TSM Investment / Trading Lessons

    Slide 1

In this video, the 3rd in the TSM series, I want to talk about how quality TSM stocks are most likely to advance over time.

As you might imagine, no matter how good the stock is its price doesn’t just go straight up like the red line. 

The reason: at some point, those that own the stock begin to worry about its rise and then begin taking profits, and as soon as they do, price begins to fall or tread water just moving sideways.  The real world is more like the blue line for a quality, TSM stock.

From A to B, price has moved sideways towards its rising 20-day moving average, as price consolidates after its recent gain.  As the two come together, the stock regains its bullish run to point C where stock owners then begin to take profits and that selling pressure causes the price to drop to D where the process begins over again, tracing out the E and F pullback.

Over time, price makes a series of higher highs and higher valleys with their turn points often supported by past highs and lows (not shown here), by major moving averages (20, 50 or 200), by the common Fibonacci ratios (something we’ll talk more about).  Buyers are looking for opportunities to enter the stock, and these are well known entry points.

If you want to hold the stock over time, each new valley or sideways consolidation presents a natural place for stop placement, as shown by the blue boxes, which rises as new valleys are traced out.

Statistical studies, mine as well as others, show that one will have greater profit opportunities buying stocks in pullback rather than buying stocks at their breakout, and that’s the basis for the TripleScreenMethod’s technical approach. 

For example, in a study that I did in 2004 tracking 36 TSM stocks over a total of 10,584 trading days, buying a 21 day low returned 2.59% after 5 days, while buying a 21 day high returned only 1.38% - both profitable but the pullback significantly more so.

Let’s talk a little more about pullbacks before we look at a couple of charts as examples.

  Slide 2

Some time ago, I conducted an experiment.  I showed 121 traders this chart (absent the percentages of course) after telling them that this was a strong, TSM stock that had just begun its pullback.  There was likely nothing wrong with the company.  This was just the normal pullback one often sees that occurs because of profit taking.

I then asked them this question:  where do you think this stock will reverse its pullback course and restart its bullish run?  Each one of the horizontal hashes was then labeled with a letter (A – H)? 

The percentages are their responses.  77.4% of this group chose the three hashes highlighted.  What’s interesting is that these three hashes are the standard Fibonacci pullback ratios.  That’s where this group would step in and buy shares.  Fib ratios result from a special sequence of numbers, which I’ll show in a minute.  They are important in nature, in architecture, in the arts and, it turns out, in the stock market.  It’s not so much that they have some sort of magical powers, other than being aesthetically pleasing, it’s just that institutional buyers know about them too, and that’s where they are most likely to step in to buy a quality stock in pullback mode.

Let me show you a little more about Fib numbers and their ratios before showing you how they impact our stock charts.

Slide 3

Fibonacci numbers are a special, but simple, sequence of numbers.  The first 22 are shown in column 2.  The sequence starts with two ones then from there each new number in the sequence is formed by adding the last two:  1+1=2, 1+2=3, 2+3=5, 3+5=8, and so on.  Simple sequence but one with some very special properties in a lot of different areas.

Let’s look at some of their special ratios.  If you divide two adjacent members in the sequence, the smaller one into the larger one, the ratio becomes 0.618 (21/34) by the 9th Fib number; if you skip a number, that ratio becomes 0.382 (13/34) and if you skip two, the ratio becomes 0.236 (13/55).  Subtract these ratios from 1 and 0.764 is added to the list of important Fib numbers that you’ll find in many charting programs.  For stocks in pullback, the important Fib ratios are 61.8%, 50% (mid way between 61.8% and 38.2%) and 38.2%.

The “Golden Ratio,” a very special ratio, is formed by dividing a Fib number by the  one that preceded it (55/34).  Geometrically, this represents a line segment’s division point where the length of a line (A) divided by its long segment (B) exactly equals the long segment length (B) divided by its short segment length (C). Both equal 1.618, the Golden Ratio.

Instead of a line segment, if we divided a rectangle similarly, this golden ratio would be aesthetically pleasing and one that highlights its point of focus at the Golden Ratio; hence, it’s often used in architecting and in the arts to stress focal points.

  Slide 4

Let’s look at a few examples in nature, one in art and another in architecture (the dimensions of the Eiffel Tower).

Nature’s spiral adds Fib number sized squares as shown overlain on the shell where their diagonals have been  connected:  1, 1, 2, 3, 5, 8, 13 – the Fibonacci sequence.

Pine cones viewed from the bottom show two sets of spirals:  13 in one direction, 8 in the other – both Fib numbers.

The number of petals for many flowers is again a Fib number: here, the Black Eyed Susan has 13 petals – again a Fib number

These are just a few examples.  Fib numbers are used throughout nature because they represent an efficient way to pack structures.

The relative dimensions shown for the Eiffel tower with its Golden Ratio overlay shows the intermediate level as a focal point of the structure by design. The whole structure becomes more aesthetically pleasing as a result of these proportions.

Similarly, by design, there are many rectangles with their respective Golden Ratios used in da Vinci’s The Last Supper to control different focal points.  Note too, it depicts Jesus and his 12 Disciples (13 again a Fib number).

Such Fib numbers and ratios are found in lots of places.  They guide us to focal points in paintings, are aesthetically pleasing in architecture and these same paintings, and they are optimal packing arrangements in nature.  Now let’s see how they influence pullbacks in our stock charts.

  Slide 5

Now Let’s look at the chart of MNK.

First, its general shape: 

   - From point A to B, MNK was in a period of consolidation and was range bound for several months;

   - Then an earnings report drove price higher to C, where it spent another month and a half in consolidation, as price moved along its 20-day moving average and approached its

      50-day average;

   - Note, the black rectangles, which mark natural areas for stops, identify areas that should not be violated if the stock remained bullish;

   - Finally, at D, price broke higher in what’s commonly known as a break-out gap to point E which marks the point where price began to pullback;

   - Note too, the stop could be raised again, as MNK continued to make higher highs in both its peaks and its valleys;

   - Price consolidated again for about half a month when it broke away in another earnings related gap, moving higher to G;

   - From G, price pulled back to I making a short recovery at H where another stop could be set;

   - The pullback to “I” would likely have violated the stop at H and forced one to exit the position; 

   - From I, price resumed its bullish run to J where it began another pullback to K.

    Points of Interest in this chart:

  -  Strong TSM stocks usually alternate between bullish runs and periods of gain consolidation or pullback;  these are normal for strong stocks;

  -  The higher highs and higher valleys enable you to control risk with a stop loss strategy so long as the stock continues its bullish run; when the stock turns over, these stops are

      violated and the position exited;

  I prefer to enter a position at the valley of a pullback as opposed to a breakout from consolidation because the risk control is better; with regard to pullback expectations, let’s talk about gaps and Fibonacci levels;

Gaps as shown at point D and F are natural areas of support; frequently price will fall back and test the gap (both at its top and at its bottom); F is an example of price falling back to the top of the gap, as is H, while I is an example of falling back to the bottom of the earlier earning’s gap;

Two sets of Fib ratios are shown”

Connecting the low of point F with the high at point G defines a distance; Fib percentages likely areas of support;

     -  In the pullback from G, the 38.2% Fib level offers support, then at H price temporarily bounces higher before falling to the support of its 50% and then to its 61.8% Fib levels

         of support;

     -  Similarly, defining the climb between the low at Point I and the high at point J, again the 38.2% Fib level has offered support and continues to do so as I write this.

In summary, then, good stocks pullback. They find spring board-like recoverys at the support of Gaps, prior highs and lows and at the common Fig levels.

  Slide 6