Stock Chart Reading II

 

Should You Buy Stock Price Strength or Weakness?

Tightening Closing Prices Can Indicate Buying Pressure

Lots of Stock Set-Ups in the Energy Patch

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With most leading stocks taking big hits during the past three weeks, the evidence for the health of the overall market has weakened—I chat more about that below. But first, I will continue my chart series, which I began two weeks ago by writing about using bursts of volume to identify areas of support (allowing you to find good entry levels) and resistance (selling levels).

I’ll start by addressing a question I frequently get from subscribers—is it better to buy on strength or on weakness? Well, like many things in the market, both can work, and I use both approaches in my advisories. There have been many times I’ve bought a stock that just gapped up out of a multi-week consolidation, so I’m clearly OK buying on strength. Yet one of the main tenents of Cabot Top Ten Trader, for instance, is to try to buy stocks in defined uptrends during temporary weakness.

Both approaches can work, and my experience is that nearly all investors fall into one of these categories; if I had to guess, 80% like to buy on pullbacks (it’s psychologically easier because it feels like you’re getting a good price), while about 20% generally buy only when a stock moves to a new high or above a resistance level.

However, there’s one aspect of chart analysis that I’ve found extremely valuable for identifying excellent entry points or times when a stock is just about to move. It’s neither strength, nor weakness, but tightness—i.e., after a stock meanders in a tight range for many days or weeks on light volume, you’ll often see an explosive move or a resumption of a stock’s major uptrend.

Before I get into the details, I just want to reiterate what I always say when talking about charts: Nothing is certain, and even the highest-probability patterns will “only” work 70% or 75% of the time. Moreover, context matters, including a stock’s fundamentals and liquidity (I deal only with relatively well-traded stocks with great sales and earnings outlooks), as well as where a stock is in its overall run (something I’ll write about in a separate lesson). But in general, training your eye to look for tightness will help your overall results.

Before I give you some examples, it’s important that you understand why tightness is a good sign, and for that, we’ll go back to thinking about institutional investors. Obviously, if big investors are buying, it can drive a stock up, and vice versa. But these guys aren’t stupid—they’re not eager to run the price up on themselves! So what you often see is that, after a period of volatility, many of the smaller players will leave for greener pastures (stocks still in strong trends), leading the institutions to accumulate shares, which they like to do in a certain price zone. They may want to buy as much as they can between 53 and 56, for instance, and if enough institutions are thinking alike, the stock will tighten up in that range.

Tightness often reflects the fact that there’s no more selling coming into the stock, leaving big investors (who are bullish on the stock’s prospects) in control. If you combine this with a major uptrend in the stock and market, as well as high-potential fundamentals, it can alert you to the fact that a stock’s consolidation phase is nearing an end.

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A classic example was Google’s (GOOG) first base in 2005 … actually a “base-on-base” (two consolidations separated by a failed breakout attempt, this one in January). After four months of ups and downs, notice how GOOG on its weekly chart calmed down in a big way—the stock closed basically at the same price four weeks in a row and the weekly spreads were small. That was a sign that this new, generally uptrending stock had likely worn out the weak hands and was ready to move. I’m not saying you should have bought it right there, but if you were playing attention (and few investors were … hence the tightness!), you would have identified this as a clue that the stock was ready to move.

You’ll often see calmer, tighter action on a weekly chart after a stock has gone through many weeks, months or even years of consolidation, again giving you a heads-up it may be ready to move.

Las Vegas Sands (LVS) is another example—the stock topped in October 2010 (the very left hand side of the chart) and then chopped sideways for three years. (It did hit marginal new price highs but its relative performance line never got going during this time.) But then it formed a tighter, proper consolidation last year—look how, after a shakeout to the 40-week moving average, LVS tightened up nicely near 55 and then broke out on the upside. It ran as high as 88 during the next six months.

Another time to look for tightness is soon after a powerful breakout; it can be spotted on either the daily or weekly chart.

Apple (AAPL) was an awesome example after its October 2004 gap up (when the iPod was a big hit). Look at how, even after a dramatic upmove, shares went straight sideways for a few days in mid-October. And then it did it again during the first part of November! You probably wouldn’t pile in with a huge position at those points, but if you didn’t own any, you could start small. And if you did own some, you could buy a little more if/when the stock moved out to new highs.

A similar post-breakout example on a weekly chart came recently with Priceline.com (PCLN). After a long consolidation (which was actually part of a bigger base-on-base), the stock broke out in April, but then paused tightly in the 800 to 850 area as the market corrected. Check out the tight, straight-sideways action for much of May and June.

The bottom line is that tight action soon after a breakout, or after many weeks of choppy action, is often a sign that the weak hands have left so there’s no more supply coming into the stock. And that means that if the market is trending up and the fundamentals are enticing, any buying pressures could send the stock skyward.

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As for the current market, I haven’t seen such a divergent situation in many, many years. From a top-down perspective, the major indexes are in pretty good shape—granted, not much progress has been made during the first three months of the year (up a couple of percent depending on the index), but the broad market is at least holding firm.

High relative performance stocks, however, (the kind I generally focus on) have been crushed during the past three weeks, with numerous liquid leaders (and many secondary leaders) decisively breaking down. It’s probably been the worst stretch for growth-oriented stocks in at least a year, probably longer.

With this evidence, I have a couple of thoughts. First, I do believe many (not all) growth stocks have hit intermediate-term tops. Sure, it’s possible that some will come roaring back (earnings season kicks off in a few weeks), but after huge runs and decisive, big-volume breakdowns, time is likely needed to repair the damage.

Second, the next few days should tell us if the selling pressure will spread from high-growth stocks to the rest of the market. The longer the S&P 500 and resilient sectors can hold up, the greater the chance they can head higher (as opposed to just chop around).

Because of that, I’m not much in a buying mood right now; I’ll do some watching and waiting instead. As always, I’ll keep my watch list up to date, focusing on well-traded stocks that are holding up well, that have good earnings outlooks and that haven’t been running for a year or two (which would make them more prone to sudden collapse).

Interestingly, I am finding a ton of set-ups in the energy group. Most energy stocks ran up during September and October, then sagged into the January low, rebounded in February ... and they’ve been consolidating tightly during the recent market turbulence.

On the mega-cap side, a name I like is Baker Hughes (BHI), which had five straight weeks of big-volume buying after the January low, and is now pausing nicely in the low 60s. The stock is just emerging from a couple of dead years, too, which is nice. Also encouraging is that earnings are projected to soar 54% this year and 25% next as the on-shore drilling cycle turns up! A stop near 58 makes sense if you buy here, or you can just wait for a breakout above 64.

On the explorer side, keep an eye on Concho Resources (CXO), which, like BHI, hasn’t done much since the spring of 2011. The stock has set up a beautiful base, and earnings estimates are up (gains of 22% this year and 26% next year). A powerful push above 123 would be intriguing, with a stop near 114.

Lastly, on the smaller side, is U.S. Silica (SLCA), which is a leading provider of fracking sand. Again, earnings are expected to grow rapidly this year and next (25% and 36%), and the stock has rallied strongly back to the top of its 21-week base. The stock is much more volatile than the other two mentioned, so if you want to play it, keep the position small and use a stop near 32 or so.

Working to make you a better investor,

Michael Cintolo
Chief Analyst of Cabot Market Letter
and Cabot Top Ten Trader

RELATED ARTICLES:

A Brief Series on Stock Chart Reading - Part I


Michael Cintolo can be found on Google Plus.

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