The following demonstration illustrates how having a disciplined approach to the application of price analysis can alert you in advance of an impending decline. This article was prepared on 1 August 2011 and therefore you are seeing firsthand how powerful the analysis can be without the benefit of hindsight. Whilst the stocks in this article have so far unfolded as expected, with more time having passed, the current analysis suggests a retest of recent lows is now probable. Let’s take a look back in time…

Australia’s Big Four Banks are among the most widely held stocks on our market, and as such they draw a lot of media attention, particularly around reporting season.  Why is that the case?

Back in the 90’s when the government undertook a massive privatisation of CBA, many retail investors bought these shares and have since taken a ‘buy and hold’ approach.  They were also told by the financial industry that to properly diversify they needed a bank in their portfolio, hence why many retail investors have at least one bank, and sadly, a stock like Telstra tucked under their pillow.

If the goal of your portfolio is capital growth rather than income from dividends, then I would argue that a strategy of ‘buy and hold’ will not necessarily get the best result out of the Big Four. Let me explain…

Looking at the top 20 stocks in the ASX over a 12 year period, between January 1999 and December 2010, the Big Four were in the bottom half as far as generating capital growth. The worst performer was NAB, which recorded an average annual capital gain of -0.33% over the twelve years. Whilst I acknowledge that the banks all appreciate over time, I propose that a higher level of growth can be achieved if these stocks are traded when the time is right. So, when is that time and how do I asses it?

One way is to follow what is referred to as the Top Down approach, where you begin by considering what the overall market is doing before moving down to smaller segments of the market and then the individual stocks within each sector. In this case, after looking at the market, we would analyse the performance of the Financial sector (ASX code XFJ), as it represents the performance of all stocks within this sector, including the banks.  

Notice on the XFJ chart below how the index has been struggling to move higher and appears to have been locked in a holding pattern for around 12 months above 50% of the All Time High (ATH at A), and below 50% of the range AB at 5,040.85 points. As the banks weigh heavily in this index their charts may look similar to the XFJ at times. What the chart really shows is how this sector is not generating growth for portfolios and, in my opinion, needs to trade back above 4,643 points before confirming it is more likely to rise than fall. That said the chart indicates the sector is heading down and therefore, failing a strong rise back above at least the 4,200 point level, the XFJ is more likely to continue down to around 3,800 points.

(Click image to enlarge)

Now let’s continue with the top down approach by looking at the Big Four, and as you will see below it’s no surprise that these stocks have been moving sideways.

ANZ:

The chart below shows how ANZ has battled resistance at around $24.00 and $25.00 for some time. Notice how it traded above the $25.00 level on four occasions (marked 1,2,3,4); once in 2009, twice in 2010 and more recently in February this year. ANZ then made a final attempt at breaking through this level before falling away to confirm a new downtrend is in place. Given that price support at around $22.00 has been broken, the probability has increased for a further decline this year to an important level of support between $19.00 and $20.00. As the trend line shown is likely to provide resistance and act like a ceiling on the share price over at least the short term, now is not the time to be long ANZ.

CBA:

The last time I talked about CBA in this newsletter was in March 2011 whilst discussing company floats. Since then the stock confirmed an uptrend, from the low at A to the high at B. This rise saw price break through resistance at around $53.00, however, instead of continuing the rise CBA reversed and fell away to an important level of support at around $49.50. Although the share price has on a number of occasions found support at around this level, the question still remains as to whether the resistance at $53.00 is stronger than the support at $49.50. Only time will tell but over the past couple of months CBA has twice traded below the March 2011 low of $49.25 and like ANZ is trading in a confirmed downtrend below a downtrend line. This signal has increased the probability of a further decline to between $42.50 and $46.00, with the next few weeks being critical in determining the next move.

NAB:

NAB is quite interesting as it has found support on a number of occasions from 50% ($22.42) of the ATH price for the stock (nominated by WD Gann himself as one of the strongest price levels) before it continued up to an important Fibonacci level at 38.2% ($27.71) of the ATH, as shown below. But since then the sellers have come in once again and pushed the price back below $26.00, with this level being the top of the prior sideways range traded in during 2010. Notice how on the chart below that the bottom end of this sideways range at around $23.00 has supported the recent rise, and may continue to provide support to prevent NAB from falling away. That said if this level is broken by strong selling activity in the near term then NAB is likely to continue to decline.

You may have already noticed how well price analysis depicts the movements of the banks, as they seem to resonate around important predictable levels. In saying that, the best analysts do not limit themselves to a strategy based on price alone and will combine this with both pattern and time, as this combination is the best method to use when forecasting the future direction of a stock or market. However, due to space constraints I have limited the analysis in this article to focus on price.

WBC:

WBC is similar to CBA and NAB in form, in that it recently broke up and out of a sideways move before pulling back. During May 2011 WBC pulled back within the sideways range to appear decidedly neutral, however, since then price is looking more bearish than neutral. Notice the important level at $23.00 and how this sits in the centre of the sideways action between the upper and lower bounds of support and resistance between $25.50 and $20.50. Often you will see stocks move back to the mid-point of a sideways move after hitting the extremes. Like CBA, WBC has again tested the lower band of support and closed below it, therefore the probability of a further decline has increased.

There is a noticeable difference between the chart of WBC and the other banks. I am referring to the gap down in price recorded when WBC went ex-dividend this month (May 2011). This occurred from the close on Friday 13th to the open on the 16th May (being the ex-dividend date). Price fell $1.13, just $0.01 less than the 1.5 times calculation mentioned above, which suggested it would fall $1.14. This strong move down shows how the buyers did not come back in to support the stock and creates a marker to which WBC may attempt to trade up to so as to ‘fill the gap’ in future. That said unless it trades back above $20.50 and holds, my analysis suggests there is further downside risk. In terms of assessing the downside risk, strong support for WBC exists not far below at the Fibonacci level of 38.2% ($19.36) of the All Time High, as well as a natural level of price support at $18.00.

Given that all of the Big Four banks look weak, I would suggest investors/traders do the wise thing and set stop losses to protect capital. Depending on your trading plan, you may already have exited if you were trading long any of these banks. As anyone who practices the proper use of stop losses will tell you, it is far safer and more profitable to protect your capital than to hang on hoping for the best.  That’s something you can bank on!

To hear about the timing of your investments and how this can impact on portfolio returns visit our website to listen to the free podcasts in the Trading Room called Portfolio Returns and Timing Investments in the Market.