When is a stock price considered value? - A case study in BHP.

For the majority of investors, the share price of a company is the standard at which they will value it's worth. The casual investor will flick through the paper and see a BHP or Rio Tinto at a certain price and instantly create an opinion based on history that the company is booming, struggling or even headed for collapse. They may say I remember when it was twice that price or they must be doing something right. Then there are the investors that will do a little more research, check some fundamentals, check the chart looks positive, read the news and hope the best the stock starts to climb higher. The traders that really succeed are those that can identify how the market cycles work and where value lies on the chart. I hear so many stories that a person buys a stock and instantly it falls and continues to do so until they decide enough is enough and they dump it. I hope this article will make you look at charts a little different and even improve your entries, as getting this right can take a lot of risk off the table and make managing trades a whole lot easier.

There are three laws that govern price movement of a stock. The laws of supply and demand, effort versus result and the final law of cause and effect. The most important of the three is the law of cause and effect when trying to establish value. The law simply put means for there to be an effect on price there first needs to have a cause created. The cause in this case is accumulation and distribution of a stock. If we can establish where large institutions are accumulating stock, we can determine where a stock is considered cheap or has a high probability of being worth a lot more in the future. If we can establish where large institutions are selling or distributing stock, we will have established where a stock is overvalued or our take profit area. Once accumulation or distribution has taken place, the balance of supply and demand becomes heavily one sided and the price will either move up or down creating momentum for a stock to trend.

If we look at a point and figure chart below for BHP, the accumulation and distribution areas are a lot more visible as all the noise is simplified. The noise is referred to all the small price movements that can make a chart look cluttered. The point and figure chart is made up of columns of "X"'s (up movements) and "O"'s (down movements). Each time the stock moves up a certain amount (box size) we add another X, and in this case that is 20c increments. We only start a new column of O's if the stock reverses a certain number of boxes and three is the most popular. So if the stock reverses 60c we would put 3 O's in the new column and if the stock kept falling we would keep adding a new "O" every 20c. The new column of X's would start if we reversed 60c higher, and the chart continues to form in this way. Theoretically if a stock continued to move within a range and did not reverse by more than 60c, you would have no need to create a new column and months of trading could be confined to 1 column. In reality this doesn't happen, but point and figure charts can be great for simplifying a chart.

If we look at item A on the chart, we see price appears to have been trading in a range with a base being formed. Accumulation is normally carried out over time in a narrow trading range, where price can be moved up and down allowing stock to be bought without tipping off the trading public that may lead price to rally prematurely before the supply has been fully taken out of the market. The one exception to this is when accumulation takes place over a few days or even one day if the news is so bad that the public dump the stock on fear and panic selling, and will normally lead to an over reaction. The smart investors will acquire as much as possible if they think the stock is fundamentally sound and will be able to recover from this minor set back. This happened with Qantas in June 2012, with record volumes sold and picked up by professionals, and the stock would rally from $1 to $1.90 over the next 10 months. The day of the panic would ultimately be the bottom of the downtrend and the day that most retail investors sold out only to watch it rally hard.

Point and figure charts will also allow a projection of price calculated by multiplying the base number of columns by the reversal amount. So in the case of Item A we see 9 columns (we do not count the breakout column of X's) by the reversal amount of 60c which gives us a $5.40 move higher. This is added to the last point of support (normally the low of the column of O's before the breakout), but a conservative calculation can also be made from the low of the whole pattern giving a range.  For these examples I have used the calculation from the last point of support. If we study the chart we can see how BHP was accumulated at Item A, re-accumulated at B, before being distributed at item C. The stock was also accumulated in D and G and distributed in E and F.

So how do we find value? To find value we have to first establish that the projection higher or lower has been accomplished, secondly that price is in an area of the chart where accumulation or distribution should take place and thirdly that we observe demand for higher prices or supply and lack of demand leading to lower prices. I will show you examples of areas of value for those looking to buy and those investors looking to short.

If we study the chart below, and assume that we have missed the majority of the move from July 2012 and are now open to the idea that the stock may be over valued and we are looking to short it. Once price moves higher out of the accumulation area in June-August 2012, we are able to construct a parallel trend channel by using two lows and an intermediate high. When price reaches our projection target of $38.58 (from the previous chart), we know the accumulation below and mark up has been accomplished. There are also further indications of shorting value as we notice that we have now seen two areas of the chart where the upper trend line (supply line) has been broken and the stock is overbought, there is a shortening of the upward thrust, there are signs of distribution taking place (supply) and we are also at a resistance level of October/November 2011.  The aggressive signal to short is item A where we see a large rejection bar with very little result (poor low close) from effort to push higher (increased volume and spread). The conservative short is item B where price had fallen heavily and tried to rally only to see low volume and a lack of demand for higher prices. The day in question was a small spread and the lowest volume for 15 sessions. If we look back at the point and figure chart we had a downside target of $31.70 (price fell as low as $30.58), with an entry of somewhere in the $38-$39 area, this was definitely an area of shorting value.

If we study the chart below and have taken profit after a great short, we would be looking to see if any buying or demand enters the market. We notice the stock price rally (April/May) and then pulls back into the same area in June/July. We have now seen price rally twice from this area and would now look for strength to return at this level again. If we look at the point and figure chart, the downside target of $30.81 has now been hit (at item G - P&F chart), and we look to see evidence of buying in this possible value area. We see a rejection off a key level on June 25, with a rather large increase in volume, wide spread, closing in the middle and very little downward result from effort. We may be witnessing demand off the bottom here. Three days later there is an ultra high volume bar on a very narrow spread, closing in the middle and price fails to fall lower over the next few days. We can now make a very low risk judgement that this is hidden buying. Price breaks the supply line and we see price rally nicely over the next 3 days with expanding volume and confirmation of the hidden buying is complete. The aggressive trader would have taken the close of the first breakout demand bar at $31.61, the conservative two days later at $32.84. If a stop was placed below the rejection bar at $30.43, this would have been a low risk entry bought in a definite area of value.

The most important decision a trader or investor will make is their entry. If they are successful in finding an entry that is of value, they will soon be in profit and they will find that the trade is a lot more manageable when playing from in front. If you have a poor entry and find yourself losing money from the get go, psychology will enter the game and when a trader is not thinking straight, mistakes are sure to follow. The buy and hold strategy can work over time, but why not get the best possible entry each and every time by analysing the chart and finding value in companies.

By Mathew McCullagh.