MANDA Update: Rohm & Haas (ROH) falls sharply on bad news

First is was the failed merger of BlueGreen Corporation (BXG) and now it's chemical company Rohm & Haas (ROH) that is putting new pressure on the MANDA portfolio. The stock dropped over 20% today on news that take-over company Dow Chemical (DOW) lost a $17.4 billion joint venture with the government of Kuwait. Although the lost venture takes away important financing, the acquisition is not contingent on it. The transaction is fully financed by a one-year syndicated bridge loan and convertible preferred investments by Warren Buffett and the Kuwait Investment Authority.

However, that doesn't mean that the terms of the deal couldn't be lowered. If that's the case, I'll most likely end up losing money on the trade. But I'm not going to sell the stock now because I believe that I've already lost as much as I think can be lost and there's no where for the stock to go but up. I've been wrong before and I'm sure I will be wrong again but the mid-$50 range is a strong support level for the stock. (It's been trading at or above $50 from the end of 2006 until just a month prior to the take-over announcement where it sunk to $45.) Also, Rohm & Haas management is committed to getting the deal done and most Wall Street pundits think it will go through.

On the negative side, take-over company Dow Chemical was downgraded earlier this morning from overweight to equal weight at Barclay's. The combined bad news sunk the stock to $15 representing a low not experienced since 1991. Ouch! Adding salt to the wound, open interest in Dow put options has increased which is typically a bearish sign. So, if any of you out there are considering taking a bullish position in either company, I strongly suggest to tread lightly and not commit an excess amount of capital to the trade. Note that if the merger does go through at the original price of $78/share, you will realize a whopping 45-55% return on your investment had you purchased Rohm & Haas stock today. In this case, the potential return just might be worth the initial risk.

What is ironic is that of all of these mergers, I thought that this one would be less risky because of the large capitalizations and reputations of the entities involved, but if we've learned anything from the Bernie Madoff scandal, size and reputation don't mean much anymore. Let's keep our fingers crossed this deal goes off!

Season's Greetings!

Merry Christmas and Happy Hanukkah from all of the elves at the Stock Market CookBook!

MANDA Portfolio Update 12-23-08

Here are the updated Manda Portfolio holdings and realized returns.

Click on image to enlarge.

Another MANDA addition: American Land Lease (ANL)

Bad year for M&A activity
The fact that 2008 has been a bad year for mergers and acquisitions is a “duh” type of statement, but the extent of withdrawn deals is noteworthy because it is unprecedented. According to a Reuters article published this morning, M&A activity is down 35% globally with over 1100 deals canceled which is 300 more than were canceled last year. Estimated total value of the withdrawn deals is around $800 billion with underwriting banks losing more than $815 million in fees. JPMorgan-Chase (JPM) and Goldman Sachs (GS) lost an estimated $73M and $64M in fees respectively. Guess they really did need a bailout.

Brighter prospects for next year
The good news is that many M&A experts feels the worst is behind us and things can only get better. Hoping that will be the case, I took another plunge into the M&A market and picked up some shares of American Land Lease (ANL) today at $13.30 per share. The proposed acquisition was announced a couple of weeks ago on December 10th. Expecting to close in the first quarter of next year, the all cash deal is for $14.20 per share. Just after the merger was announced, ANL was trading around $12.60. Although the terms of the deal sounded viable, I was skeptical for two reasons. The first was that market volatility as given by the VIX was still extremely high and I wasn't sure at the time where it was heading. (Market volatility measures not only market risk but lately has been paralleling credit risk.) The other reason was that I got burned previously on another real-estate acquisition—BlueGreen Corp. (BXG)--that didn't pan out and I wasn't eager to make a similar mistake. (It was one of those canceled deals.)

So what changed my mind?

What changed my mind was the fact that ANL's stock price has been steadily rising on much heavier than normal volume ever since the deal was announced. (Average daily volume is 83000.) Most likely this is the result of the terms of the deal which states that the acquiring company, private equity firm Green Courte Partners, must own at least 88% of ANL's outstanding shares. This reassured me that Green Courte seems to be serious about the acquisition and gave me enough courage to buy the stock today. If the deal does go through in the next month or so as projected (keeping my fingers crossed), I expect to make a tidy 6.8% profit which translates into an annual return of roughly 80%.

Other MANDA news
The current MANDA chart listed under the MANDA portfolio is not up-to-date. The return values don't reflect recent dividends. It'll be updated later today and include the addition of ANL.

