INVESTMENT EDGE
Thanksgiving is a blessing in disguise. With your friends and family near, make this day as special as you can and thank them with your heart. May you be bestowed upon with the best of everything and have the strength to surpass any obstacle.
Have a blessed thanksgiving
Much of our understanding of chart patterns can be attributed to the work of Richard Schabacker. His 1932 classic, Technical Analysis and Stock Market Profits, laid the foundations for modern pattern analysis. In his book, Schabacker refers to “the science of chart reading”, but technical analysis can at times be less science and more art. This is because pattern recognition can be open to interpretation, which can be subject to personal biases, the hobgoblin of even the best investors. In spite of this I find them and the reason behind them one of the most fascinating and fun pieces of the technical analysis puzzle. This is because not only do they provide an excellent framework to manage risk but when they work, they can be a thing of beauty as you can see in the chart of Ascendis Pharma, ASND, below.
I have found that basing patterns that extend between 6-12 months have the highest probability of success. You can see in its first consolidation February and September (7 months), price formed a very symmetrical inverse head and shoulders pattern (noted in green). The target for all target for this pattern is the distance between the head and the neckline (the lower green vertical bar), added to the neckline (T1). As you can see, price closed within pennies of its target on the breakout. As it turned out, that burst higher was all the bulls had as price pulled back and began to, once again consolidate and form another inverse head and shoulders pattern (noted in purple).
While price has not yet broken and held above the upper purple neckline to confirm the pattern, if it does the target is up around $42.16 some 15% higher. It would be great to see TA lightning strike twice in a row for ASND shareholders, but because the pattern’s base will be much less than the preferred 6 months minimum, the odds of success are a notch lower than before.
There are pattern experts who will scoff at this post because I have labeled the pattern as an inverse head and shoulders (IH&S). Technically they are correct because, IH&S patterns only form in downtrends. As such both of these patterns for ASND should be labeled as a cup and handle (which is essentially the same pattern as an IH&S except it is formed in an uptrend). So please pardon the intentional mislabeling.
Because the bond market is so large in comparison to the stock market, it can be worth monitoring for clues as to what may be in store for stocks. That might seem counterintuitive but stocks are simply a measure of investor’s appetite for risk. Within the bond market, junk (high yield) bonds take on the same role. As such, junk bond prices normally move in unison with stocks. When they diverge, like they did last week, should give investors a hint that something may be afoot.
In the upper pane of my chart below is a plot of SP500 price (in red) and the junk bond ETF, JNK, in blue. The bottom pane is a smoothed correlation coefficient of the two investments, which has hovered near 1 (perfect correlation) for most of the past year. As you can see that while the movements can vary in the size of the movement, the direction is almost always in the same direction. That is except for two times which I have identified within the purple ellipses. The first time being last April when stocks fell briefly while junk bonds rose. The second being the last few weeks as junk bonds have fallen substantially while stocks continue to rise.
All divergences, this one included, are warning signs to investors that something (or someone in this case) is wrong. The question one has to ask is, is it the bond investors or stock investors who have it wrong. Are stocks ready to follow junk bonds lower? Or is this just another example of market makers playing games with junk bonds and it eventually turns out to be a wonderful buying opportunity? The answer to these and other questions will only be known in the rear view mirror but until then the divergences should be viewed as a cautionary yellow flag for investors.
The third attempt and failure by ESV to breakout in the first quarter of this year marked “the top” as the stock went on to fall more than 65%, peak to trough. With its fortunes tied to the price of crude, as an oil services company it was no wonder its price was hammered. With the price of oil now stabilizing between $50-$60/bbl, it would seem ESV shares may have a chance to move higher and allow investors a path to profits.
Steep sell-offs can sometimes create very profitable money making opportunities. The problem is sell-offs, especially as sharp as this has been, are rarely done to healthy and viable companies. In other words, there is a reason the price just fell off a cliff and unless you know what you are doing, it’s best not to try and catch a falling knife. But if one were so inclined and because any investment at these levels would be considered going against the current trend (on my timeframe), minimization of risk via tight stops and smaller position size would be a prudent consideration. After forming positive RSI momentum divergence at the same time finding a bottom in August, price has formed a higher high and higher low, the first step required for a reversal. Additionally, an inverse head and shoulders reversal pattern with an upward sloping neckline has formed. With price currently sitting just below the neckline, a break and hold above it would signal the pattern is in play and points to a pattern target at April’s high, T1.
By no means is ESV a perfect setup. Price still is below a falling 200 day moving average and as such any move higher will likely be met with choppy action. In addition, its stock price is directly tied to the price of oil, which adds additional layers of risk and highly subject to the vagaries of geopolitics, something I would prefer to avoid.
A 20-year look in the rear view mirror at the European 600 Stoxx Index shows the current level being one of major resistance as it has failed each of the 3 other times it reached this price. The first two times it did so, this level signified “the top” was in, the index rolled over and fell ~60% from top to bottom. The 3rd and most recent time it reached this level, price hit resistance, rolled over and fell a bit more than 25% and then found support. Since that time, n it has rallied back to the underside of the resistance line looks like it wants to breakout.
It is said, the more times price tests a level, the more chance it will eventually break through. This combined with 1) the resiliency of this bull market and the fact 2) we have not formed negative RSI divergence like the prior two instances and 3) the most recent decline was more of a minor pullback rather than a major decline (as compared to the prior falls), the higher probability move points to this index eventually breaking out to all-time highs. Either way, it would be best to exhibit patience as I expect to see a period of consolidation and indecision in order to shake out all the sellers before the index actually shows us its hand and answers the question of where to next?
