Lining up the Fundamentals and Technicals

Making trading or investment decisions based on both the fundamental and technical picture is not a novel idea. There are analysts or portfolio managers with both a CFA and a CMT. Many trading firms, hedge funds, and advisories keep technical analysts on board so that they can have an understanding of what the market itself is saying. One story that Ralph Acampora likes to tell is, when fighting on behalf of the technical analysis, a SEC lawyer held up a chart, and said, "Ralph, what is fact on this?" Ralph responded that the PRICE was fact. Price is what is happening right now. It sums up what all market participants think. Earnings are history. Earnings get revised. Stocks get upgraded to buy, and then often when it is too late, they are downgraded to sell. In the realm of technical analysis, there are hundreds of different oscillators, indicators, bands, moving averages, and candlestick set-ups. But those are still just a derivative of the only thing that really matters: price.

Does that mean that fundamentals and technical indicators should be ignored? Certainly not. Using one or two technical indicators can help eliminate bad trading decisions. Understanding the fundamentals of a company can help to see the bigger picture. Then when you get price confirmation, you can be right in a big way. 

Let's look at an example of lining up the fundamentals and technicals of a stock, IBM, and see how it plays out. We will check back in every month or so. The fundamental work I leave to Barron's. I like to read Barron's on the weekends, and since they came out with a bullish piece on IBM, I thought it would be a good example. I will sum up what they say, look at the chart, and come up with a thesis.

Firstly, IBM has massively underperformed the S&P 500. Barron's believes that the stock is at a bargain price. Since the new CEO took over in 2012, shareholders have seen a loss, even with dividends. Compare that to the S&P over the same time period, which is up 130%. IBM is now leaving its lower margin businesses behind. Their gross profit could grow this quarter for the first time in years. We don't need anymore than that. If you require more evidence, go buy the paper. Barron's make a compelling case, and based on that alone, the stock is a buy. But that is not all you can base a decision on. You need to look at the chart.

To the right is the monthly chart. Right away we can see that the stock topped in 2012 at above $215 a share. It has steadily fallen since then, having put in a few lower highs. At this time frame, the stock seems pretty directionless. It might continue to consolidate until the apex of this triangle is reached. Let's zoom in. 

There are 3 lower highs and 3 lower lows that are circled on the weekly chart below. A 52-period EMA is also on the chart. The EMA has started to move sideways following its decline. That is one possible sign that the stock is beginning to stabilize. So, the lower highs and lows are circled. The more recent high, which is a higher high, is displayed in the first rectangle. The second rectangle shows that we now have a possible higher low, provided that it holds. Another sign that the stock might be stabilizing. 

So if we have a case that the stock might potentially be shifting, what now? Since we want to keep this trading decision in line with the fundamentals, we are looking for an area to be a buyer. The most obvious spot that sticks out to me would be a close above the recent high at $183. That would confirm a bull market in the stock. We can also extrapolate a possible price target by using the ABC method. 

This is a super simple technique. Just take B-A, and then add it to C. We would subtract 116.90 (A) from 182.79 (B).  The result is 65.89. Adding that to C, or 139.13, gives us our potential price target of $205.02. However, waiting to buy upon a close above B provides poor risk/reward. Where do you place your stop? Below C you are risking more than you can make. You would need to enter earlier in order for this set-up to work. Let's zoom in to a daily chart and see if there is another signal we can look for. 

The most apparent thing on the daily chart is the gap up. This followed earnings. Since then, the stock has given back nearly all of those gains. The most important thing for the stock to do right now is hold C, which is our higher low. On the daily chart it is displayed in the rectangle. Our stop, if we enter a trade, will go below that level. Buying right now would keep the risk/reward low, but possibly at the expense of having a higher probability trade. You'd only be risking $10 to make $57 (based on our ABC target of $205.02). That is great, but I need to see a little more confirmation that the stock is ready to move higher. And since the earnings gap and fill, I haven't. The high of that move was $162.51. Coincidentally, or not, that level is also where we gapped down to back in April. Above this, there is a lot of empty space. So if we get some momentum as we move higher, we could certainly propel through. The level that sticks out to me as a possible entry is at the link line. If you look back to July, we gapped down from there, and then on the most recent decline, it acted as resistance. If we get above this level, which is $151.90, I would be looking to be a buyer. Initial stop would go below C, or $139.50, and our target would be D, or $205.02. 

We will track IBM and see how it develops over the coming weeks. If C is taken out, then the trade idea is invalidated. Without that low holding, this potential reversal is moot. We would then need to wait for another signal. The stop will be moved as the position moves in our favor. It will not be set to trail, but rather be moved manually to key technical points. Finally, the entire position will likely not be closed at D. Should we fail to hold above B, we will exit some. And a small portion will be held until there is a clear reversal of trend.