From the Analyst 05/02/2000
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the Importance of Patience - and WHY Bases Really Matter
After any marked decline, stocks must enter a period of repair. While there is no hard rule for how long these repair periods last, we can recognize their
development on the charts in patterns we call bases. Bases provide support for longer-term sustainable rallies. One thing we've noticed in the tech sectors, with the
noted exception of Semiconductors, is the severe damage that has occurred on many, many charts. Face it, a stock cannot decline by 50% or more, as many of the
tech names have, and maintain a technically sound chart. These stocks must repair themselves before significant upward moves can take place. In some cases stocks
will build bases that are capable of supporting extended forward moves in a matter of weeks. In other cases it may take years to rebuild broken charts.
Consider the case of IBM between 1986 and 1995. In the chart below, shares of IBM committed the Cardinal Sin of violating the long-term Bullish Support line.
International Business Machines, Inc. - IBM Trend Chart 1986-93
45 -------------| ----------------| ------| | ----| ----| ----------| --------45 -
44 | * | | | | | | 44
43 | 8 * | | | | | | 43
42 | 6 O * | | | | | | 42
41 * | 5 O * | | | | | | 41
40 ---X --4 * --| ----X 9 ----* --| ------| | ----| ----| ----------| --------40 -
39 2 O X O * | X X O * | | | | | | 39
38 O X O X O * X O X O * | | | | | 38
37 O X 3 5 | 3 O X A | * | | | | | 37
36 1 O 9 | X 4 O | * | | | | | 36
35 ---------7 X O X ----O --------| ----* | | ----* ----| ----------| --------35 -
34 * O X O X O | * | X * | | 34
33 * O A 2 O | | * X O * | | 33
32 * O X O | X 1 | * 2 O * | 32
31 * O X * O X X 1 X O A O * X 3 | * | 31
30 -------------O X * --O X O X O X O 6 O X O X --1 O --| --* ------| --------30 -
29 1 * O X O X O X O X 8 X 3 X O C O | * | 29
28 * O X O B X O X O | O 5 O B O | * | 28
27 | O X C | 2 | O 3 8 X 4 | * | 27
26 | O | | A X O X O 9 | * 26
25 -------------| ----------------| ------| O X O | 6 X O ----7 ----| * ------25 -
24 | | | B | 7 X O 1 6 O | * 24
23 | | | | | 8 C X O X O | * 23
22 | | | | | O X O X 8 | * 22
21 | | | | | O 3 9 | 21
20 -------------| ----------------| ------| | ----| ----| ------O --| --------20 -
19.5 | | | | | | A | 19.5
19.0 ------------| ----------------| ------| | ----| ----| ------O --| --------19.0
18.5 | | | | | | O | 18.5
18.0 ------------| ----------------| ------| | ----| ----| ------O --| --------18.0
17.5 | | | | | | O | 17.5
17.0 ------------| ----------------| ------| | ----| ----| ------O X | --------17.0
16.5 | | | | | | O X O 16.5
16.0 ------------| ----------------| ------| | ----| ----| ------B X O --------16.0
15.5 | | | | | | O C 15.5
15.0 ------------| ----------------| ------| | ----| ----| ----------O --------15.0
14.5 | | | | | | O 14.5
14.0 ------------| ----------------| ------| | ----| ----| ----------O 3 ------14.0
13.5 | | | | | | O 2 O 5 13.5
13.0 ------------| ----------------| ------| | ----| ----| ----------O X O X O 13.0
12.5 | | | | | | O X O X O 12.5
12.0 ------------| ----------------| ------| | ----| ----| ----------1 X 4 --7 12.0
11.5 | | | | | | O O 11.5
11.0 ------------| ----------------| ------| | ----| ----| ----------| ------O 11.0
10.5 | | | | | | | O 10.5
10.0 ------------| ----------------| ------| | ----| ----| ----------| ------* 10.0
| | | | | | |
8 --------8 | 8 ------------8 | 8 --8 8 8 9 9 | 9 9 | 9 ------9 | 9 ----9
6 6 | 7 7 | 8 8 9 9 0 0 | 1 1 | 2 2 | 3 3
We've emphasized over and over again how critical violations of long-term trendlines are. This should be obvious when you stop and consider what the term "trend"
means. Quite simply, trends forecast the future direction of stock prices. If the long-term trend is no longer positive, then one should expect lower prices. This
concept is dramatically illustrated by IBM's chart. After violating the long-term uptrend line in July of 1986, IBM shares continued moving lower for SEVEN FULL
YEARS. Long-term investors of the Buy-and-Hold mindset are still getting over that decline. Was IBM tradeable during that decline? Certainly. There were
numerous instances where IBM could have been traded successfully during the decline. The point, however, is that when you trade a stock that is in a primary
downtrend, you are more likely to find yourself in situations where the trade goes against you, than in situations where the trade goes for you. Again, the meaning of
the word trend makes this obvious.
Now, in the case of IBM, a bottom was made in the stock seven years after the initial uptrend violation. If we stopped out on the initial trendline violation, where
would we consider returning to IBM? This is where the concept of base building comes in to play. It takes stocks time to repair technical damage that has been
inflicted during downtrends. Look at the chart of IBM from 1992-1994.
