by Mark Skousen, Advisory Panelist

“The overwhelming majority of economic theories, market forecasts, trading strategies, investment systems, hot tips and sure-fire speculations never pan out.” ~ Alexander Green

In the August 14 Investment U issue, Alexander Green urged you to stick with the tried-and-true method of fundamental analysis.

He did so using this mantra: “There is only one thing that dictates where a stock will go: earnings.”

I agree that earnings are the ultimate determinant of stock prices in the long run. But that’s not the only way to gauge where a stock is headed next.

I firmly believe that technical analysis – volume, trading patterns and historical trends – can enhance your returns tremendously and can keep you out of trouble in many cases. Here’s why…

The Problem with a Straight Earnings Approach to Investing

The problem with taking a straight earnings approach to investing is that stock prices aren’t determined by current or past earnings, but by future earnings in relation to the current price.

Throughout the past decade, for example, earnings looked great for Bank of America (NYSE: BAC). In June 2008, it earned a record $3 billion. You’d have made a bundle of money investing in BAC during the new millennium. Factoring in rising dividends, stock splits and share price appreciation, you’d have tripled your money.

But over the next year, Bank of America’s earnings plummeted, and by the end of 2008 it had lost $2.3 billion. The stock followed, collapsing from $50 to under $3 a share, wiping out all of the previous eight years’ worth of profits (although the stock has since rebounded to $17 a share).

By time the bank announced a sharp drop in earnings, the price was way down – and investors who bought based on earnings had lost their shirts.

So how does one anticipate an earnings collapse like that?

Use Technical Analysis to Prevent Pain – And Profit

Needless to say, sound economic analysis doesn’t hurt. Many economists (including our own Alex Green) predicted a real estate collapse and the subsequent financial trouble.

But using technical indicators and historical trend analysis can also prove extremely helpful in improving your investment results.

For example, many technical analysts have fared extremely well over the past decade (and more), using chart patterns, volume and historical trends. And investors like Bert Dohmen, Jim Dines and Dennis Slothower profited from major trends in commodities, stocks and foreign currency, while avoiding most of the financial crises in 2008, because they used an advanced version of technical analysis.

Here are two other simple tools that have proven very effective…

• The 200-Day Moving Average: Developed by Doug Fabian and his father Dick, this system has worked well for over 40 years, with only a few whipsaws. It was effective in both keeping investors out of the market during 2008 and getting them back into the market now.
• The New Highs/New Lows Index: This divides the number of stocks hitting new highs each day by the number of stocks hitting new lows. I’ve illustrated this on the red line in the chart below and it has worked especially well over the years.

If you used these two technical tools together, you’d have got out the stock market in October 2007 and not re-entered until April this year – without being whipsawed back into the market. Not bad.

Using Technical Analysis For Gauging Investor Sentiment

Put simply, technical analysis isn’t a crystal ball, but it’s a good way to measure the psychology of the market.

When new highs and new lows are at all-time highs, it suggests a strong bullish trend. Conversely, if the indicator is at an all-time low, it signals incredible pessimism.

The new highs/new lows indicator gave a sell signal in October 2007 and a buy signal in April 2009 it’s still bullish.

According to the chart, the market is headed higher, so investors should consider several choices…

• Buy an ETF (exchange-traded fund) such as SPDRs (NYSE: SPY), which tracks the price and yield performance of the S&P 500 index.
• Buy a five-star, no-load mutual fund such as the Janus Triton Fund (JATTX).
• Buy individual stocks, such as Bank of America (NYSE: BAC).

Of course, technical traders use a variety of ratios, indicators and charting patterns to make their buying and selling decisions. Their systems are never perfect because human action is not always predictable, but human behavior and the herd instincts are sometimes quite apparent and experienced traders can make a great deal of money and avoid the worst of bear markets.

Good trading – AEIOU,

Mark Skousen

View original at: Investment Advice and Investment Research with a Contrarian Point of View

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