April 21, 2014 - AD Line

From a market technician’s aspect there is only one thing that matters and that is price as it reflects all known information.  Most newcomers to the market can find interpreting price movement ethereal and as such attach mystical significance to indicators because they come with better “instructions”, provide simple buy-sell signals and, in general, require a lot less experience to manage.  Sadly though, the Holy Grail of indicators does not exist. That being said indicators are extremely helpful and can provide additional depth to market analysis than just price provides.  I find one without the other is like peanut butter without jelly, bananas, or chocolate.

One of my favorite indicators when looking at the health of the overall market is the Advanced-Decline line, or AD line for short. The AD line measures market breadth or simply the sum of the number of advancing stocks minus the number declining in the NYSE index.  It’s such a clean and simple concept because for a market to move higher the number of stocks moving up has to be more than the number moving down over time.  The AD line is a leading indicator meaning it moves ahead of market price. For example when the market is moving up and a correction is coming, the AD line makes the first move down as more and more stocks begin to fall. The market won’t actually begin its fall until the number of stocks going down eventually overwhelm the number increasing. Market strength is undermined when fewer stock participate in an advance.

Don’t let all this talk about the AD line and market falling leave you the impression the AD line is only good for warning of potential declines, it is in fact an equal opportunity indicator working equally well warning of potential rises or declines.

Let’s take a look at the current AD line and see what the health of today’s market.  In the 80-month chart below I have plotted the AD line in the top pane and a US stock market proxy (SP500) in the bottom. You can see the AD line began moving down in January of this year while SP500 price continued to move up during the same period.  This reflects fewer stocks moving up but because the total falling have not yet overtaken the number increasing, stock market prices push higher.  This (negative) divergence is a warning flag. To provide some historical references and why I find this indicator so persuasive, I have highlighted all prior negative divergences with blue vertical bands to help illustrate what happened subsequently.

While not reflected in this chart, there are times when the AD line warned of a change but the market never followed along. Contained within this back-tested period the AD line does a good job warning of potential market reversals but the exact timing and magnitude are unfortunately left undefined. Regrettably there is no perfect indicator and the AD line is no exception but when used to confirm price it can do wonders to keep investors on the right side of market trends.

April 14, 2014 - Workday - A case study

About 3 weeks ago I readied a post regarding how I felt it was time to short Workday (WDAY). I instead decided to shelve it and published something else. The reason I decided against it was because as a Registered Investment Advisor the SEC views anything I post on a public forum (my blog for example) as an advertisement.  Since I was not suggesting readers short the stock (rather just the fact I was going to) I had to pull the post so as not to put myself at risk.  Investment advisors walk a fine line posting publicly because if something is written and a reader views, takes action and then loses money they are at risk of being sued.

A little bit about Workday … It’s a good company, they have good products, a good business model and just as importantly, if the execute they have a bright future.  I have owned their stock for both my personal holdings and my client’s. At the time I wrote the original post I just didn’t like the price action.

I find it valuable to go back and look at examples of market crashes and booms and what can be learned.  I am not picking on WDAY as they are no different than hundreds of other stocks that go through the exact same scenario. Its human emotion that drives these repeatable patterns and until human emotions change (it hasn’t since the beginning of time) it’s going to happen again. Rinse. Wash. Repeat.  Because of this, those who recognize and take action can find it immensely profitable.

Now let’s dig into the WDAY’s chart and look at the numerous warning signs it provided. These are presented in order of occurrence. As you can see the stock was in a steep but linear uptrend and contained within its (second) channel defined by the blue trend lines from November of last year until March of 2014. 

Point #1 - At the end of February the stock gapped up more than 15% in one day and moved above the channel it was in. A huge move in a short period that changes the shape of the uptrend from linear to parabolic should be viewed with major skepticism. Next, notice that the entire 15% move up was completely taken back within the next two days. This was the first indication that those who were long should be looking to exit and those who weren’t long could consider a short position. Such strong moves up will consistently be confirmed by a major overbought condition and WDAY was no example as you see in the falling RSI.

Point #2 - We had huge volume on both that huge single day up and the following move down which was the confirmation the move was a temporary flash and warned of exhaustion. As a reminder exhaustion buying is when all buyers have purchased and the only people left are sellers.

