Chartists believe that shares gain a momentum that may or may not be justified by fundamental data.
We can see when a company is theoretically under or overvalued. The stock market can be particularly efficient at ironing out these kinks, so in theory a share price should not get far out of line before the laws of supply and demand pull it back into place.
However, the stock market can be an irrational place, running at least in part on what is referred to as sentiment, the overall feeling of investors towards particular shares or the marketplace in general.
If shares start to move in a particular direction, investors jump on the bandwagon, sometimes in simple fear of missing out. The stampede can turn into a panic.
Chartists look for trends in the share price chart. They are right to say that once a share starts to move in a particular direction, the trend often continues for much longer than investors expect. Private investors are particularly fond of grabbing profits too soon, selling out long before the share price rise is over, yet they cling to falling shares rather than admit they made a bad choice.
Charting is a highly specialised art and this book will deal only with the basics. Charting does not supply sure-fire tips for success, otherwise everyone would be doing it. Critics would say that, as with any other method of stock-picking, the only certainty is that it tells you after the event what you should have done last week or last month.
The mantras of charting are that you go with the flow and the trend is your friend. As a general principle, chartists are willing to miss out on the early opportunities for buying on the cheap. They do not try to catch falling shares as they hit the bottom or to set the momentum going. They jump on the bandwagon once it is moving and enjoy the ride, hoping to get off just before it all comes to an end.
They look for those occasions when a share chart starts to draw a pretty picture (we will cover some of the key indications). Note that the principles of charting apply not just to individual shares. We can apply them to market sectors or to the whole market. So we could, for example, study trends for banks or housebuilders and we could look at the FTSE 100 or the AIM UK 50.
We can discuss here only the basic concept of charting. It is possible to write a whole book on the subject, or even on just one aspect of charting. People have done so.
Floors and ceilings
Chartists look for support points, a level in a particular share price or index where investors have in the past been tempted to buy, sending shares higher. This is also known as a floor.
They are also wary of resistance levels or ceilings, points in the chart where shareholders have previously decided to take profits because they believed that the shares would not go any higher.
Note that, with all lines that chartists draw, it is rare for the share price to consistently touch a trend line exactly, which is why chartists usually want to see a line broken decisively before they are satisfied that a new phase has begun.
Chart 7: Balfour Beatty, example of support level
In 2014–16, Balfour Beatty shares were hit by a series of profit warnings but they found support round about 255–260p on hopes that once problem contracts had been sorted the construction and facilities group would be able to bounce back.
There were several abortive attempts to drive the shares higher with varying degrees of success but each time they fell back below 265p, the floor held.
Rangebound
An extension of the concept of support and resistance levels is that sometimes share prices move sideways, bouncing up and down between two levels. When this happens chartists are looking to see which way the shares break out, upwards or downwards, so that a new trend is established.
Chart 8: Thomas Cook
Package holiday providers such as Thomas Cook were under pressure from spring 2014 to summer 2016 for a variety of reasons: a fall in the value of sterling made foreign destinations more expensive for Britons; terrorist attacks in several European cities made tourists nervous; unrest in Egypt and elsewhere devastated popular resorts such as Sharm El-Sheikh.
After falling back in 2016, Cook shares settled around 85–95p for the first half of 2017, but in July an upbeat trading statement covering the key April–June quarter changed investors’ perceptions.
There had been a strong improvement in revenue, bookings and profits in the run-up to the summer months when holiday companies make their profits.
Thomas Cook shares rose rapidly to 127p and although they ran into profit taking they seemed to be settling into a new range at 110–120p.
Narrowing triangles
A variation on shares moving within set ceilings and floors is where the range grows ever narrower. Again, chartists will be looking to see in which direction the shares break out, only this time we can see when crunch time is looming.
Chart 9: Next
The peaks got gradually lower and the troughs sharply higher between May and September 2017 at retailer Next when a trading update caused the shares to break through the ceiling. They moved upwards much more strongly than the update justified.
However, in a warning that you sometimes have to be nimble if you’re a chartist, the shares fell back equally sharply on the next trading statement, although it was no worse than the first one.
Peaks and troughs
Shares do not run in straight lines up or down. Even on a good bull run (where markets are moving upwards in value) there will be occasional small falls among the rises, as some investors decide to take profits. Similarly, falling shares will perk up from time to time, as buyers provide support, before resuming their bear (that is, downward) trend.
We can, however, gain clues from looking at whether each peak is lower or higher than the previous one – or whether each trough is lower or higher than before. For as long as such a pattern holds we would expect the established trend to continue.
Chart 10: Share price of WPP
Shares in global advertising agency WPP were in decline for most of 2017, with each peak tending to be lower than the previous one, while troughs followed a similar trend.
When you see such a chart, draw a straight line joining as far as possible all the peaks and all the troughs. If each peak is higher than the previous peak, and if each trough is higher than the previous one, then the bull (upwards) phase is still intact.
In the case of a rising share price, the troughs are more important than the peaks. The troughs mark the point at which buyers again outnumbered the sellers who were getting out, the point at which the shares found support. As long as the shares stay above the rising support line, they are still in a bull phase. When the share price drops below the line, it can be a signal to get out.
When shares are falling, with each peak below the previous peak and each trough below the previous trough, the shares are in a bear (downwards) phase. This time the peaks are more important. They represent the falling level at which buyers lose enthusiasm and the sellers take over again.
If the shares rise above the line connecting the peaks, it is a signal that the bear phase could be over and it could be time to buy.
Note the words can and could. There is no guarantee that the trend is broken, just a strong indication. Share charts do not move in regular patterns so those straight lines cannot exactly touch every peak and trough spot on.