The Visual

Investor
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? 1

Fund Categories 2
Global Funds 2
Investors Need to Be Better Informed 3
Benefits of Visual Investing 3
Structure of the Book 3

CHAPTER 1 What Is Visual Investing? 5

Why Market Analysis? 5

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

Timing Is Everything 13
Summary 13

CHAPTER 2 The Trend Is Your Friend 15

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

CHAPTER 3 Pictures That Tell a Story 41

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

SECTION TWO INDICATORS 73

CHAPTER 4 Your Best Friend in a Trend 75

Two Classes of Indicators 75

The Moving Average 76
The Simple Average 76
Contents - ix

Weighting the Average or Smoothing It? 77

Moving Average Lengths 77
Moving Average Combinations 78
Summary 95

CHAPTER 5 Is It Overbought or Oversold? »7

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

CHAPTER 6 How to Have the Best of Both Worlds 121

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

SECTION THREE Linkage 137

CHAPTER 7 Market Linkage 139

The Asset Allocation Process 140

The Relative Strength Ratio 142
2002 Shift from Paper to Hard Assets 142
Commodity/Bond Ratio also Turned up 144
Turns in the Bond/Stock Ratio 144
X CONTENTS

2007 Ratio Shifts Back to Bonds 147

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

CHAPTER 8 Market Breadth 163

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

CHAPTER 9 Relative Strength and Rotation 183

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

TRADED 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 235

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

CHAPTER 12 Exchange-Traded Funds 251

ETFs versus Mutual Funds 252

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

Conclusion 279

Why It's Called Visual Investing 279

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

APPENDIX A Getting Started 285

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

APPENDIX B Japanese Candlesticks 295

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

APPENDIX C Point-and-Figure Charting 301

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

Index 307