March 1st, 2015

The Crash is Coming, The Crash is Coming!

The following piece appeared here on March 25, 2013 entitled The Known Stock Market World, almost exactly three years ago. I repeat it here because Paul Farrell just came out with another one of his dire, “end-of-the-market-as-we-know-it” predictions. What prompted Farrell to make his doomsday call in 2013 was the fact that the market was about to cross into all-time new high territory and he, along with many of the other gloom-and-doomers were saying that the market was about to swoon into a major correction. In today’s blast (see today’s MarketWatch), Farrell claims

“the crash of 2016 really is coming. Dead ahead. Maybe not till we get a bit closer to the presidential election cycle of 2016. But a crash is a sure bet, it’s guaranteed certain: Complete with echoes of the 2008 crash, which impacted on the GOP election results, triggering a $10 trillion loss of market cap … like the 1999 dot-com collapse, it’s post-millennium loss of $8 trillion market cap, plus a 30-month recession … moreover a lot like the 1929 crash and the long depression that followed.”

Everyone put a link to this MarketWatch article in your “stocks” Evernote folder, in your electronic calendar, where ever you can so that you’ll be alerted to it then, can quickly retrieve it (unless MarketWatch pulls the story by then) and can lobby to take away Farrell’s soapbox.

Back in 2013, it was clear that the market would be going to new heights, which it did.  In 2015, when we’re in the sixth year of a secular bull market, there’s no question there will be a correction soon.  But no one today can predict when it will begin nor how far it will carry the market down.  Anyone who claims to know, like Farrell, is taking you for a sucker.

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imageI was asked to read Paul Farrell’s most recent blurb on the Wall Street Journal’s blog site Marketwatch.com entitled “New Critical Warning as 2013 shocker looms” in which he enumerates 6 new critical warnings, which added to the 7 he says were issued last year but to which there doesn’t seem to be a convenient link of the site.  This “critical warning” comes from Gary Shilling (the others came from Bill Gross, Nouriel Robini, Reinhart and Rogoff and Farrell himself.

Farrell clearly spells out that their vision of economic and market doom is rooted in their dislike and distrust for Fed Chairman Bernanke and his policies.  Is it professional jealousy?  Does it come from an contest between Keynesian and Austrian monetarist inside schools of economic philosophy?  In Farrell’s own words:

“Timing is critical at a turning point. We warned of the coming crash well in advance in 2008. We picked the bottom in March 2009. We are in the fifth year of an aging bull. These six Critical Warnings tell of a hard turning point dead ahead. Wake up. It takes time to restructure a portfolio. If you think you can do nothing and just wait for another year, you are like most investors: You just “can’t handle the truth.” Or you “have no idea what’s about to happen.” Or you believe “this time really is different.”

But the truth of the matter is that all these perma-bears have continually been calling for the market’s reversal and demise since last year, a 15% missed opportunity had you taken their heed and fled the market.  Was the turning point in 2012, in January 2013 or some undefined point in the future.  Why do these guys want us to sell equities?  Where do they want us to put our money?  Are they gold-bugs in disguise?

I’ve been reading much over the past couple of years from those who view a market reversal at the level of the previous all time high high as indisputable.  The reasons they offer could be technical, like Prechter’s obtuse Fibonacci reckoning, or fundamental economic, like those of Farrell, et al.  To me, it all sounds like a through-back to beginning of the Age of Discovery in the 1500’s when most believed the world was flat and you’d fall off if you sailed to the end.

1500 WorldYou could sail the Mediterranean Sea or Indian Ocean but sailing beyond the sight of land meant sure disaster.  It’s like the course the market’s followed since 2000, the Secular Bear Market seas.

Map of Known Stock Market

So long as we don’t venture outside the bounds, we know the landmarks, the levels at which the market pivoted in the past and has a probability of pivoting again in the future.  If the market reversed direction for a third time, we can guess, by looking at the above “map of the known stock market” where islands of rest might be and where it might reverse direction again.

But if half the stocks break into their own all-time new high territory and cause the index, by definition, to also begin to venture into uncharted territory then where will the first island be?  Where might we hit and wreck on a market/economic shoal or reef?

Bottom line: are you someone who has the confidence to sail where no one has ever sailed before to discover new lands and new wealth?

