Stock Market Overview: Isaac newton’s Madness

Look at market in these days to have a general overview about what meant when Isaac Newton said that ” I could calculate the motions of the heavenly bodies, but not the madness of the people”. The S&P 500 which is considered the average of the stock market made new lower low that breaks all other previous lows and was able to retrace back to the top. It wiped all profit that made since the start of the bull move in November 7, 2016, and return back to 2967, which considered the last support before started move to what considers last bull impulse wave before the sharp dropped started in March 18, 2020 ,due to COVID-19 pandemic.

There are many contradictions between experts about the market. Some of which are considering this is a correction phase, while others consider it new bear market, and the media which is no expert in this filed consider this drop just as pump in the road.

There are several factors need to be outlined before decide where is the market going. Some of these factors are based in technical analysis while the other based in fundamental analysis. From technical analysis point of view:

  • The market makes new low and sharp drop in March 18, 2020 until it reached the bottom to 2195 points, which was below SM(200) and broke the last bottom which was in December 24, 2018 which was 2342 points.
  • This bottom was created in just 5 weeks of strong sell-off in the market.
  • After 13 weeks from that bottom, the market failed to reached to the point where all sell-off started, which means that there is high momentum in the down-side, rather than up-side.
  • The market made an Isolated Island which considered a reversal pattern below the last top which created in Feb 19, 2020 which was 3380 points. This isolated Island followed by two strong bearish candle one of which is an engulf with highest volume ever since the start of sell- off, which is a strong indication that the market will resume its down move as shown below:

From fundamental analysis point of view there are also many factors that suggested that the market is either going in sideways or down-trend but never in up-trend, and they are as follow:

  • The leading companies in the S&P 500 index which made the market moved up after its sell-off that started at March 18, 2020 which are ( Microsoft, Apple, Amazon, Facebook, Google, and Johnson & Johnson, UnitedHealth Group Incorporated, Home Depot Inc, NVIDIA Corporation, Adobe Inc) did failed to make new higher (EPS) than the previous quarters. These stocks lead S&P 500 index and went beyond it because they just report a profit, any kind of profit high or low, in time of pandemic as shown below:
Company nameEPS After(Sell off)EPS before (Sell off)
Microsoft1.41.51
Apple2.554.99
Amazon5.016.47
Facebook1.712.56
Google9.8715.35
Johnson & Johnson2.31.88
UnitedHealth Group Incorporated3.723.9
Home Depot Inc2.082.28
NVIDIA Corporation1.81.89
Adobe Inc2.452.27
Source Investing.com

As you can see in the above table, all companies failed to break (EPS) made before the Sell-off except for Johnson & Johnson and Adobe Inc. Even these two companies their EPS reported in time of pandemic still within the average of their EPS for the last four quarters before the Sell-off.

  • Companies such as Visa and MasterCard which their services did not distributed by the pandemic failed to lead the market in this stage and they are moving below S&P 500 index.
  • Netflix the company that should be one of the most companies that generated profit during this pandemic due to the lock-down made by all governments, failed to make an EPS greater than the one before the lock-down.

All these factors (either Technical or Fundamental) suggested that the up-move for the market which started March 24, 2020 is just a pullback for down-trend that started in March 18,2020 and will resume its down movement. Either way for those who already in the market investing in good companies at least from their point of view they don’t need to panic because the market eventually if either went sideways or downtrend will resume its movement to up trend and break 3300 points level and go beyond that.

For those who still have their cash I suggested that they don’t get into market until the following conditions are satisfied:

  • The market need to go down and do not break the last support point which reached in March 23,2020 which was 2195 points, and make new higher low near to that level.
  • Or the market need to go up and break the last high that made in March 19, 2020 which was 3380 points and pullback to it with failing to break it, in down move.
  • Or fluctuate around SM(200) with going up and down two times at minimum in order to make sure it is a correction phase that will end within months or maximum a year before it started moving up.
  • Also companies that suppose to lead the market should provide new (EPS) higher than the previous one in order to validate their up-movement.

Dividend Yield: how to use it to pick good stock

Before I explain the dividend yield, let me explain what is the dividend. The dividend is simply the amount of money that given to stockholder per year for owning stock on profitable company. This ranging from (0.5 $) to (20$) in some big companies. Once the company make profit each year they divided these profit over the number of shares and the result is dividend. Sometimes companies decided to distribute profit for the shareholders, but Some companies rather then distributed these dividend for shareholder, they either pay their debts which is good or make a new expansion by building new branches in order to increase their sales in future which will lead to increase their profit and (EPS) which is also good.

