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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January 24th, 2013

AAPL Update

imageA friend asked last night whether it might be time to jump on AAPL, now that it’s dropped so precipitously.  I referred him back to a piece I’d written early last November when the stock was at 563 entitled “AAPL Gets a Cold, the Market Gets …..?” in which I said that AAPL was forming a perfect head-and-shoulders top reversal pattern and, if it held to completion then the stock could fall to 385.

At the time, a call that AAPL would fall to 385 looked bold.  However, head-and-shoulder patterns are one of the most reliable chart patterns as are the mirror image of inverted head-and-shoulders as bottom reversal patterns (click on image to enlarge).

AAPL - 20130124

AAPL gapped down 61 points, or 12%.  My friend asked three questions: Why didn’t you sell short when you had confidence in the chart?  Should I sell short now?  Or should I buy now since it’s dropped so much already?  Typical questions that we ask every day about every stock currently in our Model Portfolio or stocks that we are looking to buy.

The first two question can be answered as a matter of general policy: I don’t short stocks.  I’ve tried it over the years and have lost money nearly each time.  Stocks can double if you hold them long enough in good market conditions but the odds of them falling 50% is rare.  We believe that the market controls 50% of a stocks action, industry 30% and factors specific to the individual stock only 20%.  Furthermore, based on my study of the stock market over the past 50 years, I know that the market increases 70% of the time.  So the odds are against you 70% of the time when you bet a stock will decline by selling it short.  You have to have close to 100% certainty that a stock will decline before taking on such long odds and, because I trade stocks based on my assessment of supply and demand dynamics rather than fundamentals, I never have that level of certainty.

The answer as to whether AAPL is a buy today is also rather easy and summed up in the Wall Street saying: “Never try to catch a falling knife”.  Right now, AAPL is clearly a falling knife.  Someday, somewhere, it will hit the ground; it’s just that we don’t know where.  When it does, the tide of momentum will have to reverse.  AAPL fell because almost every large institutional investor had AAPL as one of their major holdings.  There just wasn’t anyone in the market to sustain the demand and keep the price rising.  The balance of power flipped from demand-driven momentum to momentum propelled by supply.

As the chart above indicates, it took eight or nine months for momentum to turn from demand to supply; it will take an extended period of time for it to flip back from supply to demand.  Individual investors don’t have to be the first ones to climb on that train since we have no way of knowing when it will change direction.  What we do know is that there will be plenty of time for the individual investor to climb onto a moving train that has as large capitalization as AAPL.

My earlier guess was that the “roundhouse” will be in the 350-400 range.  No need to panic and buy now.

November 29th, 2012

Head-and-Shoulders Patterns: FDX Case Study

The key point in yesterday’s discussion of the GLD and AAPL head-and-shoulders patterns can be summed up in the post’s last paragraph:

“……. no matter how good these chart patterns may look a year from now, unless and until they cross their necklines, there’s no certainty today that they won’t fail to deliver.  While getting in early will produce a greater return, the trade entails significant risk that the stock actually winds up moving in the opposite direction.”

The point perhaps not made emphatically enough is that even though head-and-shoulders stock chart patterns appears on the surface to be similar to the results of a series of random coin tosses there is a major difference between the two should the price/value cross the neckline.  The result of coin tosses merrily continues on a random path, the path in the prices/values in stocks, indexes and commodities subsequent to a cross of the neckline usually becomes impacted by a feedback loop know as “momentum”.

When they see new highs or lows being set as the price/value crosses the neckline, investors expect, even anticipate, a continuation of the prevailing trend.  That predisposition causes them to place trades (either buy if a cross above or sell if a cross below the neckline) in anticipation of being able to close those positions some time in the future at a profit.  Coin tosses have no connection with the future but investors do.

The trading rule, therefore, is that investors should wait to commit to their prospective position until momentum is launched and the signal in the form of a neckline cross is evident.  [This presumes that a neckline is something obvious and concrete but that's the topic for the next post.]

Let’s look at another example of that trading rule.  One advisory service recently substantiated their large position in FDX (Federal Express) by arguing that FDX was restructuring their operations so that their Express division is “refined” and their Ground operation “will lead to better margins and more market-share take against UPS.”  Somebody has to perform good fundamental analysis but it’s not clear whether individual investors are equipped or has the time to uncover and evaluate such information.  Large institutional investors (what I call “the heard”) do and what we can do is to follow their footprints in their hunt for big game.

If only a small percentage of the herd know or arrive at the same conclusion as the above the FDX analysis then price action in FDX shares will not be impacted dramatically.  If the analysis is correct and is reflected in operating results, the rest of the herd will join the chase and price momentum will begin.  If its efforts, the FDX shares will languish at best and fall at worst.  I would want to buy the shares only after, and not before, sufficient numbers of investors begin to believe in the FDX transformation and the shares begin to rise.

FDX stock has been restrained from continuing its uptrend by a resistance trendline (“neckline”) for over 5 years.  It isn’t relevant to the trading strategy whether you envision an emerging inverted head-and-shoulder pattern (square 1) or the longer-term ascending triangle (square 2).  To believe the story, you have to “show me the money”. You need to see the shares cross above the resistance trendline (the “neckline”) to have confidence that the uptrend momentum is sufficiently sustainable before foregoing other opportunities and putting your good money into FDX stock.  As my slogan says, “fundamental analysis is subjective, momentum is a fact.”

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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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