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June 13th, 2013

Another Opportunity In A Market Correction

AlphaCheck out my latest article “Another Opportunity In A Market Correction” in SeekingAlpha.com. In it I explained how I combine call options on SDS (the ETF that shorts at 2x the change in the S&P 500 Index) for a very short-term speculative play on a market correction.  As I say in the article,

This is not a trade for everyone. Should you decide to try your hand “hedging” or taking a short-term bet that the market will correct in this or a similar tactic then it should be for a very small percentage of your capital. For it to be successful, you need to remember that

  1. “timing is everything,”
  2. highly leveraged transactions cut both ways and
  3. this is the antithesis of a buy-and-hold investment strategy.

 

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May 8th, 2013

Auto and Truck Parts Suppliers

I believe I’ve finally made some sense of how to differentiate between the Weekly Recap Reports offered to Members, the Stock Chartist blog and the articles I begun to write for SeekingAlpha.com. I believe the answer was provided by Seeking Alpha when they made clear that their preference is for fundamental as contrasted with technical analysis.

Every investment decision begins with a clear vision of the market’s near-term direction, or what Seeking Alpha calls “Market Orientation”. My last two articles met the prerequisites of that category and were well accepted by the Seeking Alpha readers. Once you have a market point-of-view, the next step is stock selection.

If market timing indicates that the time is opportunity for new investments then the next challenge is choosing from among the 7000 stocks and ETFs. One can do attempt to narrow the search down to a few of the best stocks by, what Cramer calls, “doing your homework”. Or you can use my approach of finding stocks that appear to be ready to cross out of consolidation or reversal areas (i.e., patterns) by crossing above resistance zones (i.e., trendlines) focusing first among the Industry Groups that seem to be most desirable at the time to the “herd”, or Wall Street’s institutional investors. The approach I use for this final step is, of course, my various scans and a continual search through literally hundreds of charts.

Instant Alerts members have the benefit of both market and stock selection plus an inside view of how I manage my Portfolio.

Bottom line, the blog will now focus on individual stocks based on my own Industry Group and stock chart analysis. Some blog posts will focus on an individual stock while other posts might include several stocks. The following is the first:

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imageThe stocks of several truck and auto original and replacement parts suppliers have advanced smartly since the beginning of the year, like AXL, DORM, SMP, LKQ and DLPH. Even though these have significant momentum, I avoid them because these are now far above what I consider breakout entry points where initial positions can be safely established.

However, a few have recently or are about to break out of consolidation areas.  I consider them consolidations since there’s nothing to indicate that the market is anywhere near making a significant reversal.  Those stocks include:

  • BWABWA - 20130508
  • LEARLEA - 20130508
  • DANDAN - 20130508
  • WBCWBC - 20130508
  • THRMTHRM - 20130508

It goes without saying that these stocks and their charts were selected exclusively on the basis on a technical analysis of price action and timeliness of an investment. There’s no attempt to rank them as to prospective appreciation of each nor the time needed to achieve those gains. Investors should assess their own tolerance for risk and perform their own assessment of their suitability to be included in a portfolio.

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April 5th, 2013

Gold (GLD) in an “Indecision Zone”

I was recently accepted as a “columnist” for the subscription portion of SeekingAlpha.com, a well-respected stock-oriented editorial site, and quickly got my first submitted article accepted.  Much to my disappointment, however, my second submission was wrongly rejected, I believe.  The rejection notice stated:

As a fundamental investing site, Seeking Alpha doesn’t publish articles based primarily on Technical Analysis.  Feel free to post this piece to your instablog.  Thanks!

Sincerely Yours,

SA Editors

As you might expect, this response raised my blood pressure on several counts.

  1. First, I thought that I had summarized most of the fundamental arguments, bullish and bearish, covering the subject of the future direction of gold prices.
  2. Second, I can’t imagine any site that doesn’t take technical factors into account when presenting content about stocks, markets, commodities and forex can do so without including a heavy dose of technical factors and opinion.
  3. Finally, why isn’t there a site that features articles contributed by vetted contributors focusing on technically-based market and stock opinions?  It might even be called www.stockchartists.com

In any event, the rejected article appears below. What say you? Should it have been rejected? Would you be interested in reading or even contributing to a technically-based content market opinion site?

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imageI know both the bull and bear fundamental arguments surrounding gold, you’ve heard alll of them before.

