I am not usually one for identifying an opportunity by studying a chart. Fundamental factors always outweigh the technical over time, and no matter how strong a signal the chart may show, if a company does poorly or the economy is tanking, any stock will reflect that. That is why I typically start with fundamental analysis, then use the chart to suggest entry and exit points for a trade. Sometimes, though, my interest is piqued by a chart first, then I start to look deeper into the stock’s prospects.
That is what happened recently with CarMax (KMX).
You don’t have to be a chart reading genius to know why this one caught my eye. After a big drop in the last quarter of last year, KMX stabilized with notable support in the low $50s, then rallied quite strongly in January before turning tail again over the last couple of months. That final move down has brought it close enough to the support level to suggest that a bounce is possible, especially given the double bottom pattern exhibited over the last few days, and certainly to use that level as the basis for a reasonable stop-loss.
That is all well and good, of course, but the return to that level could just as easily be a warning sign as an opportunity, so without fundamental reasons to buy CarMax it doesn’t warrant a trade. In this case, those fundamental reasons do seem to exist.
The reason for the big drop in KMX at the end of last year was that, after a massive post-pandemic spike, used car prices were falling, reducing the value of the company’s existing inventory and holding out the prospect of lower margins in the future. Then there was the rising interest rate environment. Most people buy cars on credit and, as credit got more expensive, so they spent, or at least were expected to spend, less on cars.
Interestingly, though, as the chart for the Manheim Used Vehicle Value Index above shows, prices have been bouncing back in the first three months of this year. The jump was caused by increased demand for used cars and trucks after Covid-related supply chain issues restricted the production of new cars, but that is now having a knock-on effect. Fewer new cars three or so years ago means fewer used cars today, so while economic conditions may be restricting demand somewhat, there seems to be an offsetting reduction in supply.
So, if KMX dropped on falling used car prices, why hasn’t it bounced back on the recovery? The answer lies in the second factor that impacted those prices last year, interest rates. The Fed has continued with rate hikes, and a used car loan at seven or eight percent interest is a different proposition to one at three or four percent. The market right now is focused on the potential for a further drop in demand as a result, but seems to be ignoring the fact that that is going to be offset by higher prices achieved for existing inventory.
I guess that makes sense if you think the situation is going to get worse. If you believe the Fed is going to keep aggressively hiking until they create a painful recession, then used car sellers will be in trouble, as will pretty much all of the stock market. If, on the other hand, you believe what most analysts are beginning to believe, that a pause of hikes is imminent and a policy reversal to cuts is possible by the end of the year, then buying KMX, given the rising used car price trend, makes perfect sense.
Don’t forget that it was the chart, and the proximity of a logical stop loss level, that prompted the idea in the first place. Use that to your advantage. As to where a stop should actually be placed, somewhere around $54 works. The actual 52-week low is $52.10, but that was an exaggerated, and quickly reversed, reaction to a confusing earnings report. The more significant support comes at around $55, hence the $54 level for a stop. That limits potential losses to around 8%, depending on your exact entry point. On the other side of the coin, just a return to where KMX was at the start of this month would offer a return of close to 20%, making for a workable risk/reward ratio.
What started as an observation of a clear and repeating support level became a viable trade when the fundamental reasons for the price movements were revealed. That is a bit backwards for me in some ways, but it is still a trade I will be taking this morning.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.