Weekend Update: Can Q2 Follow Through?

With the first quarter of 2013 coming to an end this past Thursday I think it is a good idea to take a look at how our top 10 stocks are performing heading into Q2. The SP500 gained just over 10% for the first quarter and continued its surge by finishing at a new all-time closing high. The all-time intra-day high is still roughly 6 points above where we are right now, but having the market finish off the first quarter at its highest closing price ever is impressive. And just to be clear, contrary to what you might hear on the radio or tv news, when the market makes a new high its a very good thing. There are many talking heads out there who love to drum up fear by making listeners nervous about an impending correction. But just know that markets don't crash from new highs, they crash after new highs fail and prices have already broken down, not when they close at record levels. This doesn't mean you should dump all your savings into the market on Monday, but it does mean that the market is strong and new highs are bullish indicators.

Lets take a look at our prospects now that the first quarter is behind us!

AAPL

OK, well AAPL seems to be trying to turn things around here and is forming a consolidation base between $480 and $420. There are a few positive things to discuss: first price has broken and held above its down trend resistance line. Also, the 20 DMA has been reclaimed and is no longer sloping lower, its is flattening and trying to rise. The bad news is that the relative strength trend has not confirmed the price breakout yet and as of this writing a higher high has not yet been formed. We would need to see a move above the $480 level to then feel the trend has fully reversed. Remember if you don't have higher highs and higher lows, its not an uptrend yet. Right now I am interested, but a move above $480 would make me an aggressive buyer (at least in the short term).

MOS

Mosaic still is struggling at those breakout levels around $63. They announced earnings last Thursday and posted a solid quarter. Price has begun to form a triangle pattern, which is a pattern of indecision and is characterized by higher lows and lower highs. Price tends to trade narrower as it gets closer to the apex of the triangle pattern and will then break hard in one direction or the other. Right now caution is advised until we see a move out of the pattern. A positive sign I have noticed recently is the level of buy interest there is in this stock. Look at the volume chart below the price chart; there are lots of large green volume days, which means there is accumulation of the stock underway. Could this triangle formation be the key to launch us over that stout resistance zone? I sure hope so!


HD

HD is still holding up well and has just pulled back from new all-time highs. The long term relative strength trend is now testing its support line, so we will be looking for a bounce in the next couple days to make sure this rally is not coming to an end.


CMI

Cummins has been under performing over the past 2 months and has broken down from its 6-month trend channel. But what is of key interest now will be the resolution of the 3 month trading range it has formed. A break above or below will be the signal we will wait for before proceeding further.

F

Ford is still trying to move higher but has been doing a lot of sideways consolidation over the past 3 months, which is natural after the huge rally it had since August. The relative strength trend support is being tested now and I will be looking for that to resolve soon to indicate to me how healthy this move really is.

WFC

Wells has a nice little setup forming here. After taking out its prior 52-week high, price is now retesting the breakout zone in a flag formation. Also price is retouching the rising 20 DMA; you could buy this right here with a stop below $36 and I think that could be a very fine trade.

 I did some looking through the key banking stocks this weekend (the primary holdings in the XLF, which we looked at last week) and I feel that if a bounce were to occur, it should occur at these current levels. JPM, GS, BAC, C are all showing orderly pullbacks and there has been a lot of chatter over the past week that the financials are being rotated out of. I see no real indication of that here and think they are ready to rejoin the uptrend.


PBW

Clean Energy is struggling here. I posted earlier last week about the potential for a intermediate term top forming in place. I still think that is the case and this will have to go through some significant technical healing before I would go overweight in this position. Price was able to hold the 38.3 retracement level this past week but the 20 DMA has crossed below the 50 DMA and both are beginning to slope lower. I have to assume lower prices are ahead in the near future based on what I'm seeing at the moment. I have reduced my position here to my minimum holding and plan to stay positioned that way until I see progress to refute this current setup.

DDD

DDD looks mighty interesting right here. Downtrend resistance has been broken, price has retaken the 20 DMA and both the long term price and relative strength trend have been able to hold. Also, it appears to me that the 5 wave correction we were watching recently, has completed.  Prices have dropped nearly 40% over the past 3 months and this now seems to have found a bottom.  I'm a long term buyer here with a stop below the $27.50 low.

