Are These Stocks Heading for a Breakdown?

Staring at a bunch of stock charts may sound as dopey to you as letting some crystal ball-bearing fortune teller figure out where all the planets were at the moment you were born. But while it's easy to dismiss technical analysis as a bunch of useless hogwash, it works more often than you'd think -- and it's interesting just how often it matches up with the fundamental picture of the stock market.

Anatomy of a bounce
Last Thursday, like many people, I sat watching as stocks plummeted, then soared back upward. Having lived through 2008's market meltdown, most investors didn't seem as affected by it as they would have been two years ago.

Personally, I was intrigued to note exactly how low the market went before it turned around. At its low, the S&P 500 hit 1066 -- a number important not because it was the year of the Battle of Hastings, but rather because it corresponded exactly to the S&P's 200-week moving average.

Coincidence? Maybe. But if enough people look at stuff like this, it becomes a self-fulfilling prophecy -- especially when it jibes with fundamentals affecting the market. That makes it worth knowing something about technical analysis before you put your hard-earned money at risk.

Moving averages and you
The Motley Fool's Rule Your Retirement service keeps an open mind toward many different ways of investing. In particular, frequent Rule Your Retirement contributor Doug Short, who goes by TMFDoug on the Fool's discussion boards, has taken a close look at one particular way of using technical analysis to guide investing decisions: moving averages.

Using moving averages is one of the simplest ways to distill past stock prices into a trading technique. In one article from last year, Doug describes using a 12-month moving average to time buying and selling an S&P 500 index fund. The basic idea is that you add up the monthly closes of the past 12 months, take the average of those figures, and then compare it to the current price. If today's price is above the average, then buy or hold onto your shares. If it's below, then sell them or stay out of the market.

Sound simple? Such a strategy would have allowed you to miss almost all of the bear market of 2000 to 2002. It would have gotten you back into the market early in 2003, just as a new bull market was getting started. And it would have had you sell stocks in December 2007, long before the market meltdown occurred.

Sell signal ahead?
Unfortunately for shareholders, some oft-used moving averages are flashing danger signals right now. Last week's market smackdown pushed the shares of these big-name stocks below their 200-day moving averages:

Source: Yahoo! Finance. Measured from first move above 200 DMA after March 9, 2009.

By falling below their 200-day moving averages last week, these stocks all gave sell signals.

Notice a couple of things about these stocks. B of A and JPMorgan were both directly connected to the financial crisis during 2008, and both have receded lately based on potential financial regulation and the SEC lawsuit against Goldman Sachs. Coca-Cola and Philip Morris, on the other hand, are generally considered defensive issues that hold up well in downturns. But because stocks are move in highly correlated patterns -- especially big-cap stocks that are part of major indexes like the S&P 500 -- sometimes the good stocks get thrown out with the bad.

Also, note that the technique can't avoid losses entirely. AT&T has remained in the doldrums throughout the rally, although its high dividend has ameliorated some of the pain for shareholders. But with Dow Chemical, you can see how the strategy works with stocks that make extreme moves. You won't catch the lowest prices, but you'll still get in relatively early in an advance. More impotantly, you'll avoid some big losses that can otherwise do permanent damage to your portfolio.

Not foolproof
Moving average systems do have their downsides. Sometimes, a stock will give you many signals in a short period of time, if the price keeps moving above and below the average. That's one reason why Doug's 12-month average is appealing: At most, you'll be trading just once per month.

On the whole, though, moving averages can let you benefit from long uptrends while protecting you from broad declines. That's a winning combination, especially during jumpy markets.

Even if you think technical analysis is dumb, you can still benefit from it. Knowing how others are looking at the market will help you guess what moves they'll make -- and let you get in ahead of time.

Some companies try to trick you when they talk about their fundamentals. Rick Munarriz warns about four words that should make you run away screaming.