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When you spot a hot guru, it pays to follow his advice. Since the stock market is in what IBD suggests is a “confirmed rally”, it may be too early to short stocks or take bearish positions. Yet there is some value in reviewing some concepts presented by the hot guru, with some current day chart examples. I would highly recommend reading this pamphlet and studying their chart illustrations in preparation for the next phase of the bear market. From a fundamental standpoint there is tremendous profit potential on the bear side of overvalued US stocks, and at some point valuation will matter again. I’ll discuss my interpretation of some of O’Neil’s concepts tonight. Market Conditions are Important Their “Cardinal Rule No. 1” is to sell short only during what you believe is a developing bear market, not a bull market. In addition to their general market assessment which entails counting “distribution days”, they suggest looking at the behavior of individual stocks to aid in assessing the general condition of the market. The presence of chart “breakouts” to new 52-week highs does not necessarily signal a sustained bull market. “Topping markets are also characterized by a number of stocks that will break out of chart base formations, only to fail a few weeks later. Most of these chart patterns, upon closer investigation, are actually faulty, improper formations.” I believe that we may be seeing numerous such faulty improper formations now. For example, following is a six-month weekly chart of Toll Brothers (TOL), the leading home building stock.
Toll Brothers appears to have decisively broken out of a cup formation this week on more good news from the homebuilders. Yet note how much volume there is in the lower 50% of the cup. All of this “work” in the bottom of a base is not necessarily healthy action. If the stock were to correct back to about 90 over several weeks on low volume this may constitute the “healthy” formation of a “handle” and may suggest the potential for a sustained advance if a breakout of the handle occurs. No Rush Although the stock could fail in its breakout and crash back below 90 or below, would such a move constitute an optimal shorting point according to O’Neil’s method? Probably not. O’Neil states (Page 24, black bold by authors, blue bold by Martin) “A very important and key concept in successfully timing short sales is that the optimal shorting point will, in the majority of cases, present itself five to seven months or more after the absolute peak in a stock….The primary reason this needs to occur is that bullish sentiment will remain in a former big leader for a period of time after the absolute peak. Investors, both amateur and professional alike, who watched the stock rocket higher but never got on board now see the lower price the stock as a “bargain”. This sort of bargain hunting can induce several waves of buying which create a series of rallies, normally back above a key moving average…These rallies run in premature short sellers and bring in the last, late bargain hunting buyers. It is not until all of these premature short sellers and late-comers to the stock are worn down and worn out that the stock finally will begin to break significantly.” This hasn’t come close to occurring in the homebuilding stocks yet, so except for the most aggressive traders; it is too early to invest real money against the bursting of the housing bubble. But these stocks warrant close attention in order to determine when to place speculative bearish bets which will prove to be profitable. Hope Springs Eternal – Despair Takes Patience O’Neil suggests that a way to establish when the stock may “break significantly” is when the 50-day passes below the 200-day moving average. It is at that time when the stock should be watched for an optimal entry point. Such an entry point may present itself as a high volume break of the stock decisively below the 50-day average. There are many concepts presented but few hard and fast rules. He also suggests that after topping and breaking sharply, a stock often attempts two to four rallies back through the 50-day moving average before the time when it breaks significantly. Following is a recent example, Lear Corp. (LEA).
Auto interior maker, Lear is a leader and institutional favorite in the auto parts sector. Note the stock put in a top back in January of 2004, yet didn’t “crater” until January of 2005, one full year from its top. Through that year, both bulls and bears were hurt as bullish hope was slowly lost while shorts were periodically “run in”. A look at the daily chart from the winter of 2005 shows possible entry points on the short side. By that time, there were four rallies above the 50-day moving average which sold out all “bargain hunters” while premature shorts were also “run in”. With both bargain hunters and premature shorts hurting, the stock was ready to crater. In hind site the breaking of the 50-day moving average presented an excellent point in which to short with stops set decisively above the 50-day moving average. The trip south from the mid 50s to the mid 30’s took less than one quarter.