Enbridge continues to be one of my strongest holdings. It keeps setting new highs and on Thursday it acquired its 46.50 range breakout target. While I am a big fan of this space, I still think a nice pullback would offer a better risk reward entry than current prices. That being said, for a short term position, you would be hard pressed to find too many stronger than this one.

HAIN

I'm just waiting for a breakout in HAIN to get aggressive here. After a 6 month consolidation, price is now retesting the upper range resistance. I like to see these tight flag formations just below key resistance, it tells me that the stock is getting ready to break out. But we are not predictors here, so we will need to wait until it in fact does break above the $62.50 level and holds. If that level is broken, there is practically zero resistance between $62.50 and the prior highs at $74.

Relative Strength Analysis Intro.

Welcome back all! Today I would like to start discussing a topic that we have looked at in some of our chart analysis but haven't really gotten too deep into. Relative strength analysis is my primary guide through the markets and individual stocks. What is relative strength? Quite simply, it is the performance of one asset vs another over a particular period of time. Why is it important to know how one stock is performing versus another? It is important to know which stocks are performing strongest and which are the weakest. Why would you want to buy the stock whose price is being destroyed, while its competitors are moving higher? I would hope you wouldn't want to buy those, I would hope that you would want to put your hard earned savings into the strongest most stable performers.

While relative strength analysis can be applied to any asset vs another, I prefer to compare all of my stocks' performance against the SP500 index. I feel the SP500 index represents the "Market" best overall and our goal as individual investors is to achieve gains on our investments that beat the Market's returns. That is why you see many of the charts I post with a comparison chart beneath the general price chart. That comparison chart is always showing the relationship of the stock in question vs the SP500 fund, the SPY. For most retail investors, the SPY is the vehicle that can be easily purchased and traded that reflects the performance of the SP500 index; therefore the SPY is the benchmark I am trying to beat on a yearly basis.

There are many in depth studies showing the value of using relative strength analysis for choosing your investments. I will hope you will take my word for it that using relative strength will significantly improve your overall returns. But if you don't believe me, go take a look through James P. O'Shaughnessy's book "What Works on Wall Street" for a ridiculously thorough analysis on relative strength investing. But the basic gist of relative strength investing is that buying the best performing stocks creates a much stronger return than buying stocks with the weakest. There are many investors that preach the buy low, sell high mantra. The only problem with a strategy like that is that by its very nature you are buying stocks that have been getting clobbered and are out of favor with The Street. There is the bent logic that those stocks are simply cheaper now than they were before, and buyers like discounts. However, a stock that has been getting cheaper for several years is not getting cheaper, its getting worse. A stock's performance will give you a pretty good idea of how investors feel about the future prospects of the underlining company; and you want to put your money into the leading companies, not the ones who are dying.

An analogy I like to use to describe relative strength investing is the concept of a horse race. Imagine you are at the race track and are betting on the ponies. You place your bets, take your odds and hope your horse comes out the winner or near to it. That strategy is analogous with "buy and hold" investing strategies. You place your bet and hope those stocks turn out well in the end. What if you chose wrong in the beginning? Your returns will suffer and you may not achieve the investment goals you set out to. Now imagine that while you are watching this horse race, you had the ability to change your bet after the first turn, then again after the second and even as they are coming down the home stretch! You would increase your chances of coming out in the end with the winner huh? Relative strength investing gives you the opportunity to adjust your positions so you are always backing the best performing companies and in turn gaining those more significant returns. 

The concept of relative strength investing is too large to cover in one post. I plan on showing different ways to use relative strength within your own investment plans in future posts to come.
We will discuss long term relative out performance trends, standard use of relative strength for asset allocation plans, and breakouts and breakdowns of relative strength trends for trading.

PBW update: Looks like a breakdown

Just an update for anyone concerned about the Clean Energy Fund, PBW. It looks to be triggering a Head and Shoulder Top pattern today and has a projected $.54 measured move target or 12.5% correction.

This pattern is certainly not the end of world in this space, but it is notable enough to consider taking some shares off the table if you own some here. The relative strength trend violation shows a weakening vs the overall market; it has telegraphed this move and makes it that much more likely to follow through to the downside.

Weekend Update: A Look Under the Hood

For this week's review we are going to take a look at the market's internals. Being that the SP500 is testing all-time highs and the Dow has already eclipsed its own prior highs, it is prudent to find out what the overall health of the market is and what sector groups are leading the rally higher. Sector analysis should be a very important part of your market research because it tells you where the strongest and weakest places are in the market.

