A simple way to spot ‘buys’

By Harry Domash

Fundamentally inclined investors mostly avoid looking at stock price charts, considering the art of charting or technical analysis something akin to witchcraft.

Banish that thought.

Making money in the stock market is harder than it looks, and it pays to take advantage of all available tools. Analyzing price charts can help all investors make better buy and sell decisions.

For instance, say you've spent days researching Company A and based on your analysis, buying its stock will be your ticket to early retirement. But unbeknownst to you, everything is in turmoil inside the company's executive suite.

Company A's top execs recently learned that Company B is about to introduce a new gizmo that works better and is cheaper than Company A's major product. While that news hasn't formally reached the Street, suppliers, salespeople, and in-the-know investors are busy dumping Company A's stock.

Now turn that situation around and suppose that you were researching Company B. Naturally, the same folks who are dumping Company A are probably loading up on Company B's shares.

Company A and Company B's price action would be your only clue pointing to the upcoming news that would dramatically change each company's prospects in the eyes of investors.

Here's the good news. Mining that news from the charts doesn't require spending months learning arcane lingo. Often, a quick glance at a price chart, either by itself or with the addition of readily available moving averages, is all you need. First some background.

Charting 101

Analyzing stock charts starts with the supposition that stock prices tend to move in trends. For instance, a stock price that is generally moving higher is said to be in an uptrend. Stocks moving relentlessly lower are in downtrends. Stocks that are bouncing around without any visible long-term direction are in consolidation, or no trend.

Nothing is for sure in the stock market, but my own experience, plus tons of other research, shows that uptrending stocks tend to continue moving higher and downtrending stocks more often than not continue their descent.

2 rules to live by

So that boils down to two simple rules for fundamental growth investors:

• Only buy stocks in uptrends

• Sell stocks in serious downtrends

(These rules do not apply to value investors, who look for stocks that growth investors wouldn't touch. I'll cover chart reading for value investors in another column.)

How can you tell which way a stock is trending?

You can get a pretty good idea by simply looking at a one-year price chart. From any stock quote in MSN Money, click on Charts on the left-hand side of the page. Under the chart tab, click Price History. Under the Period tab, click 1-Yr. (For a look at the current price chart of GE, click here)

A stock is probably in an uptrend if its price on the right-hand side of the chart is substantially higher than the price on the left side. Conversely, it's probably in a downtrend if its price on the right side is lower than the price on the left. These are generalizations of course; a trend can end at any time. A stock in an uptrend for the first six months of the chart could have reversed course and be in a downtrend now.

Guess who is your worst enemy?

A problem with simple visual chart inspection is that it's subject to interpretation. One person's consolidation could be another's uptrend.

Worse, you can be your worst enemy, seeing hope in a downtrending price chart because you've already invested time and energy doing your research and you want to buy the stock. Or, you may already own the stock and are looking for an excuse to procrastinate selling a loser.

Using moving averages takes subjectivity out of the equation.

Moving averages to the rescue

Moving averages are a type of technical indicator, meaning that they are calculated based on a formula using historical price data. Moving averages are the simplest and also the most widely followed technical indicators. In fact, many investors who say they don't believe in technical analysis still look at moving averages. A moving average is the average closing price over a specified period of time. For instance, the 50-day moving average (MA) is the average closing price for the last 50 market days.

To see the moving averages when looking at a price chart, use the "Analysis" dropdown menu to select the 50- and 200-day MAs.

Most pros consider a stock in an uptrend if it's above its moving average and in a downtrend if below. The distance between the stock price and its moving average reflects the trend strength. The further the stock price above or below its MA, the stronger the trend. A stock price crisscrossing its MA is usually not trending, that is, it is consolidating.

The most widely used moving averages are the 50- and 200-day MAs. The definition of short- and long-term depends on your perspective. But for fundamental investors (opposed to short-term traders), the 200-day MA reflects the long-term trend, and the 50-day MA, a short-term trend.

Stocks trading above both MAs are in both short- and long-term uptrends. Stocks trading below their 50-day MA, but above their 200-day MA may be in a short-term downtrend of a long-term uptrend, in other words a "dip." Unfortunately, and this is why understanding a company's fundamental outlook is so important, that same condition could also signal the start of a long-term downtrend.

When to buy and sell

Assuming you've done your fundamental homework, it's OK for growth investors to buy a stock trading above its 200-day MA, but to avoid the problem I just mentioned, it's better to buy when it's above its 50-day MA, as well. The ideal time to buy is when it's coming out of a dip, that is, its stock price is above its 200-day MA and has just recently moved above its 50-day MA. Growth investors should never buy stocks trading below their 200-day MAs.

If you already hold a stock, a dip below its 50-day MA is a warning to be on the lookout for bad news, but it isn't a sell signal. Most stocks in long-term uptrends occasionally dip below their 50-day MAs. However, any move below the 200-day MA is a sell signal.

Moving averages alone are not the Holy Grail. But combining them with careful fundamental analysis will make you a better investor.

At the time of publication, Harry Domash did not own or control positions in any of the stocks mentioned in this article. Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. Harry has two investing books out, the most recent being "Fire Your Stock Analyst," published by Financial Times Prentice Hall.