Our research and portfolio management methodologies are rooted in analyzing price movement to determine trend and relative strength. The trending piece gives us insight into the direction of price movement for a given security (higher or lower); the relative strength component allows us to gain perspective on the potential performance relative to other securities (under or over performance). Although it is difficult to say that one of these aspects is more important than the other, it is important to realize their strengths and shortcomings.
One of the most important things to recognize is that a relative strength strategy can only be as good as its underlying components. That is to say, if the universe/sector you are measuring is weak, relative strength will put you in the strongest of the weak, but can't help you outperform other sectors or the market in general. It is for this reason that we often defer to trending characteristics during volatile or correcting markets, because the trend will help you determine if you are more likely to see lower prices or higher prices going forward.
The primary tool that we use to determine trend and relative strength is that of the Point & Figure chart. The Point & Figure chart is simply a logical, sensible, organized way of recording supply and demand in any security. It answers the question of when to buy and sell. Charts are updated daily utilizing the high or low price for the day. Each column must have at least 3 X’s or 3 O’s, and the columns alternate.
A rising series of X’s and O’s (as seen in the chart above) tells us that demand is getting stronger and supply is getting weaker. That is what we want to see in stocks, ETFs and funds that we own. You’ll also notice two diagonal lines – red and blue. The blue line is called the Bearish Resistance Line which I like to refer to as I-75 South. As long as the price is below the blue line, its “trend” is negative. Conversely, the red line is the Bullish Support Line or I-75 North. As long as the price is above the red line, its “trend” is positive and I consider it a solid citizen. The trend is the first thing we look at when analyzing a PnF chart for any security.
As one would expect, there are many rules for constructing a PnF chart for a security. Also, there are numerous patterns that PnF charts exhibit. These rules and patterns require a more detailed analysis well beyond this “basics” commentary. We will return to conduct a deeper dive into PnF charts occasionally. In the meantime, please be assured that we are following relevant PnF charts, and many others, each trading day.
Until next time, cheers!