Dividend yield is a simple calculation which is dividing the dividend that the company distributed to shareholders , by the price of the stocks and multiply the result by 100:

Dividend Yield = ( Annual Dividend / Price of Share) * 100

To use this ratio ( dividend yield) to pick a good stocks, the only thing investor need to know is that when ever this ratio is higher than the average of ( 5 years dividend yield) the better is the company for investment. Because that means this stock which is under studying is undervalued and is a good candidate for selection.

To clarify the idea let assume that we have to companies A and B that have the following information:

 AB
Dividend yield5%3.5%
Avg. Dividend yield 5yr2.5%2%
Dividend yield

For investors that looking for undervalued company, they will chose company A over B because company A has higher dividend yield than B.

Note: in each ratio used to find undervalued companies has the price of share in the Denominator, always look for higher values.

Dividend yield can be used as (P/E). in order to end up with perfect company you need to compare it with dividend yield of other companies in the same sector as well as the dividend yield of the sector in general. Whenever you find company that had dividend yield higher than other companies and the sector in general, this company its stock price cheap compared to the profit that your are going to make form that price.

Sales: The leading indicator to pick winning Stocks

Sales is the amount of money that companies received for selling its products and/or services. This money is usually include (cost of products/services + profit ). The cost of products/services can be the raw materials that company used to produce its products/service and human recourse as well as other assets that company had to have in order to produce its products/services and make it available in the market. The profit is the amount of money that company added to the price of products/service that it produced in order to make profit form those items. Once the number or amount of sales has been increased then that the profit will increase and once the profit increase earning per share for the company will increase (EPS). Finally, when (EPS) of company’s share increase it will be under high demand and that will lead to increase in its price which will make it go up, or keep going up if it already was moving in uptrend.

Usually increasing in sales will be leading indicator for increasing in (EPS). Wise investors will screen for stocks that has increasing in its sales for three or more quarters but its (EPS) did not change except for some positive earning. But once the (EPS) of that company which its sales was increasing for a while, jump and increase 75% or 100% or more, then the investor has two indicators tell her that this stock will rise and move in strong bullish up trend, then and only then when the (EPS) increase and confirmed the sales, investors should bet on that company’s stocks and invest in it as long as its sales maintain the same records and (EPS) fluctuate within the range of increment.

Sales is one of the leading fundamental indicators that investors usually use to predict if there will be an increasing in (EPS) for stocks. Once they spot consecutive increasing in sales but no change in (EPS) they start to prepare for investing in that company once they got the green light which is an increase in (EPS).

Also investors can use sales to justify if the increase in (EPS) of company come from its sales or it just come from cutting cost.

Head and Shoulders Pattern: the complete guide

Head and Shoulders is one of the most known and successful pattern in money markets. It always appears where the price is reverse, means that when price move in uptrend and its about to go down, or the other way when price moving in down trend and the price want to reverse to up trend. It also appears in different time frame which means that you might not notice this pattern in daily time frame but when you go deep and search for it in lower time frame such as 4 hours, one hours or may be 15 minutes time frame you will notice it.

First I am going to put a picture for real chart of price movement in one of financial market that has the head and shoulder pattern, and then I am going to explain the philosophy and psychology behind this pattern and its formation and why it is so profitable.

As you can see from the above chart for Apple stock. The stock moved from almost May 2018 at price 141 $ to reach its top in March 2019 which was 230 $. It took the stock just three months or about to reach its starting price which was 141 $ and that after a successful formation of Head and Shoulder pattern. That means if someone was watching this stock closely and found that this pattern formed and short/sell Apple Stock at the right shoulder, she would make in three months as much as the one who bought this stock one year ago.

But in order to master this pattern and know where is the right moment to enter trade like this you have to know the psychology and the other traders emotions that helped the price to move that way and formed this pattern. And here we are:

  • The price moves in regular up trend where its formed higher lows and higher highs as the picture below.
  • The price moved from point 1 going up until it reach a resistance in point 2 and then drop in pull back movement. (as figure below shows)
  • When price reached point 3 which considered as support, price continue its movement upward until it reached point A.
  • When price reached point A it find a resistance there which was stronger than the resistance found in point 2 which made the price dropped in strong move down than the previous one that made price dropped from 2 to 3, and then point B formed which worked as support and helped price to move up.
  • In the price movement from (A to B), the price found strong sell momentum that made it drop strongly than the previous drop from 2 to 3, this momentum can consider as high sell volume but not greater than the volume that made price go up from point 3 to A.
  • Then price which found support in Point B go up slowly to point C, and when I said slowly I mean that this movement lack the momentum and/or high volume. Always this movement has MACD bearish diverging and/or RSI bearish diverging which means that the price in C is higher than A, while the two assigned points for A and C in MACD and/or RSI are going in down trend as shown below.

