The VisualInvestor

How to Spot Market Trends

Second Edition

JOHN J. MURPHY

WILEY

John Wiley & Sons, Inc.

Contents

Preface xv

Acknowledgments \i\

SECTION ONE II\TRODI]CTIO1\ 1

What Has Changed? 1Fund Categories 2Global Funds 2Investors Need to Be Better Informed 3Benefits of Visual Investing 3Structure of the Book 3

CHAPTER 1 What Is Visual Investing? 5

Why Market Analysis? 5The Trend Is to Blend 6What's in a Name? 6Why Study the Market? 7Chartists Are Cheaters 7It's Always Just Supply and Demand 7Charts Are Just Faster 8Charts Do Look Ahead 8Pictures Don't Lie 9Picture Anything You Want 9The Market's Always Right 9It's All About Trend 10Isn't the Past Always Prologue? 10

Vlii CONTENTS

Timing Is Everything 13Summary 13

CHAPTER 2 The Trend Is Your Friend 15

What Is a Trend? 15Support and Resistance Levels 18Role Reversal 18Short Versus Long Term 25Daily, Weekly, and Monthly Charts 28Recent versus Distant Past 28Trendlines 31Channel Lines 34Retracing Our Steps by One-Third, One-Half, and Two-Thirds 34Weekly Reversals 38Summary 38

CHAPTER 3 Pictures That Tell a Story 41

Chart Types 41Time Choices 46Scaling 46Volume Analysis 50Chart Patterns , 52Measuring Techniques 61Even the Fed Is Charting / 65The Triangle 65Point-and-Figure Charts 66Chart Pattern Recognition Software 70

SECTION TWO INDICATORS 73

CHAPTER 4 Your Best Friend in a Trend 75

Two Classes of Indicators 75The Moving Average 76The Simple Average 76

Contents - ix

Weighting the Average or Smoothing It? 77Moving Average Lengths 77Moving Average Combinations 78Summary 95

CHAPTER 5 Is It Overbought or Oversold? »7

Measuring Overbought and Oversold Conditions 97Divergences 97Momentum 99Welles Wilder's Relative Strength Index 100The Stochastics Oscillator 110Combine RSI and Stochastics 113Summary 119

CHAPTER 6 How to Have the Best of Both Worlds 121

MACD Construction 121MACD as Trend-Following Indicator 123MACD as an Oscillator 123MACD Divergences 125How to Blend Daily and Weekly Signals 125How to Make MACD Even Better—The Histogram 128Be Sure to Watch Monthly Signals 130How to Know Which Indicators to Use 130The Average Directional Movement (ADX) Line 133Summary 135

SECTION THREE Linkage 137

CHAPTER 7 Market Linkage 139

The Asset Allocation Process 140The Relative Strength Ratio 1422002 Shift from Paper to Hard Assets 142Commodity/Bond Ratio also Turned up 144Turns in the Bond/Stock Ratio 144

X CONTENTS

2007 Ratio Shifts Back to Bonds 147Bonds Rise as Stocks Fall 147Falling U.S. Rates Hurt the Dollar 147Falling Dollar Pushes Gold to Record High , 1 50Commodity-Related Stocks 153Foreign Stocks Are Linked to the Dollar 153Commodity Exporters Get Bigger Boost 156Global Decoupling Is a Myth 1 56Rising Yen Threatens Global Stocks 1 58Review of 2004 Intermarket Book 159Summary 161

CHAPTER 8 Market Breadth 163

Measuring Market Breadth with NYSE AD Line 163NYSE AD Line Violates Moving Average Lines 164Advance-Decline Shows Negative Divergence 164Where the Negative Divergences Were Located 166Retail Stocks Start to Underperform During 2007 169Retailers and Homebuilders Were Linked 1 71Consumers are also Squeezed by Rising Oil 173Dow Theory 1 73Transports Don't Confirm Industrial High 1 75Percent of NYSE Stocks above 200-Day Average 175NYSE Bullish Percent Index 1 79Point-and-Figure Version of BPI 181Summary 182

CHAPTER 9 Relative Strength and Rotation 183

Uses of Relative Strength 183Top-Down Analysis 186Relative Strength versus Absolute Performance 187Using Relative Strength between Stocks 190Comparing Gold Stocks to Gold 190How to Spot New Market Leaders 193Where the Money Came from 193Spotting Rotation Back into Large Caps 196

Contents xi

Trend Changes Are Easy to Spot 198

Rotation within Market Sectors 198

Chinese Stocks Lose Leadership Role 200

Summary 202

SECTION FOUR MUTUAL FUNDS AND EXCHANGETRADED FUNDS 205

CHAPTER 10 Sectors and Industry Groups 207

Difference between Sectors and Industry Groups 208

Performance Charts 209

Sector Carpets 211

Using Market Carpet to Find Stock Leaders 212

Industry Group Leader 213

Sector Trends Need to Be Monitored 214

Information on Sectors and Industry Groups 214

Spotting Natural Gas Leadership 215

Natural Gas Components 215

CBOE Volatility (VIX) Index 21 7

Summary 221

CHAPTER 11 Mutual Funds 227

What Works on Mutual Funds 227

Open- versus Closed-End Funds 228

Charting Adjustments on Open-End Funds 228

Blending Fundamental and Technical Data 229

Relative Strength Analysis 229

Traditional and Nontraditional Mutual Funds 229

Keep It Simple 230

200-Day Moving Average and Housing 230

Natural Gas Breakout 232

Consumer Discretionary Breakdown 232

Bear Crossing Sinks Chips 235

Negative ROC Hurts Technology 235

Consumer Staples Hold Up Okay 235

Xii CONTENTS

Retail Ratio Plunges 235Energizing a Portfolio 240Latin America Leads 240Real Estate Is Global 240Profunds Rising Rates Fund 244Profunds Falling U.S. Dollar Fund 244Commodity Mutual Funds 247Inverse Stock Funds 247Summary 250

CHAPTER 12 Exchange-Traded Funds 251

ETFs versus Mutual Funds 252Using ETFs to Hedge 253Using a Bear ETF 253Trading the Nasdaq 100 255Using Sector ETFs 258Inverse Sector ETFs 260Using Technology as a Market Indicator 260Commodity ETFs 263Foreign Currency ETFs 263Bond ETFs 267International ETFs 269Summary 275

Conclusion 279

Why It's Called Visual Investing 279The Media Will Always Tell You Why Later . 279Media Views Keep Shifting 280Visual Analysis Is More User Friendly 280Keep It Simple 280Visual Tools Are Universal 281The Stock Market Leads the Economy 281Prices Lead the Fundamentals 282Sector Investing 282Exchange-Traded Funds 283A Year After the 2007 Top 283Warning Signs were Clearly Visible 284

Contents^ xiii

APPENDIX A Getting Started 285

Find a Good Web Site 285Use the Readers Choice Awards 285StockCharts.com 286ChartSchool 286Online Bookstore 287Investor's Business Daily 288Stock Scans ' 288Bullish Percent Indexes 289DecisionPoint.com 294McClellan Breadth Indicators 294

APPENDIX B Japanese Candlesticks 295

Candlestick Patterns 297Bullish Engulfing Pattern 298Stock Scan Candlestick Patterns 300Recommended Reading 300

APPENDIX C Point-and-Figure Charting 301

Triple and Quadruple Signals 302How to Vary P&F Charts for Sensitivity 304There's No Doubt about P&F Signals 305Recommended Reading 306

Index 307