Most of the time stocks with strong fundamentals will not be undervalued. However, bad news may affect these companies and the stock price starts to fall and becomes a good opportunity for the value investor.
BUT, how to you know when is a good time to buy when prices are falling? When is a price that is low enough?
Fundamental Analysis determines Value, but not Price Low
You may have studied the fundamentals of a company and determined the value to be $2. The stock price has since fallen from $2.50 to $1.50. Based on valuation, it is definitely cheap to buy. You may have an entry rule such that you would buy the stock at 25% discount as the margin of safety. At $1.50, the stock is indeed at 25% discount to its value of $2. Unfortunately, However, the stock price continue to go down after you have entered a position. This is fine to those seasoned value investors who’s long term gain would dwarf the recent price drop. However, most retail investors will feel very frustrated naturally.
Technical Analysis can determine Price Low
Technical Analysis (TA) can augment Fundamental Analysis (FA) to enhance profits by allowing the value investor to enter at a good price. TA is good for observing the greed and fear in the market and the struggle to power between the bulls and bears. Let’s talk about a few useful reversal patterns that would help the value investor identify a possible entry point.
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1. Accelerated Price Decline
Alex wrote about selling climax in this article where he used gold as an example. During a strong price decline or selling climax, it is usually a possible sign of reversal. What goes down sharply should rebound strongly too. Hence, during a downtrend of a strong fundamental stock, watch out for this selling climax and be ready to enter AFTER the rebound has started.
Dr Alexander Elder is a famous advocate for divergence trading. I have attended his seminar in 2012 and the notes are put up in this article. A value investor can use an indicator such as the Moving Average Convergence Divergence (MACD) to check the strength of a downtrend. See the chart below: the price goes lower from Point 1 to Point 2, but the MACD went higher from Point 3 to Point 4. This is described as a divergence and it is likely the downtrend has weakened and a rebound is possible. Again, only buy after the rebound has started.
3. Candlestick Reversal Pattern
Another possible entry point would be to look for a candlestick pattern called ‘hammer’. It has a slim body (open price and closing price are close to each other) and a long tail (highest price and lowest price are very far apart). Look at the chart below to see what a hammer looks like. If price can go above the high of the hammer candle, the trend is likely to reverse. A hammer is formed when there has been selling pressure throughout the day (or week, or the time-frame you are looking at) and price went lower. However, the price recovered and close near the open price when more buyers came in. This means there are more buying interest than selling interest, especially at the lowest price.
Two of the three reversal signs can happen together and improve the probability of success. It is rare to see all three signs happening together though.
The stock market is priced by the collective greed and fear of investors. While FA is good for valuing companies and determine if a good stock is trading at a discount, it cannot measure the degree of greed and fear. In other words, what seems to be undervalued by FA can go even cheaper. This gap in FA can well be covered by applying some TA techniques as described above. This will help enhance the profits for the value investor.