International Business Machines, Inc. - IBM Trend Chart 1992-94
28 | | 28
27 * | | 27
26 * | 26
25 ---| * ------| -------------25 -
24 | * | 24
23 | * | 23
22 | * | 22
21 | * 21
20 ---| --------| * -----------20 -
19.5 | | * 19.5
19.0 --| --------| ----* ----X--19.0
18.5 | | * X 18.5
18.0 --| --------| --------* A--18.0
17.5 | | X 17.5
17.0 X | --------| ----------X--17.0
16.5 X O | X 16.5
16.0 X O --------| ------X --8--16.0
15.5 C | X O X 15.5
15.0 --O --------1 ------5 O X--15.0
14.5 O C O 3 4 7 X 14.5
14.0 --O 3 ------X O X O X O ---14.0
13.5 O 2 O 5 X 2 X O X * 13.5
13.0 --O X O X O X O --O --* ---13.0
12.5 O X O X O X * 12.5
12.0 --1 X 4 --7 B ----* -------12.0
11.5 O O X * 11.5
11.0 --| ------O X * -----------11.0
10.5 | O * 10.5
10.0 --| ------* | -------------10.0
| | 2.75
9 | 9 ----9 | 9 ---------9
2 3 3 4 4
After making a bottom at 10 1/2 in 1993, It took shares of IBM nearly a year to break through the Bearish Resistance line at 18 and change the overall trend back
to positive. Now, IBM has a positive trend. Do we buy IBM right here at 19? Is that good risk management? The stock is now extended above support at 14 so
we'd wait for a pullback AND a reversal. The reason we don't buy on a pullback to a specific number, say 15 1/2 or 16, is because we really don't know at this
point how far IBM will pullback. Who knows, maybe it will pull back to 10 1/2 from here. If we wait for the pullback AND the reversal, we'll have a better entry
point with a higher bottom and reasonable stop loss point.
Let's look at IBM's chart a few months later:
International Business Machines, Inc. - IBM Trend Chart 1992-95
28 | | | 8 28
27 * | | | X 27
26 * | | X 26
25 ---| * ------| --------------| --7 ---25 -
24 | * | | X 24
23 | * | | X 23
22 | * | | 4 22
21 | * | X 21
20 ---| --------| * ------------| --X ---20 -
19.5 | | * X 3 19.5
19.0 --| --------| ----* ----X --1 O X ---19.0
18.5 | | * X O C O X 18.5
18.0 --| --------| --------* A O X O -----18.0
17.5 | | X B X 17.5
17.0 X | --------| ----------X O | -------17.0
16.5 X O | X | 16.5
16.0 X O --------| ------X --8 --| -------16.0
15.5 C | X O X | * 15.5
15.0 --O --------1 ------5 O X --| * -----15.0
14.5 O C O 3 4 7 X * 14.5
14.0 --O 3 ------X O X O X O --* | -------14.0
13.5 O 2 O 5 X 2 X O X * | 13.5
13.0 --O X O X O X O --O --* ----| -------13.0
12.5 O X O X O X * | 12.5
12.0 --1 X 4 --7 B ----* --------| -------12.0
11.5 O O X * | 11.5
11.0 --| ------O X * ------------| -------11.0
10.5 | O * | 10.5
10.0 --| ------* | --------------| -------10.0
| | | 2.75
9 | 9 ----9 | 9 ----------9 | 9 --
2 | 3 3 | 4 4 | 5
We waited for the pullback, which took the stock to 17 in November of 1994, and bought on the first reversal, 18 1/2 in December. Actually we could have been
even more conservative and waited for the double top confirmation at 19 1/2. Either way, we would have a much closer stop, the double bottom at 16 1/2. This is
called managing risk. Think carefully about this. IBM had a run from July of 1993 to January of 1994 of 70%. This all took place BELOW the Bearish Resistance
line while the stock was in a negative trend. Now, if you were able to call the exact bottom, 10 1/2 in July, and sold at the top of the next column of X's, 15 in
January of 1994, you would have put the smack down on a 70% gain. But you also would have taken a tremendous risk. How would you have known 10 1/2 was
the bottom? Would you have sold at 15? What if you had been just a month or two early on your bottom call and paid 13 or 14 for the stock, then had to explain to
your spouse why the stock was at 10 1 /2 just six weeks later? The point of this exercise is to recognize when the odds are in your favor and when the odds are
against you. In a downtrend such as the one IBM suffered, taking a position in the stock below the trendline is clearly a case where the odds are stacked against
you. It's the equivalent of gambling.
This is why patience is so important in this business. Stocks must build bases after damaging events and this takes time. Examine closely the charts of the OTC
stocks you want to buy. Is the uptrend intact? Is the Relative Strength on a Buy signal or at least in a column of X's? Has the stock built a base from which to
support forward movement and higher prices?
Remember that despite what you hear and see on TV or read in the media, it takes time to recover from steep selloffs. The patient investor will reward himself with
solid positions that take advantage of the bulk of a forward move while limiting the downside risk attached to moving to soon. In this kind of market, patience will be
rewarded while complacency will be punished. It will be apparent on the charts when OTC stocks begin to build solid bases and repair the damage April has
brought.
While we make every effort to be free of errors in the data on our site,
it is derived from data from other sources. We believe these sources to
be reliable but we cannot guarantee their accuracy.
Copyright ¸ 1995-2000 Dorsey, Wright & Associates, Inc.
Disclaimer. |