  • The Bulls point to the fact that gold is both a commodity used by industry and consumers and, perhaps even more so, a safe haven alternative for fiat money and store of accumulated wealth.
    • Central banks around the world flooding the market with currency that eventually will lead to inflation and rising commodity and gold prices
    • A fixed world-wide supply of gold in a world of ever increasing demand
    • Increased demand resulting from the growth of ETFs
    • Increased demand due to increased wealth from emerging market consumers
    • Increased demand from governments beginning to accumulate
    • Continued political uncertainty
    • Finally, the price of gold is still only around 70% of its inflation adjusted peak price of $2300 reached during the 1970’s energy crisis.
  • The Bear’s argue that the price of gold has quadrupled with only minor corrections from less than 50 in 2005 when the GLD ETF was first made available.
    • Hedge funds are reportedly unloading their large cache of GLD
    • There will be better places to invest your money than gold as stocks and commodities continue to reflect an improved economic environment
    • The bull market for gold paralleled the secular bull market for bonds therefore a reversal in fixed income secular trend will also lead to reversal in gold prices.
    • QE and monetary easing will end soon and the excess money supply that the Fed pumped into the economy will begin to be drained
    • Governments are actually unloading their gold hoards

Rather than trying to second guess the experts and come up with my own prediction of gold’s future direction, I believe price action and trend best represents the consensus of how the world’s investors actually act on their beliefs. There’s no question that the price of GLD has stalled but what isn’t as clear is whether this the beginning of a reversal leading to sharply lower prices or whether this period could be actually represent the end of a consolidation pattern.

In the chart below, there’s not question concerning the top boundary of the pattern … it’s clearly defined.  There are two possibilities, however, for the zone’s lower boundary. The blue dashed line assumes the zone is a descending triangle reversal top pattern while the green dashed line assumes the zone is a flag consolidation pattern. We will be left in the dark as to which pattern interpretation is correct until GLD declines to approximately 137, or down another 7.4%, at which point GLD will likely find some support.

It’s said that “the longer the pattern the stronger the trend out of that pattern”. If the price stabilizes around 137 and then reverses, a major bull move could be launched that could finally carry GLD substantially above its previous high of 182. But if it again fails after that reversal at around 150, or today’s price, then a reversal top would be confirmed leading to further declines possibly to under 100. GLD is clearly in an “indecision zone” (click on image to enlarge) and I would wait to make any further commitments either way (bullish long or bearish short) until investors drive the price out of the zone one way or another.

Bull and Bear Gold Case

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March 20th, 2013

Rocket or Breakout? What say you?

imageThe second most difficult challenge (after auguring the market’s future near-term direction) is to select the best stocks into which to put some money to work so as to maximize potential returns while keeping risk of loss acceptable.  Most of the time, whenever you hear or read a comparison between two stocks, “talking heads” like Jim Cramer usually  throw out such slogans as “buy best of breed” as the guide in making your choice.  However, although “best of breed” is subjective and is boiled down fundamental factors like sales and earnings growth, great management or higher profit margins.  Seldom does Technical factors such as stock volatility, institutional support or relative strength seldom enter a “best of breed” discussion.

For example, on January 26, 2012, Cramer’s theStreet.com had a piece on XLB, the basic materials ETF in which they claimed that “DuPont Company (DD) is the undisputed king of basic materials. From the 2009 rally, DuPont was the top performing Dow component.”  However, PPG (PPG) wasn’t mentioned at all.  PPG represented only 4% of the ETF as compared with DD’s nearly 10%.  But which was actually the better stock to have bought more than a year ago.  A comparison of the two shows that PPG actually appreciated 58% while DD declined nearly -3% (click on images to enlarge).

PPG - 20130319DD - 20130319 I’m now sitting on some cash trying to figure out if I should redeploy it in yesterday’s momentum stock leaders (who are still advancing nicely) or taking a gamble on stocks that have great charts and look like they may soon breakout and become tomorrow’s leaders.

In technically-based comparison like these, IBD’s rule is to only buy stocks that are within a few percentage points above what IBD labels their “buy point”, those breakouts or crosses above resistance trendlines which are top boundaries of a variety of chart patterns such as inverted hear-and-shoulders, ascending triangles or IBD’s cups-and-handles.  This comparison might match up LKQ (automotive parts), a stock that’s advance 370% since 2009 in a near straight shot and, perhaps, may continue to advance higher against, for example, Williams-Sonoma (retail home furnishings).