More on the Santa Claus Rally

Last Thursday's blog was devoted to the Santa Claus rally characterized by a year-end surge in stock prices. We saw that there does indeed seem to be a rally in stocks just before Christmas so I thought that I'd research this phenomenon further over the weekend in between my holiday cookie baking marathon.

Evidence for a Christmas rally...
Using daily opening and closing prices for the past 15 years on the S&P 500 (which was as far back I was able to go), I was able to generate the following tables. Table 1 shows the price percentage gain or loss for the four trading days before Christmas Day (X-4 to X-1) and for the next six to seven days following it. Most years had four trading days in between Christmas and New Year's except for 1993 and 1999 which had five and is the reason those two years have an extra data point. You can see from the table that there does seem to be a statistically significant rally for the two to three days prior to Christmas with the second to last day (X-2) outperforming the others and at lower risk (risk is given by the standard deviation).



Table 2 summarizes several year-end trading strategies. You can see that the market rallies 80% of the time for the three days before Christmas, gaining on average 0.64%. Even better is holding onto this position and riding it out until the close of the second trading day after Christmas (from X-3 to X+2). Here, the average gain increases to 1.12% and at lower risk to boot. Nice!



...but little evidence for a New Year's rally
These tables also show that as New Year's approaches, the number of days closing in positive territory decreases. It's reasonable to expect the last trading day of the year (X+4 in most years and X+5 in 1999 & 1993) to be down since that's when most investors and fund managers exit the last of their losing positions. The first trading day of the New Year (N+1 in Table 2) is generally lackluster—possibly due to the hangover effect? But the day after that is a barn-burner, up over 0.5% on average nearly three-quarters of the time.

Conclusions
Although there's quite a bit of noise to these data, the fact that the market does rally over the Christmas holiday 87% of the time (only two down years in the past 15) is statistically significant. The best way to play it would be to enter a long position (S&P futures, index options or the SPY tracking stock) on the third or second trading day before Christmas with the intention of exiting near the close of the second trading day after Christmas. It may not be the perfect holiday gift but it's a lot better than a lump of coal in your stocking!

Yes, Virginia, there is a Santa Claus Rally

As a Christmas gift to my faithful readers, I was looking forward to doing a blog on the Santa Claus rally to see if there really was one. In case you don't know what that is, the Santa Claus rally is typified by a surge in stocks that occurs in before Christmas to just after New Year's. Explanations for this phenomenon include holiday-induced optimism, people investing their year-end bonuses, gift money, and the fact that the kill-joy Wall Street pros are off skiing in Aspen.

So, is this a real rally? According to a web article published last year by the CXO Advisory Service, results of data collected for the day before Christmas to six trading days after Christmas showed little evidence for a Santa Claus rally; however, their data seemed to suggest abnormal strength just before Christmas as well as for a day or two after the New Year. I wanted to see for myself if their assertions were true so I went back and examined the chart of the S&P 500 for the days before Christmas as well as the days after New Year's. Here's what I discovered.

The days before Christmas
The last trading day before Christmas closed up four times, with three of the four days occurring in 1998, 1999, and 2000. (The other up day was 2007.) It closed down three times but only slightly and the other three times were essentially flat. Not very exciting news. However, in nine of the past ten years, the market did go up just before the last trading day, which is statistically significant. My data show that the market rose for the preceding two days three times and the preceding three days twice. The other four times it went up for periods lasting up to seven days. [One way to play this would be put on bullish strategies (buy the SPY or index call options) two to three days in advance of the holiday (like next Monday) if the market opens up.]

The days after New Year's
I looked at the first trading day after New Year's for the past ten years and found that there were six down days ranging from -0.1% to -2.8% (in 2001), three up days ranging from 0.6% to 3.3% (in 2003), and one day that was essentially flat (1999). The days following the first trading day of the New Year were evenly split with five up periods and five down periods. These data are not statistically significant.

Conclusion
We can conclude that a pre-Christmas rally seems to be more than just a coincidence but there is no evidence from ten-year data to support a New Year's rally.

Correction to yesterday's blog

In yesterday's blog concerning Washington, D.C. based REITs, I erroneously gave the stock symbol of Corporate Office Properties Trust as COPT. It used to be listed under that symbol when it traded on the Nasdaq but it is now trading on the NYSE as OFC. I have updated and noted the correction in yesterday's blog. My sincere apologies for the error.