Point #3 - Price moved back into the original channel which was constructive for WDAY bulls. The concern at that point was whether or not the selling was over.  If so, we would expect price would resume its prior linear move up.

Point #4 – a few days later the bottom of the channel provided support as price stopped exactly there … but only for one day. We found out the following day the bears were still in control as selling resumed in earnest. That provided the next signal to those who were still long should be recognizing the boat was taking on massive water and it was time to jump ship (unless you were the captain of course who are paid to stay with the ship). Those who were short got what they needed, further confirmation to hold their position as selling pressure would most likely push price down to the next support level.

Point #5 - This was the next major support line once the channel was broken to the downside. There was a brief rally  in between the two support/resistance lines where price went right back up to test the resistance line (remember support lines once broken becomes resistance) and once again began its fall all but confirming much more downside was to come.  Those who weren’t short found another good entry point at the retrace back to the top resistance line. Those that were still long and had missed prior opportunities to sell were given a gift to unload their shares before the onslaught of further selling took hold.

Point #6 - This was the next level of support below point 5. Once again price stopped right on the line .. but just as with point 5, it only lasted one day and the fall resumed.

Point #7 – This was the start of a short counter trend 3-day rally that brought price up to the green 200 day moving average. As expected that provided resistance and price commenced to the downside.

Point #8 - This takes us to today where prices are still in free fall. When I wrote this post initial my final worst-case target for this decline was the 200DMA (point 7) or if it got really bad, point 8 which is a major support level from one year ago.  As you can see we closed very close to that level on Friday.

Besides being a WDAY proponent I have also been one of their biggest stock price skeptics of late solely because of fundamentals.  Any company with zero earnings yet share price > $100 in my opinion cannot sustain that level forever. We learned in 2000 and 2008 for example, when the bull market gets long in the tooth that fundamentals eventually matter.  This recent correction is a humbling experience to those who were heavily aboard the momentum stock train. The companies with good earnings, solid balance sheets and good fundamentals have barely a scratch.

What I have attempted to do here by analyzing WDAY price movement is identify those very repeatable stock price patterns that occur time and time again. Investors who recognize and identify this action should now have a framework on what to expect and the right course of action.  In a nutshell anytime you see the following all occurring you should seriously consider taking evasive action:

1.       A parabolic move up followed by

2.       Volume confirming price action followed by  

3.       Continued violation of multiple major support lines (price is especially vulnerable in long running bull markets)

Regarding WDAY right now ... it has moved into oversold territory and is creating positive momentum divergence which is telling me this major selloff should soon be coming to an end.  Once this near term bottom has been found it should provide a nice lower-risk, short-term opportunity on what is now a much more attractively priced stock.

April 7, 2014 - Energy strength

The energy sector has had a strong week and has been the strongest sector in the S&P 500 over the past month.  A look at the Energy SPDR ETF (XLE) chart below shows the sector breaking out to new all time highs.  You can see the area highlighted in red has, up until now, provide strong resistance as each time it has been reached in the past prices have fallen. This area was breached on March 28th in the form of a gap followed by a large move up.  This type of action is usually indicative of the potential for continued strength.    One other important thing to note in this move is the lack of divergence in our momentum oscillator which is something we look to avoid (or sell into).

For those that missed the breakout, there is always the chance of a retracement back to levels of support. If that occurs and it holds, that could provide an excellent opportunity. Since resistance that has been broken through becomes support, investors who caught and bought the breakout needs to keep a close eye on the red area in case we get a correction.  Any breakdown below that support is your warning of potential bigger problems ahead.

Mar 31, 2014 - Time to take a seat on the other side of the boat?

Ever since June of last year when Chairman Bernanke told congress of the likelihood that the FED would begin scaling back bond purchases (and thereby ending the support for low bond yields) the bond market has been in a tailspin.  Any student of the markets know they can overreact to news and overreact to this news they did. The chart below of the 30-year Treasury bond shows the magnitude of the decline, 17% in 3 ½ months which is a HUGE move for bonds.  The market mouthpieces were calling for the end of the bond market as we knew it. If this were football the refs would call a penalty for piling on.

