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Ed. Note - These mailbag articles first appeared on StockCharts.com back in 2000. They are just as valuable now as they were then, so we've added them to our new Mailbag blog. Enjoy!
Q: What does the term "liquidity" mean? Is this the same as overbought/oversold?
A: Liquidity refers to the number of trades (volume) that occur in a stock. The larger the volume, the more liquid a stock is. Liquid stocks are very easy to buy and/or sell. Large Caps are usually very liquid. Small Caps, on the other hand -- especially OTC (over the counter) and BB (bulletin board) stocks -- often have liquidity problems. That means that when you want to sell, there may not be any immediate buyers. The price of the stock may have to change significantly before a trade can occur. This is often a shock to novices, who think that stocks can always be traded at the current price. If they issue a Market order for an illiquid small-cap, the order may be executed at a much different price than they were expecting. Experienced daytraders can often take advantage of these situations. Buyer beware.
- Chip Anderson
Q: How do I go about selecting stocks to invest in? I don't even know where to start!
A: There are thousands of stocks, hundreds of industries, up to 15 sectors and usually just a few broad market indices. A top-down methodology provides the means to narrow the vast array of stocks by starting with the broader market and working down through the sectors and industries to pick stocks.
To begin a top-down approach, you should choose a broad market index that is representative of US economic performance. For many years, the benchmark index for the US market has been the S&P 500 ($SPX). The Nasdaq ($COMPQ), while it may be the most popular index currently, is heavily weighted in technology and would not represent a good cross section of US economy. At the very least, the market assessment should give you an idea of the type of market (bull or bear). A more detailed approach might also determine the stage (early, middle, late).
Once your analysis of the overall market is complete, turn your attention to the various sectors that make up the economy. Depending on who's counting, there are between 8 and 15 sectors represented in the economy. The SPDRs (pronounced spiders) traded on the Amex represent 9 different sectors of the economy.
AMEX Sector SPDRS
- Basic Industries Sector (XLB)
- Consumer Services Sector (XLV)
- Consumer Staples Sector (XLP)
- Cyclicals/Transportation Sector (XLY)
- Energy Sector (XLE)
- Financial Sector (XLF)
- Industrial Sector (XLI)
- Technology Sector (XLK)
- Utilities Sector (XLU)
StockCharts.com also has a sector performance chart that allows for a relative strength comparison among the S&P sectors.
An analysis of the sectors would indicate which were in bull and bear markets, as well as the stage of their potential trend. From the 9 sectors listed above, an analyst might pick the top two for further analysis. Sectors are broad-based and made up of many different industry groups. Sometimes it is necessary to find the top industries with a sector. If we chose technology and finance, there would be the need to narrow further within these sectors. Within the tech sector, there are many high-tech industries including computer software, mainframes, PCs, data storage, fiber-optics and semi-conductors. Within the finance sector there are industries focusing on multi-line insurance, property and casualty insurance, regional banking, investment banking, and stock brokering.
Once the top industries from each sector are chosen, your attention could then turn to individual stock analysis. By narrowing the sector to specific industries, the list of potential stocks becomes much smaller. Instead of the whole tech sector, analysis could focus on software and data storage. Instead of the whole finance sector, analysis could focus on the regional banking and stock broking. From these 4 industry groups, the top 2-3 stocks could be selected to make up part of a portfolio.
- Arthur Hill
Q: What do the terms "reaction lows" and "reaction highs" mean?
A: Reaction highs are minor highs that form within the larger trend. Reaction lows are minor lows in the same capacity. Sometimes these lows or highs can be connected to form a trendline. Other times, they will not match up perfectly.
Support levels (lows) and resistance levels (highs) are sometimes determined by 1 or more reaction lows or highs. Deciding on the importance of each reaction high or low depends on the amount of time spent at that level. For instance, the Dow spent 5 days in early June and 6 days in July at 10,850, indicating that these reaction highs marked an important resistance level. Whereas the 25-Apr reaction high at 11,137 and the 17-May reaction high both formed with just two trading days. While they are legitimate reaction highs, the validity of these as resistance levels may be questionable. You can also see that the reaction lows around 10,350 in May and June formed over a number of trading days, increasing the validity of this support level.
- Arthur Hill