Part of my investing strategy is to buy the strongest performing stocks over a given time-frame. If I'm taking a shorter trade I will only look back a couple months to determine relative strength. For longer, investment type purchases, I like to look much further back and find the long term out performers. Relative Strength is the concept of tracking a certain asset's performance compared to the SP500 or any other stock or index. If you just buy stocks or mutual funds without first comparing it to the overall market performance you may be putting you money in the wrong place for best results. If a stock is under performing compared to the SP500 then why take any time at doing research at all? You would be much better off just buying the SP500 fund and leaving it alone. But that is not the purpose of what we are trying to do here, we are trying to beat the market, we are looking for superior returns. In that case we need to be owning assets that are performing better than the SP500, and should be paying close attention to each group's relative strength. 

The SP500 sector groups are broken into 9 primary groups:

Offensive Groups
Financials- XLF
Consumer Discretionary- XLY
Technology- XLK
Industrials- XLI
Basic Materials- XLB
Energy- XLE

Defensive Groups
Consumer Staples- XLP
Healthcare- XLV
Utilities- XLU
Bonds
Gold
US$

Bonds, Gold, and the US Dollar are not SP500 sectors, but I like to look at them as well to get an idea of investor's risk appetite.

Typically the offensive sectors are the more economically sensitive groups. So when market conditions are the strongest, those are the groups that should be performing the best. The defensive groups tend to see money flow into them when conditions become more risk adverse and these are thought of as "safe haven" holdings. You see, big funds cannot sit in cash for long periods of time. They are required to put money to work for their investors, and therefore we tend to see their money rotate from group to group as conditions and valuations change. As you can guess, its pretty important to know where money is shifting within the markets at any given time because that is what makes prices move up and down.

All that being said, lets take a look into the SP500 groups to see where we stand at these near historic market levels.

Financials- XLF

The Financials look strong here. They are riding a very strong price trend and have been consistently out performing the SP500 for a year now. Any weakness at this point has to be considered a buying opportunity until the lower trend and rising 50 DMA is broken. This is bullish for the market.

Consumer Discretionary- XLY

The Discretionary space looks very similar to the Financials right here. Strong price trend and strong relative strength; continue to buy dips in this space as long as these two factors are in play. 

Technology- XLK

Technology has been a very disappointing space for investors for this entire 4 month rally as it has consistently under performed  for over 6 months now. This is primarily linked to the horrible performance of AAPL which has dragged the whole sector down. Until we see money start to flow into tech, its better to stay away. The first thing we will be looking for here is for the relative strength line to break above the downtrend resistance. That will be a signal that a shift is underway.

Industrials- XLI

Industrials have performed well over the past 4 months, but now have seemed to have slowed. With concerns over China's growth coming back to the forefront, the industrial space has started to break its out performance uptrend. Typically when the relative strength trend breaks its no bueno.

Basic Materials- XLB

Materials have been disappointing during most of this rally and have been showing clear under performance as a group since mid-January. Until this starts acting better you would be wise to look elsewhere.

Energy- XLE

Energy looks a lot like Materials. I think there are better prospects in the market right now.

Consumer Staples- XLP

  
While it seems that consumer staples have been ripping, they haven't really been doing so on a relative basis. The staples are now testing upper resistance on its relative strength chart and this could help clarify in the coming weeks whether staples will make a new relative high or continue to trade in the range.

Healthcare- XLV

Healthcare has been a top performer during this current rally and has a very strong trend vs the SPY, which has recently moved to new highs. Price looks to be forming a rising wedge pattern which tends to resolve to the downside, but we will have to see that happen before we get too concerned about healthcare.

Utilities- XLU

Utilities have broken out of a longer term downtrend in relative strength and seem to be seeing a solid rotation of funds. Usually when utilities start to out perform, its bad news for the market as a whole.

20+ Year Treasury Bond- TLT

Treasury bonds have been in a very clean downtrend for about 6 months now and are currently testing the upper resistance boundary in price and relative strength. Treasury bonds as an asset class tend to trade inversely to the market. If both price and relative strength were to break to the upside here that would be a very negative signal for the market.

