Gavekal Capital: A Deep Dive on Our Point-and-Figure Methodology

Friday, February 6, 2015

A Deep Dive on Our Point-and-Figure Methodology

Familiar readers are aware that we use point-and-figure methodology as a technical complement to our extensive fundamental analysis.  For a brief discussion of how it works, you may watch a video blog on the subject here.  For more details, read on.

Generally speaking, a column of x’s denotes a gain in price while a column of o’s represents a decline in price.  In our proprietary model, we selected a ‘box size’ of 2.5%-- this means that each ‘x’ or ‘o’ is equivalent to a 2.5% gain or 2.5% loss, respectively.  Most of the time, we look at a stock (or an ETF, or a sector, etc) relative to an index.  In this case, each ‘x’ (or ‘o’) represents a relative outperformance (or underperformance) compared to the selected index.  In order for a ‘reversal’—or a change from one ascending (‘x’)/ descending (‘o’) column to the opposite—to occur, a certain threshold must be met.  For our purposes, we have selected a three box reversal.  This means that, in order to reverse from an ascending column of x’s to a descending column of o’s, the stock must decline 7.5% relative to the selected benchmark index.  No ‘o’ will be marked until the full 7.5% decline is registered at which point all three o’s are recorded (more, if the total decline is greater than 7.5%).  This is important to note because it is the means by which a great deal of day-to-day volatility, or noise, is eliminated—leaving us with a more clear picture of the true signal in the price trend of the stock.

With respect to the alpha numeric labels on the x- and y-axes, these are simply used as coordinates to identify positions on the chart.  In addition, while we have noted years across the top of the chart, time is not a variable here and they are only meant for reference.  Each chart plots the (relative) performance versus the variability of that (relative) performance or, said another way, return against risk over the last 1008 trading days.  So, though we have included time in order to orient the viewer, it is noteworthy that the position of the dates vary a great deal from chart to chart precisely because it is not a component of the actual plot.

There are a number of different lines that we draw on the charts, in order to highlight areas of support and/or resistance.  The light blue, horizontal line is said to act as resistance when the formation of x’s and o’s cannot move above it.  Conversely, it is referred to as support when the formation remains above the line.  When the formation is bound by two light blue lines, it is said to be in a trading range.

The medium blue line is called the 45-degree bullish support line (BSL) and is an important indicator of the health of an uptrend.

When this line is definitively violated by a descending column of o’s, there is a significant likelihood that the uptrend is over and that the stock in question is headed for a trading range (at best) or an outright decline.

In some cases, the slope of an uptrend is steeper than the 45-degree BSL.  In these instances, we mark support with the dark blue, high performance support line.

Finally, persistent downtrends are indicated by the red line (with a slope of -1).

Stocks that are able to decisively overcome the resistance indicated by the red downtrend line—and particularly those that have managed to form a base of support (indicated by a light blue, horizontal line)—typically exhibit a greater likelihood of reversing the long-term downtrend in favor of a more constructive uptrend.