The following investment feature by Rufus Mwanyasi was first published in the Business Daily.
Will this stock rise or fall? Should I buy or sell? Traders use multiple tools to find answers to these questions. Many tie themselves in knots trying to choose between pattern recognition, fundamental analysis, market and sector indicators among others.
No one can know everything about the markets. You have to find a niche that attracts you and specialise in it.
In this article, I focus on two related patterns; accumulation and distribution patterns which basically seek to detect divergence in strength and/or weakness of a particular stock compared to the overall market.
Accumulation can best be described as when there is strong professional buying while distribution occurs when professionals are aggressively selling.
To detect accumulation, we look for bullish divergences between the market itself and the stock we are attempting to analyse. Bullish divergence can best be seen when a stock fails to be as severely affected by selling pressures as the broad market.
Another way of putting this is that a stock exhibits accumulation when it does not match the market’s downward moves. Instead, the stock holds up better than the averages on market down moves and rallies stronger on market rallies.
Notice in example one, the NSE20 index repeatedly declined to new lows, hop-stepping down. However the stock, Williamson Tea, not only failed to move to progressively lower prices, it actually found support in its intermediate-term lows while the market fell below its corresponding points.
This is a sign of extremely strong accumulation. The holders of this stock show that they did not panic inside a very weak market. They held onto their stock even though the market was taking a clobbering.
Clearly, new buyers were willing to come in and hold up the existing price structure. In short, while most other stocks were declining, someone, somewhere, had bullish convictions strong enough to step in and buy this stock regardless of overall market conditions.
In case, you haven’t guessed it, the distribution pattern is just the reverse of the accumulation pattern. What you should be looking for here is a stock that has consistently underperformed the market.
The most apparent example would be a stock that has failed to rally to a new high while the market has moved to a new rally high.
Looking at the chart two, notice that while index stocks were able to appreciate in value, Mumias did not. Selling was coming in at a time of overall market bullishness. Certainly, we could not ask for better signs of professional selling or distribution.
So, in a classic distribution pattern we will see the market move up to a new rally high, while a stock under professional distribution will fail to make the same new high.
The extent to which it falls below this new high gives us an indication of how aggressive the distribution is.
So, how do we make money using these patterns? This will require the use of a combination of stock selection and market timing. You can begin working on the first part— stock selection—by scanning all the stocks you trade, to pre-screen and select the strong and weak stocks.