LKQ - 20130320WSM - 20130320

Putting aside fundamentals and basing the investment choice strictly on a technical basis, the choice rests on how one evaluates two factors:

  • Trading off the risk one perceives in buying a stock continuing to advance after having nearly doubled in each of the past four years vs. the risk that a stock will continue to languish for continued economic sluggishness.
  • How important the psychic reward might be for you to have found a new “high flyer” before others vs. piggybacking on a winner that others continually discovered over the past four years.

I’ve always tended to chose the breakout but what say you?  Would you catch the tail of a comet like LKQ or get on what you hope might be a future rocket?  And why?

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March 1st, 2013

“Timing Is Everything”

imageCNBC never cease to amaze me the way they always trot out mostly bearish commentators on day’s when the market is declining severely, like Monday’s 1.83% plunge, but the bull’s when the market makes a stunning advance like the 1.27% rise a few days later.  Rather than counter-balancing the market’s prevailing psychology, CNBC feels that it’s in their best interest to go with the flow: panic when everyone else is throwing stocks overboard and be euphoric when buyers are flocking back into stocks.  Promote “risk off” on days when everyone has already decided to sell and “risk on” when the bulls are already stampeding.

They are a “news” organization and, as such, their time horizon is  very short and they need to present stories and “talking heads” who primarily describe or explain why something is just happening or has recently happened.  The information they offer is mostly anecdotal, opinions or canned offerings by companies rather than analytic and are, therefore, irrelevant to decision-making about the investable future.

That’s why I don’t watch the business media.  Rather, I attempt to peer out into the future and see if I can perceive where the next turning point might be. Towards that end, I’ve been focusing an area I labelled the “Crunch Zone”, the range between the 2000 all-time high and the 2007 all-time high (approximately 1545-1575) and have been monitoring for Members since the beginning of February as the market closes in on that target:

  • February 2: “The most glaring difference [between the 2007 attempt at crossing into new high territory and now] is that OBV [on-balance volume indicator] was also making new highs in 2007 but it has failed to do so, so far, this time.  That difference could be attributed to greater investor skepticism in 2012 than there was in 2007 as evidenced by the huge volumes of cash still sitting on the sidelines and in fixed income/gold safe haven investments.  That actually, could be positive indicator for the market actually finding success in breaking higher this time around.”
  • February 10: “the 50-day moving average of daily volume of the 500 S&P stocks has declined since peaking in 2006.  As the Index and OBV (on-balance-volume) continued to advance to new highs in 2007, average daily volume diverged and failed to move higher.  As a matter of fact, average daily volumes have trended lower to where they are now about 50% of the that 2006 peak….What events will cause these trends to reverse direction?…Stocks usually move opposite of interest rates: when interest rates decline, stocks advance and when interest rates rise, stocks fall.  Rates have been falling since 2009 and stocks have increase.  But because of the Fed’s intervention, when interest rates begin to rise, stocks could also rise.”
  • February 17: “Technically almost nothing new has happened other than the market has edged a little closer to the “crunch zone” ….The one significant development is on the volume side: 1) On-Balance Volume (OBV) has finally matched the peak during last year’s March high and 2) the 50-day moving average of daily volume seems to have finally bottomed out and shows a teeny-tiny upward slope…..Since the Market moves at glacier rather than human speed, we probably won’t get an answer of what follows the Crunch Zone interaction until the fall.”
  • February 24: “the market is bumping up against the “Crunch Zone”….I wouldn’t be surprised if we were stuck in this area through the summer…..Don’t believe the media “talking heads” who offer explanations for a pause or correction at these levels grounded in the employment numbers, earnings reports, interest rates, exchange rates or corporate guidance announcements.  The true explanation is that investors small and large have acrophobia, they fear heights, especially those at levels they’ve never seen before…..What encourages me is that there aren’t any bubbles today and, rather than being buoyant, the economy is still struggling to gain its footing.  Rather than exuberance, there’s still a lot of skepticism and fear about the stock market and the economy, the sort of ground in which the seeds of a true bull market can begin to root and grow.”

We don’t need CNBC to tell us that approaching the bottom edge of the Crunch Zone will be a bumpy ride.  As much as we might hang on every word of their prognostications, neither Cramer, Gartman, Kass nor any of the other familiar cast of characters can tell us whether we will ultimately cross through the Zone or bounce off it, reverse and begin sliding lower again (click on image to enlarge).