As you can see in the above figure the price of Apple stock made new high and uptrend while the MACD and RSI were making down-trend, and this is what I meant about bearish diverging which is a good sign but not the only one for Head and shoulder formation.

Back to our pattern explanation:

  • Once the price barley reached point C, it will drop with high momentum and strong volume to reach point D. This high momentum and strong volume helped the price to break the up-trend pattern and formed the first lower low in the pattern which is point D.
  • Once point D is formed, the wise trader who followed the trend will reconsider her positions, and think hard to either keep her position or exit this long position that she entered in point 1. But she still waits for good bargain and good price to sell her share. She does not trust this up trend pattern anymore specially when there was a contradiction in the main principle of uptrend which is forming higher highs and higher lows, and now there was new lower low which formed in point D. Even if she does not know any thing about volume or momentum or how to read it, but she only knew that this contradiction in the price movement that lead to form new lower low does not make her feel right and the market is going to do something else but not going up. At this point this wise trader will decide to exit her long position as I said that she entered in point 1, but she will wait for right moment to exit with maximizing her profit, and that will happen only when price move up and reached point E and failed to go more further than that.
  • At that time she will know that this price is either going to go sideways or down which will be no good for her, and she with other wise traders who think the same way decided to exit their long positions that they entered in point 1 when price reached to point E which is another contradiction for up trend when price formed lower high.
  • The price will reach point D with low volume and low momentum which prove this movement was just a reaction to the previous strong movement that made it drop from C to D. Once those wise trader exit this long move started in point (1) especially after they see price started forming lower highs and lower lows which is a sign for down trend, their exit will combined with the high momentum and volume of sellers who caused the up momentum of previous up-movement from 3 to A and from B to C to fade , and only then the price will drop in strong movement from D to reach the same level that it started with, which was point (1). This is exactly what happened in Apple’s stock movement in the previous figure. 

But how can trader make sure that the head and shoulder pattern has been formed and its good time for trading this pattern and making some money, this is what I am going to show in the coming points:

  1. First of all, the trader must make sure that the pattern has been formed and satisfied the following point with accuracy not less than 90% or more, if it is less than that she must not enter this trade as head and shoulder pattern formation. And these points are as following:
  2. The price should go down to point B in strong move, stronger than the movement that made it stop in point 3.As shown in the previous figure.
  3. The movement that took price up after that to pint C should be equal or less stronger than the previous movement that took price down to point B. That means the bearish has a strong power that equal to or greater than the bullish which made strong believe that they are able to take the price down.
  4. To make sure that point 3 is satisfied the next down movement for the price will make new support point which is lower than the support in point B, which is D and this point will make sure that those traders will have confusing and the long position they entered is no more valid and they should re-consider their position by exit it and take their profit.
  5. Those long traders who decided to exit their long positions will hold those position to get the maximum profit by waiting until the price reach point E. The price movement to point E will have lower and weak movement compared to movement from point C to D which means the price moved as consolidation or reaction to the bearish movement and the bearish just resting and willing to take the price down again to make new lows.
  6. Once the price barley reached point E with low momentum and weak volume the bearish will took the control and drive the price down again and the price will be ready to broke all down levels and reached to the place where all this was starting to the beginning of this up movement.

Here is some other considerations about point ( A, E) which consider the two shoulders of this pattern as well as points (B,D) which consider the Nick-line for this pattern:

  1. Point E (right shoulder) should reach the same level as point A (left Shoulder) which means that point A should work as Resistance for point E and prevent it from going higher than this level, and its totally recommended to have down trend between these two points. (as shown below between left and right shoulders).
  2. The same is true for point B and D, it’s totally recommended to have down trend between these two points as shown in the figure below:

Finally, head and shoulders is not that famous pattern as other patterns, but once this pattern started forming, trader should pay clear attention to it to make sure its completed all its characteristic explained above, because it will be completely profitable for traders of all markets types. This pattern can be found in revers way which called “Revers head and shoulders” pattern which make markets reversing from down-trend to up-trend. The same principle applied in head and shoulders pattern can be applied in Reverse head and shoulders pattern but instead of sellers taking controls in head and shoulders pattern, the buyers will take the control and will take the price from low prices to more higher prices in revers head and shoulders pattern.