Gold- GLD

Gold has looked similar to bonds since mid-November and shows the risk appetite for market participants over that period of time. Gold is thought of as a fear trade, people want lots of it when they are scared and want nothing to do with it when they feel safe. Right now GLD is attempting a breakout of the 6 month relative strength trend and seems to be catching a bounce. The key test for gold will be sustaining this bounce and breaking out above the $159 level. I would be a buyer of that move.

US Dollar- DXY0

Yet another safety trade is the US Dollar. When Europe or Emerging Markets get all jittery the Dollar catches a bid. First it was the elections in Italy and now the Cyprus banking issues, the world continues to see the US as the strongest and safest. The Dollar has broken out from its relative strength downtrend and is now sustaining a 2-month upward trend. Typically the S&P performs better as the Dollar moves lower, now the Dollar seems to be taking the lead.

Conclusions:

I'm seeing some things that concern me and others that could be great opportunities. As of right now only 2 offensive sectors are leading (XLF,XLY), and most others seem to be rolling over. Technology could be interesting if it breaks out. There are many big investment managers that won't believe in a major rally unless technology is leading the move higher. Tech has lagged badly for this entire rally and it is possible that if technology breaks out it could be the next catalyst for the breakout to new market highs. AAPL would be VERY interesting for a short-term trade if that were to be the case.

What concerns me is how almost every defensive group is breaking out or testing a breakout to the upside vs the SP500. All the while, over the past month Industrials, Materials and Energy all seem to be weakening considerably. When momentum starts to swing from prior out performers into the defensive's, its usually a sign of underlying weakening of the current trend.

While I remain 50% invested at the close Friday, I will continue to look for both opportunities to buy and opportunities to sell. I would be a buyer on further weakness in Financials and Discretionary, as well as Technology if it were to breakout here. But at the same time, if the offensives continue to lag while these key defensive plays rally, I will be looking to further reduce my holdings into any market strength we see up to S&P 1,575.

Weekend Update March 15: Closing in on All Time Highs

Hi Everyone, I hope you had a good week. I just got news that my wife and I are expecting our second child! We are very excited about that! The tentative due date is October 20. I will keep you all posted on number 2 as we continue through the process. While we are discussing babies, our 14 month old, Lyra, started taking her first steps also this week! So I hope you will forgive me this week as my attention has been on some pretty important things. 

As for the markets, the SP500 just continues to grind higher, much to the irritation of many out there who are under invested. We still have an inverse head/shoulder pattern in play with a target price of 1,566, and all indications show that we should achieve that target.

Being that we are so close to achieving our target and very near all-time highs, I think it would make sense to move your stops up on short term positions. If the SP500 were to break trend and fall through the 1,548 level I would be reducing positions. There will be another time to buy when the market has corrected and will offer lower risk opportunities. For example, choosing to wait for this recent pattern to set up allowed us to position ourselves to get our money invested in a much higher probability situation. Right now we are very near the pattern completion and is the time to start looking for exit points are you holdings. The nice thing about stocks is that you can always buy them back. If you are not correct in your idea of where a stock will move, you can just wait until an opportunity arises again.


Some quick thoughts on our holdings of interest:

WFC

Well my call last week proved to be ill timed. While JPM has performed very well, WFC has been more or less sideways for a year, at least until Friday. Wells got a huge breakout while JPM was hit with some concern over current risk taking strategies. While shares managed to hold up quite well in JPM after the news, Wells clearly started showing some real strength. Both I feel are excellent investments long term and should provide solid returns as housing continues to recover.

DDD

DDD continues its move lower, closing lower every day this week. I feel that we are nearing the end of a 5-wave correction and major support is just below current prices. I suggest you do a little research on Elliott Wave Theory as that will help you understand basic sentiment patterns in the market. This is getting really close to what I would consider a strong long-term buy.

ENB

 Enbridge continues its string of new all-time highs. Just really strong action over the past several years. Keep riding this one but I would wait for a decent pullback to around $42 to put new money to work. I'm not selling ENB up here but I'm not buying either.

PBW

Speaking of wave theory, I think the move in clean energy is in the early stages. I can see how we possibly could have just completed a 2nd wave pullback after a solid 1st impulse wave. A quick note on 5-wave sequences: Typically the 3rd wave is the longest and the 5th wave is the most violent. Any counter-trend wave (waves 2 and 4) should never correct all of the prior wave. Wave analysis is tricky and is much more of an art than a science, but it is based in human psychology and is an important concept to be familiar with.

