed as being pricey, or not likely to rise much in the future. At this higher level, the stock's price is considered overvalued, or too expensive. So, once this higher prices reached, sellers, or supply, begin to overpower buyers, or demand. As a result, price will and it's increase and may well start to decline. This higher price level is called resistance. You should use highs as the basis for resistance.

Both of these concepts are discussed all the time in the media. You need to be aware of what they are, so you know understand what is being discussed.While you might not realize it, these two concepts are the basis for several things that you often see "prognosticated."

The first of these is the notion of "buy low and sell high." Support and resistance provide us with an operational basis for defining "low" and "high" prices. "Buy low "should mean purchasing a stock when its price is at or near the support. This assumes, of course, that support will hold. And that will ultimately depend on factors such as how well the economy is doing, factors specific to an industry or sector, etc. "Sell high" should mean selling a stock when its price gets close to or at resistance, assuming that resistance holds. Whether or not it holds depends on factors similar to those that determine the support.

The one thing I never hear discussed in the media is that you should avoid putting all your money into or pulling all of your money out of the market at one time. Instead, you should scale into or out of investments. And, you can use support and resistance to help you with this. For example, if stock price has been rising and is starting to move closer to resistance, that might be a good time to sell some of your shares and take profit on them, thus scaling out. You can do this in steps, as well. Similarly, if price has been falling, and it is moving closer to support, you might begin to scale into that stock, purchasing a fraction of the total you might want ultimately invested. So, if support doesn't hold, and price drops farther than you originally anticipated, you won't have all your money on the line, only some of it, which should help you cushion losses.

The second notion related to support and resistance details how far stock price is likely to fall or rise. Did you ever wonder where the analysts come up with these numbers? Do they go into the desert for 40 days and 40 nights, or is there some other process at work? While there are different ways this can be done, technical analysis, which I have been discussing here, has a fairly straightforward way of answering this question, one that is almost always the basis for what you hear in the media.

Q: How far is price likely to fall?
Translation: Where is the next level of support?

Q: How far is price likely to rise?
Translation: Where is the next level of resistance?

Let me clarify this a bit by providing a chart of Gold prices over the past three months (click to enlarge), using the open-high-low-close framework (refer to Stikki Stock Charts).

Clearly, gold price has been in a sharp uptrend since early July. The pace of that uptrend went "parabolic" in early August. Looking at the end of the recent upturn, resistance was established over the August 8 - 20 period at around $1,825. Gold price went above resistance (a breakout), but that breakout was not sustainable, so gold price corrected (parabolic price moves mean too far, too fast). How much might gold price decline? First, nobody knows that with perfect certainty. Using this framework, in the near term, look at early August support, $1,725. Should that level not hold, the next support, shown above, is from very early August, $1,675. I'll leave it to you to find the next lower level of support from the chart.

Let me conclude with one other element of technical analysis. Should the price of gold begin to move higher again, and I believe it ultimately will, how high is it likely to go? To answer this, determine resistance levels. Note, interestingly (to me, at least) that PRIOR SUPPORT LEVELS WILL NOW DEFINE RESISTANCE!

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