A Capitol Idea

I've been reading how people, especially young people, have been inspired by President-elect Obama to consider government service as a possible career. Combine this with substantially increased government oversight of the financial and automotive industries along with the proposed public works projects and what do you get? You get bigger government. A lot bigger. In the end, not only will we taxpayers be footing the bill for all of this but we'll also be paying the salaries of everyone hired to implement these programs. How we do this is up to Congress but I'd be willing to bet that some fairly hefty tax hikes will be involved, even for middle-income folks. (Here in California Gov. Schwartzenegger is proposing a sales tax increase that in Los Angeles County could come to 10.25%!)

This got me thinking as to how we, the taxpayers, can at least recoup some of the monies we'll be shelling out down the road. Let's see...tons of new jobs...in Washington, DC...people needing places to live, work, and shop...hmmm. Spelling it out like this, the answer is pretty obvious: Real-estate investment trusts (REITs) with a heavy emphasis in the D.C. area. Note that the D.C. conurbation is the nation's fifth largest metropolitan area and third largest office market after New York and Chicago. Its office market has traditionally been stable since the federal government is the major employer.

Real-estate cognoscenti are predicting that a turnaround in real-estate won't be seen for at least another six months to a year or perhaps even longer. But with the Fed today promising that it will do whatever it takes to inject liquidity into the credit and mortgage markets, now would be a good time to start taking a look around the REIT aisle and readying our shopping lists.

REIT categories
REITS, or real-estate investment trusts, are corporations that can be involved in many aspects of the real-estate market. As long as they pass on a significant portion of their income to investors (at least 90%), they are exempt from corporate taxation. REITs can operate in any or all of the following categories: industrial, office, retail, and residential. So here's my list of REITs that have a strong presence in our nation's capitol listed according to category.

Office REITs
Boston Properties (BXP): The company has three major projects under development in the D.C. area. It leases over 8 million square feet of Class A office space in the Boston, Manhattan, and D.C. areas with about half that (4 million sq. ft.) in San Francisco and 2 million sq. ft. in Princeton, NJ. Fundamentally, it is outperforming its peers but the balance sheet is showing some quarterly cash-flow issues possibly due to several recent acquisitions. The company issued 4Q guidance above analysts' estimates and is maintaining its current dividend. The dividend yield (D/Y) is 4.6%.

Corporate Office Properties Trust (OFC)*: This REIT focuses on strategic customer relationships and specialized tenant requirements in the government defense IT and data sectors. Its properties are typically concentrated in large office parks adjacent to government demand drivers and/or in growth corridors. It owns 253 office and data properties totaling 19.1 million square feet, most of which is concentrated in the D.C. area. (It has much smaller holdings in Colorado Springs, Princeton, and Philadelphia.) It prides itself on providing technically sophisticated buildings in visually appealing settings that are environmentally sensitive, sustainable and meet unique customer requirements (many of its buildings are LEEDS certified).
One potential problem I see with this company is that a Democratic-controlled Congress might well cut back on defense spending. (Congress is going to have to make some cuts somewhere to pay for all of Obama's proposed new programs.) The company has been steadily increasing dividends for the past eight years. Current D/Y is about 4.8%.

Brookfield Properties (BPO): The company owns, develops, and operates premier assets in the downtown cores of high-growth North American cities including New York, Boston, Washington, D.C., Los Angeles, Houston, Toronto, and Calgary. Its skyline-defining portfolio attracts major financial, energy and professional services corporations which have high credit ratings and maintain long-term leases. The company’s performance through the years is distinguished by strong, consistent financial results and a track record of steady growth. Currently, it owns 15 properties in the greater D.C. area. It's raised its annual dividend since 2001 and now is paying a D/Y of just over 8%.

Industrial REITs
First Potomac (FPO): The company invests in light-industrial properties of at least 50,000 square feet in the D.C. area as well as the surrounding Mid-Atlantic states. It was recently upgraded based on the belief it can continue to obtain financing due to the small size of its assets, management competency, and the expected continuation of acquisitions via joint ventures. A price target of $10 was put on the stock which ended today up almost 11% to $7.65. The company has paid a steady dividend since 2004. Current D/Y is a hefty 17.8%.

Retail REITs
Washington REIT (WRE): Although this company is classified as a retail REIT, it has a diversified portfolio of 89 properties consisting of 14 retail centers, 25 office properties, 17 medical office properties, 23 industrial/flex properties, 10 multifamily properties all totaling 12.8 million square feet. This is a pure play in the D.C. area since all of its holdings are located here. The company lowered year-end guidance citing equity dilution and delay in proposed acquisitions. Fundamentally, the company's balance sheet isn't as strong as some of the REITs in the other categories, possibly due to the downturn in retail, but it still has managed to increase its annual dividend since 1992. Current D/Y is about 6.1%.