HAIN

HAIN just won't give up. It managed to hold above a key resistance level of $57 and now seems poised to retest the upper range resistance. I am impressed with how it has managed to hold off the bear flag setup we saw in last weekend's update, and move back above the key $57 level. Also of note, even after a ~25% pullback from its highs, HAIN's long-term relative out performance trend is still intact.

AAPL

Well, well...Some light at the end of the tunnel? We are seeing a positive divergence in momentum vs. price and price has just broken back above the down trend resistance line. $480 is a key level to me, if $480 was retaken I would like to be a buyer. It's not at a buy just yet, but things are starting to look a little better. This week will be very interesting in terms of whether this is a false breakout or if a reversal is developing. AAPL should be on your radar now.

MOS

Mosaic is now retesting its key resistance area. Remember about resistance areas, the more times a level is tested, the more likely it is to fail. After a sharp and rapid decline, MOS looks ready to push to new 52 week highs

HD

Home Depot has begun to take a breather after a torrid 2 week period. It is in mid trend here and sort of in no-man's-land. I would be a buyer near trend support, but the $68 level should provide some near term support also.

CMI

Cummins is about to test its prior 52-week high and is holding near the lower end of its uptrend channel. A cup/handle type pattern is forming and a break above $120 would set this pattern into motion. This cup has a price target to $129 and would retest all-time highs.

F

F still seems to be working on its double bottom formation. This week we saw price get back above the key $13 level and is showing strong action. A break of the prior low around $12 would present a problem to  our double bottom thesis.

Weekend Update: Continuing Higher?

With February now behind us, the SP500 sits at a roughly a 10% gain on the year. Short term there is an inverse head/shoulder pattern in play with a target price of 1,566, 1% away from current levels, and less than 2% below the all-time closing high at 1,576. The February non-farm payrolls report last Friday came in better than expected and the Federal Reserve's monetary policy continues to be easy.

Today though, I want to take a look at a little longer term view. We are going to be looking back a year or two at some weekly bar charts to try and gain some perspective on these recent, impressive stats.

The SP500 will be testing some very important and significant resistance very soon. Not only are the all-time highs just above, but the intermediate term trend channel resistance is also right there. Our short-term head/shoulder pattern has us moving ever so much closer to those levels. I try not to get ahead of myself too much with these strong up trends, typically I need to see some significantly poor trading action before I would want to sellout in a trend this strong. But there are times during even the strongest of trends where it is smart to tread lightly and we are approaching one of those times.

That doesn't mean I going to sell everything as we near this resistance, but it does mean you should reduce exposure to maybe 50% or so. I am a long term believer that the market will continue higher, but there will also be times during that period where you will not want to hold too many stocks. Now is not that time; stocks right now should be considered a strong percentage of your savings in my opinion, but I don't like the idea of putting too much new money to work at these levels for anything more than shorter term trades. To build long term positions, there will be better entry points in the near future. I am pro short term trades, intermediate term holdings, and saving some cash up for a time when the sky seems to be falling a bit more.

Here's a few thoughts about some of our watch list stocks:

DDD

Once super hot, DDD has now cut roughly 40% off of its share price since late January. For a long term investment (as you know from previous posts I am a believer in 3D printing) this is exactly the kind of opportunity you want to look for. If you have conviction in a stock and believe the long term story, you want to be a buyer on significant price weakness. I liked this stock at $50...I REALLY like it at $33 and change. I am stalking this one for an entry and it seems to be approaching fairly significant support around the $30 area. If $30 breaks down easily then we will step aside a bit longer and continue to watch.

For anyone wondering why the price scale in DDD has changed so much from earlier this year, its because they just underwent a 3-2 stock split. Simply meaning for every two shares you owned prior to the split, you would now have three and the share price would be 1/3 less. It really changes nothing in terms value, its simply to make the stock trade more liquid (more shares available for a lesser price tag).

AAPL

 
Still getting clobbered and making lots of new lows. I do think this will present very compelling value when it finally settles out, but right now it just keeps creating new levels of resistance as it trades lower.

MOS

After failing at resistance earlier this year MOS has been able to stabilize itself at key support. Price still made a higher low in late 2012, then a higher high and now another higher low. Also impressive is how it held key support so well. The 20 and 50 week averages, and the 38.2 retracement level were tested. As long as the recent low holds, I think the thesis we had at the beginning of the year is still intact.  