SP 500-20130222

You’re familiar with the old saw that “timing is everything”; the next few weeks or maybe months is a perfect time to heed it.  This is no time to make new commitments if you’re getting into the market for the first time or are looking to put some idle cash to work.  You’ll know when this struggle between bulls and bears, supply and demand, in the “crunch zone” is resolved and you’ll have plenty of time to add new positions to participate in the next trend to higher levels.  Don’t fret losing the first few percentage points; consider them insurance against the possibility that the market reverses instead.

On the other hand, I like most of the 70 positions in my Portfolio and don’t see weakness in most of their charts.  There’s little reason to unload them and run the risk of losing out on the launch of the next wave higher if the “crunch zone” turns out to be only a milestone rather than an insurmountable wall.

I don’t know about you but I’m currently around 90% invested and have no plans to either unload in anticipation of a correction or bear market or aggressively put the remaining cash to work until this uncertainty is resolved.  The Market moves at glacier rather than human speed so we probably won’t know what follows the Crunch Zone interaction until sometime around Fall. This may not be want you want to hear – we all like to see more action – but it’s unfortunately what we’re going to get.

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January 2nd, 2013

Shaking Off the Fear

If you’re an individual investor, one of the most important articles of last week besides the focus on the “Fiscal Cliff” debacle was an article in the December 29 Washington Post entitled “Bull market roars past many U.S. investors“.  The gist of the story was that “Americans have missed out on almost $200 billion of stock gains as they drained money from the market in the past four years, haunted by the financial crisis……Individuals are withdrawing money as political leaders struggle to avert budget cuts that threaten to throw the economy into a new slump.”

According to the Post, much of the damage to investors is “self-inflicted” because of fear and anxiety brought on by market volatility and memories of past “crashes”.  However, U.S. growth has improved and earnings tied to the economic are expanding.  Those improvements have been reflected in stock prices.  Of the 500 stocks comprising the S&P 500 Index, 481 are higher now than they were in March 2009 or when they entered the gauge.  Some of the statistics supporting these conclusions are:

  • Investors are lowering the proportion of stocks they own in retirement funds during a bull market for the first time in 20 years.
  • The proportion of stocks in the assets in 401(k) and IRA (excluding money market funds) fell to 72 percent from 72.5 percent in 2009.
  • The percentage of households owning stock mutual funds has dropped every year since 2008 to 46.4 percent in 2011, the second-lowest since 1997. [Of course, this could also result from the wide choice, availability and acceptance of competitive ETFs]
  • New money has gone to the relative safety of fixed-income investments as corporate bonds and Treasuries have received nearly $1 trillion since March 2009.

Housing is making a comeback and housing stocks were among the leaders last year, banks are on the mend and financial stocks were also among the best performers and 2013 auto sales are projected to approach 1.5 million. Is it time then for individual investors to begin fearing declines in the value of their fixed income investments as interest rates reverse (regardless of Bernanke’s protestations to the contrary) and start moving money back into stocks?

Meanwhile, institutional investors (the group I call the “herd”) hasn’t fared that well in the market either.  According to in December 26 Wall Street Journal article entitled “2012 Was Good for Stocks, Bad for Stock Pundits“,

  • At the end of 2011, Mr. Cramer warned investors to avoid bank stocks. Oops. They were one of the best-performing sectors in 2012. He urged investors to avoid real estate, but housing prices are up more than 2% from a year ago…..and the stocks of home builders, as measured by the S&P Homebuilders exchange-traded fund, are up 53.6%.
  • Of the 65 market “gurus” tracked during the last few years by CXO Advisory Group, the median accuracy for market calls is 47%. If that sounds low, or you wonder about the quality of the pundit, consider that the list includes such well-known names as Bill Fleckenstein (37%), Jeremy Grantham (48%), Bill Gross (46%) and Louis Navellier (60%).

So how do I deal with the noise coming from the “talking heads” and the uncertain produced by the market?  I maintain my equanimity in the face of volatility by relying on how market participants have behaved during similar situations in the market’s history.  I rely on my Market Momentum Meter to give me some indication of what market participants believe will happen, on average, in the near-term as reflected in their collective buying and selling decisions.  It’s measure by whether they are pushing prices up or down and the momentum behind those decisions.