P/E Ratio, the true story

A lot of investors specially those who called value investors love (P/E) ratio. They believe that whenever this ratio is below certain number which let say 10, it will be a good opportunity to pick a stock and invest on it, and the opposite is true once they found that this number is above 17 or 20 it will be an expensive stock and they will prefer not to invest in it and look for some other stocks.

Let me challenge this idea and provide you with two stocks for two different companies where, the first of which the P/E was below 10 and the stock was not good investment and the second of which the P/E was above 15 or higher than that and the stocks keep going up.

  • Dell Tech, its P/E= (9.75) and its stock dropped from 67 $ to 49 $ and its keep dropping.
  • Apple Inc, its P/E = (26.4) and its stock keep going up from below 200 $ per share up to 312 $ per share and above.

Investors should read this ratio or financial indicators the way it should. It is simply divided the price of stock on its earning and provide a value. This value increase when the price increase and decrease when the earning increase which is simple math. This ratio measure how much investor should pay for higher return or earning. Once he/she found the ratio is high that means price is higher to received earning which consider an overvalued investment, on the other hand when the ratio is small that means the price is low compared to the earning which consider an undervalued investment and good opportunity for investment.

But the question is what if the market is going up and there are some companies has low (P/E) ratio. What does that told us. It means that those companies are still struggling to make money and their stocks did not worth demand form investors which will lead to decrease in stocks prices and end up with low (P/E) ratio.

Another case where the (P/E) can misguided investors is where the market going through correction phase and investors come cross some company where its (P/E) ratio has not changed for long time and they think that this company is becoming undervalued since its (P/E) ratio has low value, and when the market finished its correction phase and start going up those investors notice those stocks they bought did not move with market and once the market become moving very fast upward those stocks barley move in up trend which was only a reaction to the market movement. And once something wrong happen that affect the market negatively those stocks will not stand that and will be the first to drop. That when those investors realize that they bet in the wrong horse by using the formula which supposed to be number one in picking the undervalued stocks.

(P/E) ratio was really the most valuable indicator that used by investors but that when they were checking the price in daily or weekly basis in newspaper but not after the internet ear and so many users can engage in millions of transaction in a day in stock market.

So the question now is what can investors do in order to use this indicators correctly and avoid been invested in bad companies which they are maybe about to bankrupted?

In order to use this ratio correctly and avoid been trapped in bad company’s stock you have to use it the way it should be which are as below:

  1. First investor should list the companies that have high earning in ascending order started from low earning companies to the high earning companies. Like for example if you have three companies A,B and C and their earning per share is A = 3, B = 2 and C = 5 , you should list them as below:
    • B = 2
    • A = 3
    • C = 5
  2. These earnings should be better than the last quarter earning, which mean there should be an improvement in earning from last quarter by at least 75% because you know that earning is what matter.
  3. Let us assume that the stocks prices for each company above as below:
    • A = 20 $
    • B = 27 $
    • C = 35 $
  4. The (P/E) ratio for all above companies are as followed
    • A = 10
    • B = 9
    • C = 7
  5. Based in (P/E) ratio and how to choose the best undervalued company. Company C has lower ratio that is (7) even though its stock price is the highest price among other. That means the best minimum price investors can pay for high return is going to company C.
  6. That is not all. Investor now should compare (P/E) ratio of company C to the Sector that it belong to. If (P/E) of company C is equal to or higher than the sector (P/E) ratio that means C is one of the leading company on that sector and they should invest in it. But if C’s (P/E) ratio is way below the sector (P/E) ratio investors should know that this company is lagging company on that sector and they either should ignore this investment or wait until next quarter to see if there is an increment in company C (P/E) ratio to reach at least 9 with both increase in price and earning then they can invest in this company.

This is the right way for investors who want to use this ratio. They should use it as comparison tool between good companies which has improvement in earning, and they also should use it to indicate if the company they are about to invest in is leading company in that sector or lagging one. Also investors need to ignore this ratio or tool and never think to use it in bull market because once it used in any bull market whomever use it will end up with a company that struggle between a lot of success companies, which might be the start of this company to vanish from market.