HD

Sigh...Another one that slipped away. If only I would have taken more time with reviewing this position I could have looked at this chart and still felt very confident in the holding. Instead I got preoccupied with the short-term and lost perspective on the bigger picture. Aside from that, HD continues to make new all-time highs and I will be looking for the next retest of the trend support to reenter.

F

 Ford is at an interesting juncture here. It pulled back below the key $13.00 level and is now trying to retest the level. The uptrend is intact still and we want to see a resolution back above 13.00. Possibly seeing a bull flag formation here, again the 13.00 level will be key for a breakout.

WFC

Wells is back testing its 2 year highs which is good. What isn't the best is that the price is not being confirmed by momentum. As you can see the MACD is putting in lower highs while price is back at its highs. This is a divergence and doesn't mean too much yet,but if Wells struggles it could breakdown faster than normal. Which leads to our next chart...

 JPM

Bonus chart of the week is JP Morgan Chase. This chart is to compliment the WFC analysis and an observation I have made. I like stocks that perform the strongest for owning and trading. In terms of Relative Strength, JPM is outperforming Wells and the SP500 by a healthy margin. Plus JPM has already taken out its prior highs and has shown good breakout follow through, while Wells is still testing. You can also see how momentum has not dipped in JPM as the MACD still looks strong.

To be clear I still like Wells as a long term option, but I am favoring JPM for now and have switched them in my own portfolios. JPM has a higher risk profile than Wells, but also has stronger overall action and the nice thing about trading is that you can change horses mid-race to make sure you are behind the leader. There may be a time when Wells starts outperforming JPM, and when that time comes we can simply adjust our holdings to match the strength.

HAIN

 As we discussed in our recent chart patterns post, HAIN has a couple tough tests ahead of it in the short term. There are also some tests with the longer time frame that are appearing. Both the 20 and 50 week averages are just above and could provide some resistance. We are seeing the long term relative strength ratio testing key trend support, that will be important to hold for the strength of the rally. Lastly, HAIN seems to be creating a trading range between $63 and $52.50; remember from our range trades lesson, a resolution of this range will be the most important factor in determining the next intermediate move.

Chart Patterns Part 3: Continuation Patterns

In previous posts we have discussed a few key reversal patterns and now we need to cover patterns that form in between reversals; we need to identify patterns that occur during trends. There are many patterns that occur while a trend is in place, they are often referred to as continuation patterns. Just as with the reversal patterns, we are only going to focus on the most common continuation patterns.

Continuation patterns, by their very names, tend to resolve in the current direction of the pattern or prior trend. The primary continuation patterns I like to focus on are Flags, Cup/Handles, and consolidation ranges.

Flags

Flag patterns come in two varieties Bull Flags and Bear Flags. A flag pattern symbolizes a swift, sharp move in one direction followed by a pausing period where short-term traders take profits and reposition after the quick rally.

 Bull Flag

You can see the sharp increase in price (flag pole) that almost moved straight up for several bars right at the end of 2012, followed by a tight downward consolidation (flag). Flag patterns are also accompanied by a large spike in trading volume during the flag pole stage, then preceded by a low volume consolidation. This sort of volume spike rally and subsequent sideways trading without heavy selling shows strong conviction behind the previous up move. The pattern triggers once price breaks above the upper consolidation line and continues the upward momentum. Measuring a flag pattern is as simple as taking the length of the mast (flag pole) and adding that to the breakout area. That gives you your projected price target from the flag pattern.

Bear Flag

Here is a possible Bear flag in process; this is one of our watch list stocks HAIN. To me it looks like HAIN is forming a bear flag. Keep in mind that until the support trendline of the flag area breaks, nothing is confirmed. However, this is setting up like a textbook bear flag patten: high volume selloff, followed by a low volume rally into over head resistance (if you remember back to previous posts the $57 level is key here in HAIN). Also price is nearing a test of its down-sloping 20 DMA (blue line). If the 50 DMA (red line) fails, that would be the pattern confirmation and a definite sell signal.

 Cup/Handle

Cup/Handle patterns can also be called rounded bottoms. A Cup/Handle formation gets its name because the formation very much resembles a cup with a handle. This is a bullish pattern setup and can be found often in rallying stocks.