The Market Momentum Meter turned a bright Green on January 31, 2012 when the Index was 1312.41, or 10.25% under today’s close of 1462.42.  It wasn’t Green for only 10 trading days during the year (the longest period was 7 days around the November correction low:

Like a parent who never quite trusts riding in a car that his kid is driving, I didn’t fully trust my own creation.  It took me a few months after that Green signal at the end of January to increase the money I had in stocks.  As hard as I tried to totally drown out the noise (news) about Euro debt and currency problems and, more recently, the fiscal cliff debates, I never could bring myself to be fully invested and, like corporate America, always had a significant amount of cash on the sidelines.  And then in after the November elections, as the Market reacted to the realization of a second Obama term and continued Congressional stalemate, it looked for a couple of weeks like we might see a repeat of the 2011 market implosion.  Fortunately, I waited this one out and saw money begin flowing back into stocks as prices quickly recovered.

Like many other market participants, I need additional “guarantees”.  Even though the Meter says that these sorts of market conditions in the past have lead to higher prices and that it’s all clear to be fully invested with relatively low risk, I still want to see the Index continue its assault on the all-time highs by first crossing above where it stalled out last September.  When that happens (which could be next week), I’ll feel more comfortable putting rest of cash to work.

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December 6th, 2012

More Reliable: Horizontal vs. Sloped Trendlines?

Over the past several years, charts have become more pervasive than ever in discussions, commentaries and prognostications about individual stocks and the market in general.  Even Cramer, who once considered technicians to be on the same level as astrologers or readers of tea leaves, no regularly refers to the analysis of one chartist or another.

One of my pet peeves, however, is that bloggers and media talking heads will insert trendlines in their discussions almost willy-nilly as they pontificate about the support or resistance they hope the line they drew will presumably offered them. Because the use of trendlines is so prevalent, it’s assumed that everyone understands their meaning and relevance; we rarely hear about the arbitrariness and subjectivity that goes into their selection.

Last week, I offered three examples of head-and-shoulders patterns (GLD, AAPL and FDX), each demarcated by a horizontal trendline, or the pattern’s “neckline”.  [As an interesting aside, I may have been one of the first to publish an alert about the possibility of AAPL forming a head-and-shoulder top which could result in a correction down to approximately 400 in my November 8 post, “AAPL Gets a Cold, the Market Gets …..?”  Now many are commenting about it and Cramer even had a segment tonight dismissing the stocks technical risks.] What makes the head-and-shoulder such a “reliable” (if you allow me to use that term in the context of something so subjective as the reading of stock charts) pattern is that the supporting trendline is horizontal.  I’ve seen sloping necklines but these never turn out to be as recognizable nor as accurate.

As I describe in my book, Run with the Herd,

What makes trendlines so confusing is that many trendlines that seemed so precise at first may lose their potency as new trading is tacked on.  As a matter of fact, as more transaction data over longer and longer periods of time with multiple trading days condensed into individual bars, you’ll usually find yourself drawing a plethora of trendlines.  Some trendlines are short and some long, some connect pivot points that once seemed compelling and inviolate become less significant and even irrelevant when viewed in a longer-term.  The support or resistance expectations implicit in short trendlines at one may become overwhelmed and irrelevant as more recent buying and selling emerges.

Trendlines are nothing more than an arbitrary, imaginary lines that visually connect two or more pivot points. Pivot points are those spaces in time and price where control is transfers between buyers and sellers, when one trend in one direction reverses and begins moving in the opposite direction. In reality, this transfer doesn’t occur in one transaction at one price but instead occur over a period of time, a large number of trades at a range of prices.  There’s no precise way of locating when that transfer is complete and the struggle continue even when a reversal appears to be complete.

Why is it important to locate these pivots? Because we believe that after having occurred several times at approximately the same point, the failure to occur at that same level sometime in the future means that the winner of the last battle has lost control of the trend and it now resides in the other side who will control the trend until the next struggle begins.  That transfer of control is the breakout.

Repetitive struggles at the same price make intuitive sense.  An institutional investor looking to sell its large holding in a stock will continue to do so as long as a stock’s price is above a certain level; when it drops to or below the level they hold their shares back from the market; they will continue to accumulate shares up to a certain price but not above that price.  But what can we say the same thing about pivot points at different levels?  Bottom line, they tell us little about what we can expect about where the next pivot might be and we can say little about whether that recent pivot is the beginning of a reversal or the continuation of a trend.

The above chart for LKQ presents a pretty channel but it offers little information about the risks of the trend failing, how much profit potential remains in the channel trend or when it might collapse.  It is easy to draw the channel trendlines after the fact but drawing those lines in 2010 would have produced the dotted trendlines.  Which more accurately defines the trend, the solid or dotted lines.  Is the stock currently within the trend boundary or is it outside the bounds and bound to correct.  The most common mistake when inserting trendlines is thinking that the recent pivot is critical in establishing a meaningful trendline.  In other words, trendlines are usually discovered within the time frames of the chart, rarely coming in from prior the chart’s beginning.  That’s why I always simultaneously look at a charts in three time horizons.

