The Trouble with Triangles

I know I lured in some unsuspecting geometry haters but this week’s blog post has to do with the chart pattern rather than the geometric shape.

The chart below is a 5 year weekly look at the Chinese Stock market ETF, FXI.  You can see while price has swung up and down as much as 30% from its mean, it really has gone nowhere over the entire 5 year period. Also, you can see since the 2010 high, price has traded within a triangle bounded by the blue trend lines. Triangles are consolidation patterns and while we try and avoid consolidation zones they should not be ignored because eventually they lead to a breakout.

Breakouts are what every investor dreams to find because they can be the start of a new trend. And trends are where investors make money, not areas of consolidation.  All patterns in technical analysis have probabilities associated with their outcome. Technicians look for the patterns with the highest probability as that logically improves investing success. The higher the probability the higher the success. Now, here is the trouble with triangles they have no edge.  They provide no statistical probability greater than flipping a coin. Because of their 50% probability of breaking either up or down, you should wait for the breakout before entering a position.  To make things even worse, if you buy the breakout, there is an equal  probability it will reverse back in the other direction.

My chart of FXI is a perfect example of what I tried to explain above and why I hate triangles.  Price broke out to the upside (bullish breakout) which pulled in new investors thinking this was the start of a new bullish trend. After a 10% rise, almost up to the prior late 2010 high, price immediately reversed and fell right back into the triangle where it sits today. Those who bought the breakout and were not prepared with an exit strategy are likely now sitting with a loss. Those who were familiar with triangles could have entered with a tight leash and may have been skillful enough to have eeked out a small gain or better yet, have avoided this investment altogether.

Now you know the troubles with triangles

Crossroad

When the stock market moves (up or down), the strength of that move is dependent upon how many stocks are participating in the direction of the move. For example, the more stocks that are going higher, the not only the higher the market goes but also the longer that move can last.  Logically, the inverse is true too.

There are many ways to slice up the US stock market but one of the simplest ways is to look at it by company market capitalization. Since the start of the year we can see in the chart below that performance has been directly proportional to market size. The largest companies (in red) have outperformed the mid-sized companies (in blue) which have, in turn, outperformed the smallest companies (in green).   As you can see, the smallest are actually negative for the year.  In a bullish environment we would expect to see all 3 segments moving up strongly together.

Looking at this same information for the current quarter shows not only the continuing performance to size relationship but a something a little disturbing.  Not only are the small caps (600 stocks) negative but the mid-caps (400 stocks) have turned down too.  This shows a deterioration in the underlying market structure.  Right now, the only thing holding the market up are the generals (the largest stocks).

The market is at a crossroad right here, right now and until it can get broader participation from the “soldiers” (small and mid-sized companies), further gains will be limited and an increasing chance that long overdue correction is at our doorstep.  

Panera Bread - PNRA

Panera Bread - PNRA

In 1987 the St. Louis Bread Company opened its first location in Kirkwood, Missouri. Panera bread is the newer name for St. Louis Bread Company outside of the St. Louis area. In 1993, Au Bon Pain Co. purchased the St. Louis Bread Company and operates more than 2000 locations.

Since May of last year when the price of PNRA peaked at just under $195, share prices have been in a downtrend printing lower highs and lower lows. In August after a 25% decline from its high, a tradable bottom was formed and (at least for the time being) prices have reversed course and have established a new uptrend, now closing with higher highs and higher lows. Earlier this week strong momentum pushed the price above an important line of resistance (red horizontal line).  With that important line breached and armed with the confidence of an interim bottom in place and a new (for the time being) uptrend established, investors should be pondering if this is a good time to hop on board.

From my perspective, other than the overbought condition (see upper RSI pane), the chart pattern looks fairly attractive. Remember, overbought conditions should just raise a flag because ultimately being overbought is a sign of strength and is very desirable if you own a stock.  Who wants to buy stocks when their prices are stalling?

If I were investing in PNRA (and I am not at this time nor am I recommending you do) I would wait for a pullback in price which would have the effect of unwinding the overbought conditions. If price falls back to the red line of support (what was resistance becomes support) or above and holds above it I would consider taking a position. If price falls back below the line and stays, this would signal the sellers are wrestling control away from the buyers which would be enough to have me turn my attention to better opportunities.