Saul Centers (BFS): The company's portfolio consists of 50 community and neighborhood shopping center and office properties totaling approximately 8.2 million square feet. Approximately 80 percent of cash flow is generated from properties in the metropolitan Washington, D.C./Baltimore area. Revenues and income have been steadily increasing, although there was a small drop in the 3Q numbers. Dividends have been increasing since 2005. Current D/Y is 3.9%. Technically, the stock today broke through major resistance—a bullish sign.

Residential REITs
Most of the residential REITs that I researched operate across the U.S., but I did find one that is concentrated in the northeast, including substantial holdings in the D.C. area.

Home Properties (HME): The company operates 125 communities totaling close to 35,000 apartment units in the Northeast, Mid-Atlantic, and Southeast Florida markets. In its third quarter report, the company CEO said that occupancy was at 95.1%, the highest level since 2000. Clearly, the recession hasn't caught up with this company yet. It has been steadily increasing dividends since 1994 inception. Current D/Y is 6.4%

Summary
I think that if there is an expansion in the D.C. area, the REITs that will benefit the most will be in the residential and office categories. Industrial properties could contract if Congress slashes defense spending, and unless consumers can be coaxed into opening their wallets, the retail markets could be lackluster as well. Some folks may object to the omission of Vornado (VNO) but I felt that even though it does have a significant commercial presence in D.C., it was just an average sized piece of its portfolio pie.

Technically, REITs have been taking a beating along with pretty much everything else, but today's Fed news could be just the spark needed to ignite the real-estate and financial sectors. REIT stocks zoomed up 10-20% today but is it time to buy? I think so as many of them took out major resistance. Even if the stocks do head back down, most of them are still trading 30-50% off their September values. Plus, they pay a nice dividend and none of the REITs mentioned here have reported a dividend cut--at least not yet.

The time may be right to add some REITs to your portfolio.

*Symbol correction (dated 12/17/08): This symbol was originally given as COPT. The company did trade under that symbol when it was listed on the Nasdaq. It now trades on the NYSE under the symbol OFC. My sincere apologies for the error.

Using the Parabolic SAR to determine exit points

In general, exiting a trade is probably tougher for most investors than entering one despite the fact that there are many ways of doing so, either technically or quantitatively. Quantitative approaches include fixed stops that will trigger once a profit percentage is reached or trailing stops that follow the price and are triggered once the price begins to move against the position by a designated percentage. Technical criteria include trend-line violations or a reversal in a technical indicators. One such indicator that is particularly useful in determining exit points is a called the parabolic SAR.

The parabolic SAR (short for Stop And Reverse) is a trend following indicator invented by J. Welles Wilder, Jr. a mechanical engineer who also created the RSI (Relative Strength Index) and the DMI (Directional Movement Indicator). It is based upon the theory that the path of a strong trend is shaped like the arc of a parabola. In up-trends, the indicator is displayed as a series of dots underneath the price bars; in down-trends, the dots are above the price bars. A “buy” position is entered when the indicator moves below the price, and a “sell” position is signaled when the indicator moves above the price. (See below charts.)

Once in a position, think of the dots as a type of trailing stop. From the charts below you can see that the dots are farther away from the price at the beginning of a move and tighten up as the trend continues. The position of the indicator is controlled by two variables: the step and the maximum step. If the step is set too high, the indicator will fluctuate more often and whipsawing will occur. The maximum step controls the adjustment of the indicator as the price moves. Lowering the maximum step furthers the indicator from the price. Wilder recommends setting the step at .02 and the maximum step at .20. Most charting services will allow the user to tweak these variables.





Potential problems
The parabolic SAR works great in trending markets but is miserable during periods of consolidation. One way to minimize this effect is to look at longer time periods—a weekly chart instead of a daily chart, for example. You can see from the charts of the Nasdaq 100 tracking stock, the QQQQ, that the parabolic SAR switched three times on the daily chart during brief consolidation periods that occurred from September to November, but this whipsawing is not evident in the weekly chart where the indicator has signaled a downturn since the beginning of September. This is not to say that using a longer time period is the way to go, either, for you do lose some accuracy when it comes to timing your entry and exit points.

So what's the solution? One way is to use other technical events like the breaking of a major support or resistance line or the breaking out of a base. Another way is to use other technical indicators for trend confirmation. Wilder himself estimated that trends occur only about 30% of the time and suggested using an oscillator such as his ADX (Average Directional Index) to determine the direction of the trend. Other indicators that can be used effectively are the CCI, the MACD, and moving average cross-overs.