This is one of my favorite setups at the current moment, Abbott Labs (ABT). The Cup/Handle pattern represents a pause in a previous rally, followed by a bullish move to retest the prior high. After the retest, price will then pull back, but not back to the previous lows; price forms a higher low. The pattern is triggered once the price breaks out back above the recent high. Something that you may notice with Cup/Handles is that the right part of the cup and then handle, resembles the bull flag we just discussed. That's the thing about reading patterns and price action, many of these patterns form within other patterns and simply reenforce the bias of the larger pattern in play. So to see a cup/handle forming with the right side of the cup being a bull flag symbolizes a strong conviction behind the future upward movement of the stock. Cup/Handles are measured similarly to other patterns we have discussed; take the highs of the rim of the cup, minus the low that forms the bottom of the cup and project that difference above the breakout from the rim highs.


Rectangles/Consolidation Ranges

Consolidation ranges and rectangles are very common forms of price taking a pause from its recent ascent/descent. Similar to what we have looked at with flag patterns, consolidations tend to let a strong move cool off a bit and allow traders to reposition for another leg higher or lower. The most important thing to remember with consolidations and rectangles is that nothing is resolved until a new high or a new low is made. Also, being continuation patterns, ranges tend to resolve in the direction of the larger trend in play.

Enbridge is a great example of a range consolidation. After moving strongly higher over the past few years, price took about a 9 month pause in the uptrend and chopped sideways. ENB recently broke out of this rectangle formation and has continued higher over the past 6 months. When measuring a range breakout you simply take the difference between the highs of the range and the lows of the range. You then add that range height to the breakout area and that projects your expected move.

Here is another example of a rectangle/range trade. This shows a downward breakout from rectangle patterns preceded by a longer-term down trend. 


To wrap up our lessons on patterns, I would like to say that these patterns don't always play out to fruition. Sometimes patterns fail and as always you need to be ready and aware of any curve balls the market might through your way. Remember if it was easy then everyone would be a millionaire. But being able to successfully identify these reoccurring and consistent formations can give you some valuable information about the future price movements of the assets you choose to invest in.

I strongly advise you to do further reading and research into these pattern formations which you can find on investopedia, stockcharts.com in their chart school section, or in your google browser. There are always nuances and different perspectives on trading psychology that can be shared from others as well. I have found through my experiences in the markets that these formations play out to success at a very high frequency and give you yet another way to navigate the waters ahead.

Beta: Know Your Movers, Know Your Risk

I really like to find stocks that tend to outperform the SP500 during up trends; stocks that tend to outperform during up markets show strong relative strength. However, stocks that outperform during rallies tend to carry inherently more risk for their potential reward.  An important concept for understanding the risk of a particular stock is knowing what its Beta is. A stock's Beta is basically its relationship (performance) vs. the SP500 over a long period of time. More risky stocks tend to have higher Beta and safer stocks have lower Beta. A stock with a higher beta (>1) will outperform the market during rallies and under perform during declines. A lower beta stock (<1) will under perform during rallies but with outperform during declines. Understanding beta is a very important concept when it comes building and managing your investments. If you are building a portfolio of stocks you need to identify what the primary purpose of your investments will be. Are you investing for growth? For value? For dividends? Understanding the proper asset for each investment plan is absolutely critical to achieve the results you desire.

If you are relatively young (under 40) and looking to put away some savings hoping it will grow fast then you will need to create a high beta portfolio. If you are over 50, nearing retirement, and hoping to maintain what you currently have, then low beta dividend positions would be right for you. The nice thing about understanding beta is that you can also mix and match them in a portfolio. You may choose to invest in some higher beta positions while hedging those riskier assets with some lower beta holdings. That way when the market goes up, part of your portfolio will outperform. When the market takes a hit you will lose some with the higher risk holdings, but the other portion of lower beta assets will hold up much better.

Quantifing the effect of beta vs SP500 performance 

When you are looking through assets for higher or lower beta you will find that rarely are they nice round numbers. The important thing to know about determining high or low beta is how far from 1 the asset's beta is. For example a stock with a beta of 2 will move twice as fast as the SP500 on average. Therefore if the SP500 is up 1% on the day, we would expect the 2 beta stock to be up close to 2%. On the flip side of that, if the market is down 1%, our stock would be down about 2%. So you can see the inherent risk/reward with higher beta stocks. The SP500 has a beta of 1; 1 is the constant for "market perform" or matching the return of the SP500. A stock with a beta of 1 will be expected to perform equal to the market. A stock with a beta of .5 will return about half of the SP500, which is great if the market is down 5%, but not as much if the market is up 5%. Your .5 beta stock would be down 2.5% and up 2.5% respectively.

