Interactive Investor

Chart of the week: A 'buy low, sell high' candidate?

13th February 2017 13:14

John Burford from interactive investor

Will the other shoe drop for Pearson?

Pearson plc had its share of problems for about two years with a string of profit warnings (PW) culminating on 18 January with its latest – and possibly worst - horror story of missed targets. But, since then, the shares have been nervously recovering, so the inevitable question is this: Is Pearson a 'buy low, sell high' candidate?

Of course, many investors assume that because the shares are now cheap – unlike most others in the FTSE 100 index - it's OK to fill yer boots. After all, the general market is in a strong bull trend, and many pundits are calling the UK economy the strongest in the G7 over the next few years. And, because the company has a big business in the USA, the Trump Bump has likewise been signalling better times for the US economy, too.

So, the argument goes, with that kind of wind in your sails, Pearson must be reckoned to be a 'buy'. After all, a rising tide lifts all boats, doesn't it?

But that kind of thinking is more a reflection of the investor's bullish bias than an honest analysis of the state of the market. A bear could just as easily put forward pretty convincing arguments to either avoid or even sell the shares. In fact, that is always the case at any time in history!

When share prices are rising, few investors ask why the sellers are selling to the buyers. Surely, with prices rising, they would receive more for their shares if they waited a while and so benefit. That would be a rational strategy.

But investors are not rational! Most people trade with their emotions. If feeling bullish, they will tend to buy and hold what they own. If feeling bearish, they will tend to sell and unload at least some of what they own. If feeling neutral, they will likely cross their fingers and pray.

It is not the mythical 'wall of money' that boosts prices – there is no such effect. When a trade is made, the same amount of money is transferred from the buyer's account to the seller's (less commissions) with no net change, except ownership. No, prices rise and fall because both buyers and sellers agree that they should. Therefore, a rising market is an expression of a bullish bias in the market, not anything to do with funds available for investment.

But, of course, bull markets do end and turn into bear trends – and the Pearson chart shows this beautifully. Here is the long-term weekly:

From the February 2015 high just under the £10 mark, the shares entered a severe bear trend as profit warnings started coming through thick and fast.

Many investors have a rule that they sell when the company issues a PW for the first time. That is not a bad rule, but like all rules it is not infallible. That is why I like to use the Elliott wave model to judge the state of the market. And Pearson is offering a textbook example of how to use Elliott waves.

I have labelled the waves in the downtrend with waves 2 and 4 both showing three-wave A-B-C patterns, as is normal. Remember, a three-wave pattern is always corrective to the main trend.

Also, wave 3 is very long and strong, which also is normal. And the January plunge is in my wave 5 which sports a very large momentum divergence with wave 3.

So far, so textbook. The only question is this: Has red wave 5 completed, or is there more to go on the downside before a large correction can be mounted?

That is where the daily chart comes in:

Ideally, fifth waves should show a five-wave pattern or a variation thereof. And that is precisely what I can show. Purple wave 3 is pretty long and strong and has its own five-wave pattern (green bars). From the wave 4 high, the market started falling to the 18 January gap and then plunged. That could be the wave 5 termination.

One other clue that the plunge is very likely a selling exhaustion is that trading volume spiked to a level almost 10 times average volume on that day.

But there is one piece of the jigsaw missing – instead of the 18 January low being purple wave 5/red wave 5 low, there could be one more decline to complete the pattern. The plunge could be purple wave 3 of red wave 5. That would satisfy the Elliott wave rules a little better.

So, at this stage, the market is trying desperately to close the 18 January gap, but may not succeed as the larger pattern seems to need one more down before a big up can start. For me, I would not chase the market and prefer to watch and wait.

The recovery does not appear to be impulsive so far, but merely corrective and that is why I have a big question mark on the above chart.

Depending on what kind of chart pattern emerges will decide whether I wish to trade it or not. There are other shares with more certain patterns and I will be focusing on these.

Actually, performing this kind of analysis is not a waste of time because now I have a solid basis on which to do nothing – at least for now!

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John Burford is a freelance contributor and not a direct employee of Interactive Investor. All correspondence is with John Burford who, for these purposes, is deemed a third-party supplier. Buying, selling and investing in shares is not without risk. Market and company movement will affect your performance and you may get back less than you invest. Neither John Burford, Shareprice, or Interactive Investor will be responsible for any losses that may be incurred as a result of following a trading idea.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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