Modern Day Tea Leaf Reading

I have been actively speculating in the stock market for a few years now.  I call it speculating as opposed to investing since investing in my mind involves long term goals based on fundamentals as well as possible usability of what is purchased.  Speculating to me is simply trying to make a short-term profit without regard to fundamentals.  Therefore, I am more interested in current public sentiment than I am long-term fundamentals.

The way to determine public sentiment is by the use of historical charts.  For a long time chart-reading was considered akin to divination.  There are still some who don't put so much importance on it but I am for whatever works.  The thing about reading charts is they are open to interpretation.  It is definitely not an exact science but we are dealing here with decisions and actions of a large bunch of people.  When you're dealing with herd mentality you can get surprised at times but the charts show that a herd's major moves can be predicted with a good degree of certainty.

I remember when I first started looking at charts.  I couldn't get much useful information out of them because I didn't know what I was looking at.  I eventually learned about "indicators" which are mathematical formulas derived from the charts which show which way the herd is favoring.  "The trend is your friend" is a common and useful saying.

My favorite indicator is named the MACD, short for Moving Average Convergence/Divergence.  The MACD has only been around since the 1970s!  Here is a wikipedia link explaining it.  The chart below is from the article.

 








For the example above this means:

• MACD line (blue line): difference between the 12 and 26 days EMAs
• signal (red line): 9 day EMA of the blue line
• histogram (bar graph): difference between the blue and red lines

The straight line is called the "zero line" where there is no difference between the fast and slow exponential moving averages.  The zero line is the goal of the moving lines.  If a stock stayed at the same price for awhile, both lines would ride exactly on the zero since there would be no difference.

What this tells me is when the moving lines goes south of the zero line, sentiment is more negative than positive, and when it goes north it is more negative.  But the real fun starts when the blue MACD line crosses the red MACD signal line.  Keep in mind that the MACD is a "lagging indicator," so we are not trying to find an exact bottom or top.  If you want the exact bottom or top I say good luck.  I am only interested in trends.  I will let the herd change course before I put my money to work.  There is still plenty of money to be made without picking the bottom or top.  (There is some debate how dependable the MACD is.  I have found that it is very dependable in precious metals and mining stocks but not as dependable elsewhere.  That's fine with me as I concentrate on precious metals).

So let's see how this works in the real world.  Here is a 1-year daily chart of Silver Wheaton, or SLW.  I recommend opening another browser showing this blog so you can look at the chart on one side of the screen while you read the comments below.








The top chart are "candlesticks" which show the daily price action, volume is numbers of shares traded, then we have our MACD with the RSI below it, the Relative Strength Indicator.  We won't talk about that one today.


We see that this stock went from under $20 to $47, came back down some, and is now at $36.53.  Of course it didn't go in a straight line because that isn't how sentiment works, but if you followed the MACD you would have done well.  Again, we are looking for when the blue line crosses the red line.  You can see the MACD turned north early in August when the price was under $20, but let's call it $20.  It then went up to about $27 by early October and flattened out while the MACD turned south slightly saying to sell.  It then turned up again at the first of November at $28 and shot up to $35 in a little over a week.  The MACD wanted to turn down but didn't quite cross.  It finally crossed down hard in December at say $38, went down until $30, then turned up and went all the way to $45 and turned down and said to get out.  Even though it went down to $38 and back up to $47, the MACD said "be wary."  It then ripped down hard to the $33 area and has now turned back up again.

What we can see here is the zero line is quite important in reading sentiment.  The MACD was only below the zero line three times in the last year.  The farther the line goes below the zero line the worse sentiment is, and the farther the line goes above the zero line the higher sentiment is.  The way you use this is, to buy cheap, you have to buy when sentiment is too bad and sell when sentiment is too good.  This is what the MACD does for me in the precious metals arena.

Secondly, the severity of the crossing of the line usually involves more volatility.  People are throwing in the towel at lows and piling in with buying at the top.  People jump on the bandwagon en masse near tops and sell like it's 1929 at lows, it's just how people are.

Here is a 6-month chart of the same stock.  (Move your other browser down to the 6-month chart).  How would you have liked a nice little 50% profit in 5 weeks, $30 to $45?  



By using the daily chart we see that you could have sold in December, waited until the first of February to buy in at $30, sold out at say $44 only 5 weeks later, and bought back in last week at $34.  Notice how the MACD tried to move north at the end of March but it was above the zero line.  These moves are not as strong because sentiment is already positive, or above the zero line.  Yes, the price WAS going up, but we were running out of buyers.  The up-turn last week was way below the zero line and indicates another very profitable and playable move.  Also, the angle of crossing and its ascent is sharp which is very good.  I got in at $34.50 and am already up $2/share and will hold on for a nice ride.  When the MACD turns up like this below the zero line then in my opinion this is where there is the least risk.  You just can't let the first down day scare you out.

So when you play the daily chart the moves are normally a few weeks to a month or two, sometimes longer.  Of course it doesn't go in a straight line and shorter-term traders are buying and selling the whole time.  You have to figure out what kind of trader you are, in other words, what time frame you are comfortable with.  I prefer the daily charts.  You can play shorter or longer time frames, but the shorter time frames are probably less reliable because they are smaller herds.

These charts can be found at bigcharts.marketwatch.com.   Enter SLW and click on Advanced Chart.  You can then select indicators as well as time frame and chart style.  I also use a 9-day SMA or Simple Moving Average which is embedded on the top chart.  The candles tend to stay above the line on up moves and below the line on down moves if you want intermediate plays.

To quote the Mogambu Guru, this investing stuff is easy!