High and Low Beta Stocks

High                                               Low

DDD  2.05                                       HAIN   0.3
MOS  1.55                                       AAPL  0.74
F         1.55                                       ENB    0.46
WFC  1.23                                       HD       0.99
CMI   1.74

This is the beta list for our watch list stocks. The beta for any other stock can easily be found on Yahoo Finance or any other reputable business news website. 

Most of the higher paying dividend stocks have lower beta:

T          0.39 
AEP     0.33
PFE      0.74
AGNC  0.24

While other riskier stocks tend to have higher beta

BBRY  1.54
SSYS   1.53
FB        1.70

Beta doesn't guarantee an exact result in relationship to market performance, but it does give us some idea as to how a particular investment should behave. Investing only in Beta is a terrible way to build a portfolio, however it is another important concept for understanding the risk you are exposing yourself and your savings to. 

Weekend Update: February in the Books

February was more or less a sideways month for the markets. Jobless claims continue to decline signaling a steady but slow job recovery and the stock market continues to flirt with all-time highs. The Federal Reserve continues to prop up the market with its ongoing stimulus activities (here is the POMO schedule for March). 

Sideways markets tend to be the hardest for me to trade. I seem to be able to outperform the market during up trends and down trends, but during sideways trades I tend to under perform significantly. This is something I will continue to work on. Each time I go through a sideways market I improve, but I am still not where I need to be in this environment. For this week's discussion we will be looking at a shorter time view; all charts shown are 30 minute bar charts covering roughly the past 2 weeks to one month.

As for the recent trading action, the SP500 is beginning to show some signs that it wants to continue higher after its recent pause and chop. Since completing its inverse head/shoulder reversal at 1,525 two weeks ago there has been a lot of talk about a top being in the market and significantly lower prices just ahead. However this market continues to be resilient and is once again trying to throw everyone a curve ball. We seem to be forming another inverse head/shoulder pattern that is trying to reverse the near term down swing. For this pattern to trigger we need to see a close higher than the 1,525 resistance area. Along with the pattern triggering on a 1,525 break we would also break the recent pattern of lower highs. This HS pattern has a 40 point measured target which would be acquired at 1,565 and would be within 1% of reaching new all time highs.

DDD

One way I intend to trade the breakout in the market (if we get one) will be through DDD. 3D Systems is a fast mover and those are the types of stocks we want to trade for short term gains. Also you can see above that DDD is forming its own inverse HS pattern that would trigger with a break above 38.30. I would look to buy this aggressively if the SP500 breaks out.

HD

This is a perfect lesson of how even with a solid trading plan we can succumb to emotions and make poor decisions. Here is good old Home Depot which I decided to take my profits and get out of the way once this Double Top pattern triggered. Even though it was still in its long term trend channel, I chose to sell, just to watch it turn and rip in my face. This was actually a pretty sweet setup watching it with a clear head; The Double Top pattern triggered and completed almost exactly on trend support. That would have been an excellent place to add to a position, yet I failed to assess that in real time and have since had to watch this one run on me.

Making one mistake however doesn't mean compounding that mistake with another. It is not a good idea to chase this one right here. We have missed this leg higher and we will need to wait for this to set up again.


PBW

PBW is looking rather unpleasant in the short term here. Forming a pretty nasty HS Top formation. You can also see the Relative Strength has performed poorly recently and has also broken its uptrend. With a break below 4.35, this has a measured move target to about 3.85. This isn't an end to my clean energy thesis and if you are playing this one longer term, there isn't too much to worry about yet. As a trade, we need to put this on ice for a while and wait for it to set up.

CAT

Caterpillar isn't one of our main watch list stocks but I thought I would share this one with you. I follow this regularly on my big watch list and really like how this is setting up. We have seen a HS Top form in late January to early February and has now completed and it attempting a reversal to continue the longer term uptrend. Similarly to DDD, I plan to trade CAT aggressively if the SP500 can manage to break out with its own pattern.