Where to find the parabolic SAR
If your charting service doesn't carry the parabolic SAR, you can find it at Yahoo! Finance and StockCharts.com which has a whole boat-load of charting tools along with an in-depth description of each and how to use it. Have fun!

How fundamental events affect stock price

Everyone knows that events are what feeds the market, but how do these events translate into price movement? Any market technician is able to look at the chart of an unspecified company and give a fairly accurate history of the events that shaped its price profile. I know because I've wowed my friends with it, and by learning just a few market moving basics, you'll be on your way to wowing your friends (and yourself), too.

Parlor tricks aside, the main reason you'll want to learn how to read a chart is to make you money, or at the very least, avoid losing it. In Recipe #5: News Nicoise, we list market moving events and identify ways to profit from them. Some events, however, affect price more than others. Here's a list of events that generally have the greatest impact: mergers, earnings guidance raised or lowered, credit rating raised or lowered, analyst rating raised or lowered, dividends increased or decreased, stock buy-backs, and sundry corporate events such as accounting irregularities or abrupt changes in high-level management. There are also industry-specific events. For example, the success or failure of a clinical trial has the potential to make or break a fledgling biotech.

Graphic examples of some market-moving events

A bearish example
One doesn't have to look very far in today's market to find stinky stock charts. I selected the chart of insurance giant Genworth Financial (GNW) because it illustrates several major events.



A. 11/6 (after market close): Reports huge third quarter loss. Withdraws full-year guidance. Suspends dividend and stock buy-back program. The stock gaps down 14% the next day, dropping another 34% at the close.

B. 11/10 (after market close): Moody's downgrades the company's debt rating. Next day, the stock gaps down 25%, closing the day off 40% from the open.

C. 12/8: Proposals aimed at freeing up insurers' capital are tentatively approved. This cheery news produced industry gains across the board. Genworth gapped up on the open, closing up 42% over the previous day's close.

This week, the stock has been in an uptrend and has closed the price gap triggered on November 11th. This is a short-term bullish move. Barring any other unforeseen bad news in the financial sector, we could reasonably expect the price to gain another $1.50 where it will have to fill the 11/7 gap at $4. I wouldn't advise conservative investors to jump in until the stock convincingly clears major resistance at $5.

Note that an “island reversal” was formed between the 11/11 exhaustion gap and the 12/8 breakaway gap. Island reversals don't necessarily signal a change in direction; they can signal the start of a consolidation process as well which is why I urge all but the speculative to wait until major resistance is toppled.

A biotech example
A couple of years ago, a web acquaintance of mine was touting Northfield Labs (NFLD) as the next biotech giant based on their sole product called Polyheme, a red-blood substitute, that was still in development. So convinced was he of this company's success that he not only convinced his relatives to heavily invest in it, he also TOOK OUT BIG LOANS (pardon my yelling) to buy more stock! Any reputable financial advisor would have had an apoplectic fit.

Okay, you all know what's coming here. Take a look at the company's price movement between the end of 2006 through the middle of 2007.



A. 12/20/06 (before the market opens): Preliminary results of a late-stage trial of PolyHeme show that it failed to meet the study's primary goals and was shown, in fact, to be inferior to a saline solution. This announcement whacked two/thirds off the stock price in one day.

B. 5/23/07: PolyHeme failed to show any significant efficacy in its Phase III clinical trial. The stock shed over 50% that day. Surprisingly, the company is still around but the stock is now trading around 50 cents, down almost 98% from its $23 high set at the beginning of 2005.

A takeover example
On November 24th (point A in the chart below), Johnson & Johnson (JNJ) announced that it would purchase Omrix Biopharmaceuticals (OMRI) for $25 per share in cash. The stock immediately jumped up 13% on the open and has been trading in a very tight range since. I'm including this chart so you'll know what a company that is being acquired looks like. Unless there's some significant short-term money to be made on the transaction (see Recipe #13: Post-Takeover Tacos*), investors should avoid these.



Summary
This is just the tip of the iceberg when it comes to technical analysis (TA). My purpose here was to show all of you scaredy-cat fundamentalists that TA is not Jamaican voodoo but more like the map of the mind of the investing collective. It's really not that tough, and once you've analyzed a half a million charts or so, you'll get the hang of it.

In the next day or so I'll be showing you how you can use a chart to quickly and accurately determine that slipperiest of fishes: the exit point to a trade.

A useful charting tool
Google Finance provides stock charts with news flags that are described in an adjacent scrolling menu. You can set up this feature as well as adding dividend flags and stock splits to your charts via the settings tab. Nifty, no?