Brazil – Terra da Santa Cruz

The long term investment prospects for Brazil are exciting and are nicely detailed here.  What should pique investors interest is the potential for outsized profits as experienced in in the early-mid 2000’s where the price of the Brazilian market was up more than 1000%. As with all investments, being patient and finding attractive entry points can help maximize any opportunity.  Below is a weekly chart of Brazil showing price action since the bottom in 2009 until May of this year.   Hopefully it’s obvious the Brazilian market has been in a poor investment since 2011 as it has printed lower highs and lower lows. Being invested during this time has been a painful, losing proposition, as the Brazilian index has fallen more than 40%. As an investor, the further something falls the more I become interested because the greater the fall the greater the chance for a big snap back rally.  As always with investments who's price is falling, the question is always when does it become worthy of your investment dollar as we all would prefer not to be catching the proverbial knife.

As I have mentioned many times throughout the years, I find that weekly, oversold conditions with divergence creates the high probability for an attractive entry point. The Brazil ETF, EWZ, created that exact setup early this year. As you can see below highlighted with the red circles, price fell while momentum (upper RSI pane) increased.  That divergence was the first flag to get ready for a possible entry.  From the lower price low in February priced moved higher, eventually breaking above the blue down trending channel.   The final buy confirmation an investor would like to see came when volume (lowest pane) increased leading up the breakout. 

Switching to a daily chart and looking at price since the low created in February shows a great example of an uptrend, higher highs and higher lows. In addition since April, price has been nicely contained within the blue ascending channel. That is until the start of September where it broke out to the upside and then again last Friday where it broke down. The 10% decline over the last week and a half are tough for investors to stomach as you have seen profits quickly disappear. Other than to have a direct vision into the future it would have been nice to be warned ahead of time the chance for a breakdown was in the works in order to lock in profits.

The fact is there was ample warning you just needed to know where to look. The market provided 3 signals all which happened around the same time and provided an early opportunity to take evasive action.

1.       Price closed outside the Keltner channel (green band) for 3 consecutive days. This is a signal price has moved too far too fast and warns of a potential reversal ahead. What it doesn’t do is indicate how big that reversal will be.

2.       The highest candlestick on the breakout (highlighted within the red circle) and the ones just before and after formed a rare evening star (bearish) reversal pattern which was provided the 2nd confirmation of trouble ahead.

3.       Trendlines are important and as you can see price closed above the upper blue support/resistance trendline. A breakout can be either bullish or bearish you need further confirmation before acting on any break. And we got the confirmation we needed within the next 3 trading days. There is a very important maxim that states “from false breaks comes big moves” (in the opposite direction). This is a great example of that maxim as it played out exactly. Price broke out to the upside and then quickly reversed (false break) and fell hard.

4.       While not a warning sign, the big volume spike that occurred (reflected in the lower pane) is the greatest I could find over the last 5 years.

While I am always on the lookout for good investments that  have been oversold, there is nothing in the charts that says the "bottomz in" for this current decline. The markets could quickly change all that next week but for now I will personally be avoiding Land of the Holy Cross until further notice.

Death of the Dollar

 In case its not clear, my title is said with tongue firmly planted in cheek

I wrote this post 10 days ago and while it is a bit stale, it is just as important now as it was then. For the past 2-3 years I have read so many stories about how “the dollar is dead” and how “the world’s reserve currency is history”. While that may be true at some point in time in our future, right now, as with all things in which sentiment has risen to an extreme, it is moving in exactly the opposite direction that everyone predicts.

While we were closely watching the Euro and Yen fall on hard times, the lowly and unloved dollar slyly staged a breakout of a multi-year downtrend.

While many investors don’t pay attention to the movement of currencies because they are typically not a part of most investment strategies, there are very strong inter-market relationships between investments and the dollar. For this reason, the ramification of ongoing dollar strength can play havoc with portfolios that are not positioned correctly. Some of the potential major implications of this upside breakout are:

• US Dollar denominated yields could fall further
  • If bond yields fall, US bond prices will strengthen.
• Foreign denominated bond prices should weaken
• A strong dollar puts downward pressure on commodities – while not all commodities move in tandem, most commodity prices should move lower.
• Foreign stock prices should weaken.

How far the dollar can climb is anyone’s guess but the first target that shows up on the charts is the 2013 high of 85.  Beyond that and depending upon what is driving it higher, a retest of the 2009 (88) peak or even 2007 (91.5) highs may not be out of the question.

In spite of the dollar doomsayers, the (2013) world’s largest economy (European Union) is teetering on recession, the US, while not robust, keeps chugging along. Whether this is the impetus for a continued stronger dollar no one knows for sure and regardless of your long-term feelings about the dollar, right now she is the prettiest girl at the dance.