What exacerbated the selloff was, as you can see in the 30 year bond price chart below, bond prices created a divergent high (1) (higher prices but lower momentum – identified in blue line in upper RSI pane) which was a warning flag even before Mr. Bernake said word one.  Bonds were headed down anyway and Mr. Bernanke’s comments gave them a big shove.

What we know is that when the sentiment is overcrowded to extremes the best short-term move can quite often be in the opposite direction.  Bond prices eventually bottomed in August (2) and spent the next 5 months building a base and chopping sideways. This basing pattern is something a technician looks for as if it actually is a bottom, it can present a very attractive entry point and profitable opportunity. As you can see late January bonds eventually popped their head up above the blue horizontal resistance (basing pattern) line but soon thereafter fell back down. This created a higher high (3) which, in addition to the higher low that printed in February (4), was the confirmation an investor should look for to let them know the short term trend has changed. There are no guarantees but this type of setup increases an investor’s probability of a profitable investment. Because I am working with other people’s money I prefer to add one more level of confidence before I commit to an investment which for me was for price to make a higher high.  That high at (3) was tested 2 more times which proved its importance and finally broke through this week (5). This was the confirmation I needed. These patterns are nice as they provide estimated price targets and this has one that ends at about 115.5 (6).  If this plays out the investment will conservatively provide a 5% capital gain in addition to the 3.5% yield this bond carries.  While this would be considered a “yawner” if you are talking about risk assets such as stocks, for a bond this provides more than what you would expect from a bond in an entire year.  While what I have is provided a conservative price target there is the possibility of even greater upside. If the stock market takes a long overdue breather there is no question some of the money coming out of stocks will find a temporary home in bonds and could be the catalyst to even higher prices.

With any investment It’s important to keep your expectations in check and the same is required here. This will most likely not be a straight line to 15.5 but rather a choppy ride. I have no question there will be a few times it will challenge our conviction. If I take the FED at their word and their promise to eventually raise rates but not until late 2015 or early 2016, I go into this investment managing as an intermediate term investment only (not buy and hold forever).  But until then or until the market tells me otherwise, I find this contrarian side of the boat a compelling, low-risk to reward opportunity.

Mar 24, 2014 - Biotech harbinger?

For the past 3 years, biotech stocks have been the darlings of the market. The compelling stories they present having the potential to solve the maladies and genetic imperfections of the human race have brought immense amounts of money into this sector. The chart below shows just over the past 3 years (through February of this year), biotech stocks have outperformed the SP500 index by more than 90%. That is an astonishing ~25%/year compounded differential.

One of the interesting back stories in the markets this week was the bearish action in Biotech stocks. While the SP500 index was making new all-time intraday highs (but failed to keep it at the close), biotech stocks were experiencing their biggest decline in a year. We all understand declines are a normal part of the markets ebb and flow and biotech’s have experienced their share.  Over the past 3 years Biotech’s worst year selloff’s have been; 2011 = ~ -24%, 2012 = ~ -16%, 2013 = ~ -12% . You can see that each year the selloff has gotten smaller and smaller which underscores their strength as investors jumped at the buying opportunity more aggressively each time they had the chance.

Last month’s beginning of the selloff was not much of a surprise as we had plenty of warning. You can see in the chart below we printed a divergent high (prices are rising while momentum is falling) on the 25th of Feb as we did in last year’s October sell off. In addition to that warning flag, when looking closer at the Feb 25th close, we formed a hanging man candlestick which was the confirmation that a (temporary) top was in and we should expect a change in direction. So far the 2014 decline has been ~11%. While we have broken the up-trending support line, we sit right on the 50dma which may be all this current decline needs to stop. If not, a logical next stop would first be 235 followed by 225.  If the market really gets going to the downside, major support exists at the 200dma which right now is at 215.

 What is especially interesting is looking at past selloffs over the last 3 years biotech stocks either coincided exactly with the timing of or lagged slightly behind the broader SP500 index.  This time it is leading. This, combined with divergent highs on the index, the bearish shooting star candlestick close on Friday, the huge increase in volume and the lack of near term support levels, I fully expect to see a few more bears come out of hibernation this next week.  The first question one must ask is if Friday's sell off is creating a major buying opportunity or the even bigger question is if not how long can the strongest sector of the index continue to fall until it begins to have a negative effect on the overall market and pull it down along with it?