*My MANDA (M & A) Portfolio is based on this recipe and Mario Gabelli's ABC Fund operates on similar principles.

Basic chartology: Linear vs Log scales & other useful tips

Several of my close friends in the investment field have recently admitted to me in whispered tones that they have suffered significant losses this year not only in their personal portfolios but their professionally managed ones as well. These are serious people who make stock selections based on fundamentals and hold on to them through thick and thin, provided the reasons that they bought them in the first place don't change. Whenever I happen to toss in a polite comment such as "Your favorite stock just broke major support and I strongly recommend dumping that stinker," I receive reactions that range from rolling eyes to actual nose scrunching, as if I just presented them with a plate of Limburger.

The financial field is divided into two camps, much like the Republicans and Democrats--the technicians who see the world as it is and the fundamentalists, like my friends, who insist on viewing the world through rose-colored glasses. In general, the fundamentalist camp lumps technical analysis in with voodoo and elven runes and therefore since they don't know anything about it, it must be evil. Frankly, we technicians don't give a damn what they think as long as they leave us alone.

But sometimes miracles do happen.

It's amazing how a contraction in one's financial security can change a person's point of view, for in fact, a couple of my friends have recently admitted that they wished they had understood the basics of technical analysis. I accept their hidden apologies and in the spirit of their recent enlightenment, today's article is dedicated to them and all other beginning chartologists.

Note: Seasoned technicians need not proceed any further.

What am I looking at?
Before one can even begin to dissect a stock chart, one needs to understand the difference between a linear and a logarithmic scale. On a linear scale, all whole numbers are equidistant from each other. In other words, the distance between, say, one and two is the same as the distance between one hundred and fifty-nine and one hundred and sixty. Simple, right?

A logarithmic, or log, scale is very different. Here, the numbers are not equally spaced distance-wise; rather, they are equally spaced percentage-wise. For example, the distance between 5 and 10 is the same as the distance between 10 and 20. What this means on a stock chart is that a price bar representing a 50% gain will be the same size no matter where it appears. In this case, a picture is probably worth a thousand words. Below are two charts of Excel Maritime, EXM—one linear and one log.




Comparing these two charts, you can see that the log scale puts an equal weight on each price bar making today's 42% move that much more dramatic. Most technicians prefer a log price scale for this very reason, but it's okay if a linear scale makes more sense to you. Just know the difference.

A few other technical tips
You might notice a few things from examining the above charts. For one, you can see that the price tends to “bunch up” at the decade intervals, i.e. 10, 20, 30, etc., and to a lesser extent, at the 5-levels, i.e. 5, 15, 25, etc. These are called support and resistance levels. For EXM, you can see that it spent a good month bouncing off the $10 level in October which became a level of support because it was, in fact, “supporting” the price.

You'll see this support was violated on November 11th followed by another down day. This was a strong indication that the buyers had thrown in the towel and the sellers were now in charge. The price plunged. Its recent $3.50 low could be the bottom as evidenced by two factors: 1. The past two days of strong price movement have been accompanied by much heavier than normal volume (not shown on the charts above), meaning that the shorts are probably covering and the bulls are regaining power; and 2. Today's price bar has filled the gap set on November 20th. Once a price gap is filled, chances are good that it will continue moving in the direction of the fill.

Notice that the previous $10 support level is now a resistance level. This is a psychological barrier for traders and will be the stock's next hurdle to upward progression. If it manages to break through it on heavy volume, further upside movement is highly probable.

Well, that's the long and the short of log and linear scales. I hope this mini-chartology lesson has whetted your appetite for further study into the beauty of technical analysis. Tomorrow, I'll continue our education with a few other interesting and useful chart-reading tips.

Note: All of the major web-based financial sites--MSN Money, Google, Yahoo!--offer both linear and log charts. MSN Money also offers a log base 2 scale, not that I'm sure how to use it.

Today's market surge: A head-fake or the beginning of a real turnaround?

Whether Congress's proposed temporary bailout of Detroit combined with Obama's stimulus plans to create jobs by repairing our aging infrastructure was the engine that fueled today's broad-based rally is immaterial to market technicians who, like me, are getting excited over the forming chart patterns. Not only are today's break-outs and bullish gaps displayed by many individual stocks (most notably the best-of-breed companies in the infrastructure and basic material sectors such as water transport, coal, construction, and steel as well as some tech stocks and electronic stock exchanges) but for me, the most exciting and possibly telling pattern could be forming in the the S&P 500 index itself.