Modern-Day Head-and-Shoulders Patterns O’Neil suggests shorting off of head-and-shoulders reversal patterns, yet whereas the neckline breakdown or rally back to the neckline represents the optimal entry point from most of the technical literature, O’Neil states (Page 29), “Normally trying to short at the neckline is too obvious, which is why we use 50-day moving average breaks to determine proper shorts.” Climax Tops The pamphlet points out that in the last bull market Human Genome (HGSI), Qualcom (QCOM), and AOL ended their huge runs with a “climax top”. This is described in page 19. “Sometimes a stock’s advance gets so active that it has a rapid price run-up for two or three weeks on a weekly chart (eight to ten days on a daily chart). Often times this final run-up is accompanied by several upside “gaps” in the daily chart. The price spread from the stock’s low to high for the week will be greater than in any prior week since the beginning of the original move many months earlier.” I believe that we have the beginnings of a classic climax top in Google, Inc. Note the 3 gaps on the daily chart and the rapid run up.
The weekly chart paints a similar picture. Note the Monday morning gaps which is highly unusual and smells to me.
There is no reason to short this stock at these levels. There is much hope and hubris that needs to get wrung out of this $82 billion dollar company before valuation will count. This will probably need to occur over several quarters and numerous analyst upgrades. Today’s Market The chart below is a 6-month daily candlestick chart of the Nasdaq composite. We are in a sharp sustainable rally that began with a decisive “hammer” pattern and follow through that occurred in late April at just above 1900. So far there has been barely a pullback. So much for “sell in May and go away”! We are now at a key support/resistance technical level near 2100, with the Nasdaq composite gaining volume over the last 2 trading days. If the Nasdaq fails at the lower blue line, it will want to fill the gap between 2000 and 2010 (thin purple line). Classic technical analysis would suggest that the Nasdaq would need to take a breather before making an attempt at the New Year’s high. Yet the last year has been filled with long “V” patterns and explosive moves to the upside to run out shorts and attract hot money going long for the most basic reason out there: “its going up!”.
While you could make a good case for the overvaluation of stocks such as Google, one could also argue (as in 2000) that it is difficult to evaluate a company that is so new in its business model and growing. But who is to explain the valuations and lack of dividends that now exist in the retail sector? Some of these stocks are totally visible in their business model and it is very clear that such companies are clearly cyclical in nature. It is also clear that within their cyclical nature they are near the top of their respective cycles. And still the stock market is discounting historically high multiples of their Fed-liquidity-induced record earnings. So while fundamentally one could argue Google, it is suspect that consumer related companies are so “hot." In my view the current stock market bubble is being hidden by the more formidable real estate bubble. But in its own right, it’s a bubble also. Here is an example – Michael Stores (MIK).
Note how this stock, after being in a linear uptrend for over a year, has accelerated in its upward trajectory. It is great to be in this stock, yet it is also important to note that such vertical moves are not sustainable. It is not time to short this stock, obviously, since there is a lot of hope to hurt, and early shorts to be “run in.” But action such as this deserves attention since it no longer looks like “smart buying,” but rather something quite emotional. Greed prevails in the retail sector. Aeropostale is a company that went public less than three years ago and somehow managed to sell out shares to a point where insiders now only own 2.4% of the company according to Yahoo! finance. The stock was up 5.6% today on same store sales that were down but beat analyst expectations. This is one worth watching from the bear side when the hope dies out as ARO is a laggard in the extremely hot retail sector of kid’s cloths. For the shorter-term-minded, it’s in a tradable trading range as you can see from the chart below.
Bonds continue to rally, oil held its ground and gold and silver continued in their short term rally, although the XAU and HUI were down. Let me leave you with a conspiracy theory. Looking at the recent behavior of the Nasdaq compared to the S&P, it becomes apparent that something “good” has happened to the Nasdaq, relatively speaking, and that this good fortune was discounted by the stock market for several weeks.
Today the option-granting technology generals, Cisco, Intel, Dell, and Oracle were up 1.2, 1.1, 0.74, and 1.0 percent, respectively. Yet the technology general that expenses options, Microsoft was down fractionally today. Today a SEC Chairman from the Silicon Valley state, California was appointed by the President after the existing chairman resigned yesterday. So is this what’s behind the Nasdaq rally? The rapidity which with this all happened leads me to believe that many people knew in advance. Think about this bid of paranoia on my part as you enjoy this beautiful spring evening. Martin Goldberg
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