That error doesn’t occur when you look for breakouts across horizontal trendlines like this one for NEOG.  Is there any doubt that a cross above 48.00 indicates that the bears have lost control to the bulls who have launched a new push to higher stock prices?

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November 28th, 2012

Head-and-Shoulders Patterns: AAPL and GLD Case Studies

In my book, Run with the Herd, I retell the coin toss experiment from Burton Malkiel’s book, A Random Walk Down Wall Street.  In it, he asked students to

“continuously toss coins with heads arbitrarily representing a move up in a stock’s price and, conversely, tails a move down.  All the price changes were assumed to be of equal magnitude and all were recorded in a line chart.  After an unspecified number of tosses, the students began to see patterns in the charts that looked similar to those of stock charts.”

One of the most talked about, recognized and perhaps most reliable stock chart patterns are the head-and-shoulders and its mirror image the inverted head-and-shoulders. What makes these patterns so important is that they fall into the reversal category (as contrasted with the continuation or trending patterns).  In these patterns, the price/value of the stock, index or commodity makes three different attempts to reverse the direction of the prevailing trend.  Characteristically, the price/value reaches approximately the same level the first two times and then falters; it succeeds in the third attempt and crosses the level reached the previous two attempts. The elements of the pattern include a shorter left “shoulder”, a longer middle “head”, and a shorter right shoulder; all are connected by a trendline at what is called a “neckline”.

As you might expect, as a chartist I believe that comparison between the randomness of coin tosses and stock chart patterns is a false one using the wrong logical argument (incorrectly using deductive reasoning rather than inductive reasoning).  But it is true, however, that the head-and-shoulder chart patterns are easier to perceive in retrospect and not as readily discernable in real-time.  Furthermore, when the pattern has evolved sufficiently in order to actually intimate its future likely outline, the practical question remains as to when might be the best (highest probability of being realized with the lowest risk of being failing) time to act on that perception.  Here are two cases in point:

    • AAPL: At the beginning of the month, I wrote a piece entitled “AAPL Gets a Cold, the Market Gets …..?” when the stock was at 563 in which I included a chart showing a partially formed head-and-shoulder pattern and wrote: “Has the stock hit bottom and is it poised for a turn around (a large Wall Street firm recently called on CNBC for AAPL to more than double over the next year)?  Double it might but in the near-term it’s setting up for another 25% decline below what might be consider the neckline of an emerging head-and-shoulder topall the way down to 390 (nearly 30% from current levels).”Compare the chart in that post with the one below and you’ll find that AAPL is closely following the course outlined there:

      Although Robert Weinstein of Cramer’s theStreet.com wrote today that investors should “Put Away the Prozac, Apple’s Just Fine”, this emerging pattern continues to look to me uncannily like an emerging head-and-shoulders top [Cramer’s Action Alerts Plus service has been a long-term AAPL investor with a 90+% profit].  There’s no way to tell whether the stock will follow-through but it pivots and starts declining again, I would order a refill from the pharmacy.

    • GLD: I wrote a piece at the beginning of the summer entitled “When It Comes to Technical Analysis, Accuracy Depends on Time Horizon (GLD)” in which I included a chart of GLD with a pattern that looked like a descending channel and wrote: “I look at a possible breakout from my flag and see a long-term move equal to the preceding the neckline.  I see the possibility of a 75-80% move to the 250-270 level over a year or two.  It all depends on how much time you want to spend managing your portfolio and making trading decisions.”

Today that channel has morphed into what might turn out ultimately to be an inverted head-and-shoulder pattern.  The hesitation in calling it that is that the pattern is developing after a major bull run rather than at the bottom of a major decline.  Consequently, this inverted head-and-shoulder will further morph a consolidation pattern or some type of reversal top pattern.

Bottom line, no matter how good these chart patterns may look a year from now, unless and until they cross their necklines, there’s no certainty that they won’t fail to deliver.  While getting in early will produce a greater return, the trade entails more risk that the stock moves in the opposite direction.  [In fact, even after a trendline is crossed, the stock will often reverse and test the trendline in what is called a “Buyers’/Sellers’ Remorse Correction”.]

 

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