Below is a daily chart of the SPX. To me, it sure looks like it is in the process of forming an inverse head and shoulders pattern. For the chartologically challenged, a head and shoulders formation is a very powerful chart pattern that is coveted by many traders because it is so successful. (For a closer look at these patterns and some examples, see my March 5th and 6th blogs.) Let's look at this chart more closely.



You can see that the left shoulder was formed from the beginning of October to the beginning of November. The neckline, or the new level of overhead resistance, is at 1000. The top of the shoulder is at 850. The head was put in two weeks later and occurred at the 750 level, one hundred points below the shoulder. The last several trading sessions have touched the 850 level again and today's gap up is a strong indication that a right shoulder is beginning to form.

If this pattern is indeed in the formation process, what can we expect from here? As my arrows on the chart indicate, we should expect to see the SPX retest the neckline level at 1000 in the next week or so. The index will then reverse, and head back down to the 850 shoulder level probably some time in the beginning of January. If this level is successfully retested, then the only thing left to complete the pattern is for the S&P to rise back up again to the neckline. If it manages to break through that on heavy volume, we can easily expect it to rise at least another 250 points which is the magnitude of the distance between the neckline and the top of the head.

Of course, these are a lot of ifs. Trading mavericks can play each leg of this formation as it develops; for the gun-shy, I'd recommend waiting until the entire pattern is formed and then taking a bullish position if and only if the index decisively breaks through its neckline level which will most likely happen in the middle to the end of January.

If this pattern does play out as I've indicated, it would do a lot to boost the confidence and morale of the retail investor which, I believe, have been more badly beaten up than the market itself.

Oops!

Apparently in my fever-induced haze yesterday, I misunderstood Cramer. I thought he was looking at potential takeover targets in the drug sector only but obviously that isn't the case given his picks today.

He proposed that Illinois Tool Works (ITW) acquire Manitowoc (MTW) (which, by the way, he mispronounces but I'll cut him some slack since he's not a Cheesehead) and Nike (NKE) for Under Armour (UA). Both look good to me, especially a Nike/Under Armour merger and am rather surprised it hasn't happened already. If you like it, too, and are looking for a cheap, conservative way to play it, I'd suggest the July 25/30 bull-call spread at a $2 debit. The maximum loss here is $2 (the debit amount) with a maximum gain of $3 (the difference between the strike prices less the debit).

Second guessing Cramer

Yesterday on CNBC's Fast Money show, it was noted that Big Pharma companies are sitting on piles of cash (read: billion$ and billion$) fueling speculation that M&A activity in the drug sector will probably happen and soon due to the depressed stock prices of many of the companies in the sector. Not only did Jim Cramer pick up this ball, but he ran with it in his show. He said that he was going to identify five companies that he feels are ripe for the picking. In a blatant attempt to boost his ratings, he only mentioned one candidate yesterday—Pfizer targeting Allergan—and will give his next two picks today and the other two tomorrow.

I decided that I would try to second guess Cramu (as he used to call himself in his newsletters years ago) and have come up with my own candidates. What I did was run a screen on the biotechs with EPS 5 year growth rate > 8%, average daily trading volume > 150,000, and market capitalization > $1B. Out of the top 25, I then hand-picked those that had positive cash flows and high sales per share. I whittled the list down to the seven listed in the chart below.



Of this seven, I looked at those that had robust drug pipelines as well as many drug collaborations. [Note: Genentech (DNA) is supposed to be in the process of being acquired by Roche but rumors are flying that Roche many not be able to come up with the money. If not, Genentech will be back on the block but with a market cap of $775B it's not going to be a cheap date.] I don't claim to be a specialist in the drug sector and can only make recommendations based on my short amount of research, but I do think the following are attractive take-over targets:

Biogen-Idec (BIIB): The company already has many drugs on the market and many in development, mostly in the areas of MS, non-Hodgkin's lymphoma, leukemia, and rheumatoid arthritis. It collaborates with many other biotech firms including PDL BioPharma, Elan, and Schering AG. Technically, the stock is down 50% from its all-time high put in a little over a year ago and is sitting on major support at $40.

Gilead Sciences (GILD): The company engages in the discovery, development, and commercialization of therapeutics for the treatment of life-threatening infectious diseases including hepatitis B, HIV, and the flu (you'll recognize Tamiflu). It has many research collaborations including Abbott and Novartis and commercial collaborations with GlaxoSmithKline and Bristol-Myers Squibb, to name a few. The stock price has survived better than others in this group, down only about 18% from recent highs so it might not be a
a great bargain especially considering its large market cap.

Genzyme (GENZ): The company develops and distributes treatments for renal, kidney, and thyroid diseases, osteoarthritis, and provides reproductive testing and genetic counseling among other services. The company has a collaboration agreement with PTC Therapeutics and a strategic alliance with Osiris Therapeutics. The stock has slumped 27% from recent highs and is threatening support at $60.

The rest of the companies in the above chart are not primarily involved in drug development (most of them make biotech supplies) and I must confess that I don't know enough about this space to make an educated guess as to who might want to acquire them.

Well, these are my candidates in the biotech area. Let's see if Cramu thinks so, too.

Under the weather

Dr. Kris is--achoo!--feeling a bit under the weather. She tried to put out a blog today but quickly chucked it for a nice warm bath. She's currently snuggled under a fluffy down comforter alternately sipping chamomile tea and dozing off to Turner Classic Movies.

She's hoping to return to her blogging duties as soon as possible.

Index & Currency Plays

It looks like today's market gobbled up the gains of the Thanksgiving rally. It was to be expected since the Monday following Black Friday is historically a down day. (See last Wednesday's blog, “The Turkey Effect,” for further details.) Last week's rally sparked hope of a market bottom; I, however, do not share that hope as evidenced by the following charts of the the VIX and the S&P 500.

What the charts are saying and how we can profit from them

The volatility index, the VIX
The chart of the VIX, the market volatility index, shows that it's been trading in a horizontal range for the past two months. The lower support level is around 55 (you could argue the case for support around 47 as well). Upper resistance is defined by the 80 level. A bottoming tail formed on Friday and today's gap up further emphasized this turn-around in direction. (Remember that the VIX and the markets move counter to each other.) So, is there any way one can profit from this channeling behavior?



Well, you can't actually buy the VIX but there are options on it with good liquidity at many strike prices. One conservative options play is to sell bull-put credit spreads on a day like today when the VIX is bouncing off lower resistance. Try the December 55/50 put spread (sell the 55 strike and buy the 50 strike) or the December 50/45 spread if you're of a more conservative bent.

This is a directional play and as such you don't want to wait for the price to move against you so I'd recommend closing out the spread when the VIX gets near upper resistance at 80. When it shows signs of heading back down, I'd reverse the process by selling an at-the-money (ATM) or slightly out-of-the-money (OTM) bear-call credit spread.

Nothing channels forever, so you may only get to do this a couple of times, but it could be worth your while. If the trade does happen to move against you, close it out or roll down the strike prices. I'd recommend setting your stop-loss at the break-even (B/E) price. For a bull-put credit spread, the B/E is the lower strike price less the net credit; on the bear-call side, the B/E is the price of the higher strike plus the net credit.

The major market indexes
The chart below shows the daily price action of the S&P 500. (I chose the S&P because it's the benchmark index for most comparison purposes but all of the other major indexes look similar.) You can see that it's found a new trading range bounded by a downwards sloping channel. For reference, I also included the 30 day exponential moving average as it seems to coincide with the upper price channel boundary.



We can play this in several ways using equities and options. (This channel is also a handy reference for index futures traders, too.) First, there's the tracking stocks—the SPY, DIA, QQQQ, etc. along with their double and triple long/short ETF counterparts. You can buy these when the index turns up from its lower channel boundary, sell when it reaches the upper boundary, and then take a short position (by either shorting the tracking stock or buying the short equivalent) when the index begins to head back down.

Options players can play the options on either the indexes or the tracking stocks. Options on the latter are cheaper and generally more liquid than the former. Possible options strategies include the above-mentioned credit-spreads, debit-spreads, or straight calls and puts. Because of the time decay factor inherent in options pricing, I prefer buying options with strikes that are at least 6 months out if I plan on holding them for more than a day or two.

A note on currencies

The Greenback
The long US dollar tracking stock, the UUP, has been trading in the $26-$27 range for the past six weeks. A definitive break on either side will likely continue in the same direction—just a heads up to you currency traders out there. (There are no options on the UUP, alas.)



The Yen
The Japanese yen is the only currency (with a tracking stock) that is bucking the buck. It's tracking stock, the FXY, has been rising steadily since its October 6th breakout and is less than $2 away from hitting its yearly high at $108.79. This tracking stock is optionable and selling the December 105 cash-secured put when it next takes a breather (maybe as soon as tomorrow) would be a nice way to ease into a long position. Note that many of its options are thinly traded and you can't buy any further into the future than June 2009.