Friday, February 27, 2009

Channel Breakout Examples

Yesterday, we looked at a recipe for trading stocks (or futures) that have just broken out of their consolidation patterns. Today, we'll look at a couple of examples of this strategy--Goldman Sachs (GS) and Honeywell (HON).

Goldman-Sachs: Daily Chart

[Click on chart to enlarge.]

Here's a daily chart of Goldman-Sachs (GS). The stock began consolidating in March of last year, trading between $152 and $190-$200. On September 15th, the stock ended its consolidation pattern and gapped down through support, closing the day at $135.50 on heavier than normal volume. This was the day to enter a bearish position, either by shorting the stock or buying put options. It was also the day for you to either enter a sell-stop order or set an alert for your exit point.

Where is your exit? From yesterday, we saw that we can expect the stock to drop at least the same magnitude as the breadth of the consolidation ON A LOG SCALE and we gave formulas so that we can calculate it directly instead of measuring it on a chart. For Goldman, it's pretty clear where the bottom support level is—about $152, but the upper resistance level isn't quite as obvious. One technician might determine that $190 is the proper level thereby ignoring the data point at $200, while another technician might include it. You can choose which ever one you want, but I'd err on the conservative side and select the one at $190.

Using the $190 level, our exit point will be $122; using the $200 level, the exit point is at $116. You can see from the chart that the stock had no trouble sliding by either one. Exiting according to this plan would have netted at least $13 for an ROI (return on investment) of almost 10%. Not bad for two days!

But what would have been your return had you instead purchased a put? The only data I have at my fingertips is the price history of the 2009 April 135 put. On Sept. 15, it closed at a price of $21.40. Two days later, it closed at $36.20. That gives a profit of $14.80 per contract for a return of almost 70%--yowza! You can see why options can be so alluring and why they are used in come-on ads to inflate potential returns. What they don't tell you is that trading options is not a piece of cake--you really need to know what you're doing! (Please see my sidebar for options education info.)

Honeywell: Weekly Chart

Sometimes consolidation patterns that have long cycle periods (aka wavelengths to you tech-heads) aren't obvious on daily charts and you'll have to go to the weekly or even monthly charts to discern them. The chart of Honeywell (HON) above is one such example. A well-defined channeling pattern began in mid-2006. It enjoyed a successful two year run, bouncing between $52 and $62 (you could have made some money playing the channel—see recipe #3) before it finally broke down on 6/26/08. (You have to go to the daily chart to see this.)

Actually, it broke support the day before, closing under $52 for the first time in two years. The stock gapped down the next day which would have been your signal to enter a short position. If you had shorted near the open, you could have gotten in at $51. Your exit point for this trade would have been $43.60 (or you could have made it an even $44—this science isn't that exact). Several weeks later, the stock finally hit the $44 mark and had you exited then, you would have netted $7 for an ROI of almost 14%.

Had you instead bought the 2010 January 50 put on 6/26 at the closing price of $6.40, you could have sold it on 9/17 for $10.40. That's a gain of $4/contract for an ROI of over 60%!

You can see the power of channel breakouts, especially when the stock is moving in the same direction as the market. Of course, any monkey's uncle in recent months could have thrown a dart at the stock market and done well shorting virtually anything out there, but most of the time the market is not nearly this volatile. You should note this because in the case of the above two stocks, had you held at least a portion of your position past the exit point, you could have profited even further. This certainly would have been true had you shorted the stocks, but be aware that because of changes in implied volatility, your option positions may not have fared so well. Also be aware of the fact that the above options returns were based on the assumption that the options were liquid enough for me to buy and sell at those prices. In a real-life situation, that might not have been the case.

Later this weekend or Monday, I'll try to rustle up some stocks that are consolidating right now so that you can add them to your watch list.

Tuesday, February 24, 2009

MANDA Updated Table

This table incorporates today's additions of NCX and HIFN.

Click on table to enlarge.

MANDA Portfolio Additions: NCX & HIFN

It looks as if M&A activity isn't completely dead. Yesterday, Abu Dhabi state-owned International Petroleum Investment Co (IPIC) launched a $500 million takeover of Nova Chemicals on Monday in an effort to rescue the Canadian-based plastics maker from drowning in debt. Note that Nova trades both on the Toronto exchange and on the NYSE under ticker symbol NCX. Under the proposed terms of this friendly deal, IPIC will pay NCX shareholders (US) $6 per share in cash with the caveat that at least two-thirds of the shares are tendered.

Looking at the chart of NCX yesterday (shown below), my first thought was that too many people already owned the shares at higher prices and would be loathe to part with them at a loss. But last night I looked at the chart again and noticed the substantial rise in trading volume in recent weeks. Adding up the daily volumes, I found that more shares than the float (approximately 85.6million versus a float of 82.6 million shares) had been traded since 1/21/09 when the stock price began trading under $5. The stock hit a low of a buck and change on 2/3 and has stayed below the $2 mark until yesterday when the acquisition was announced. With more than the float changing hands below $5, this was the reassurance I needed to jump in at today's opening price of $5.20.

Right after my purchase of NCX, I bought shares of Hifn (NASDAQ: HIFN) for $3.80, a maker of processors used in network and data storage security. Chip maker Exar (NASDAQ: EXAR) agreed to buy all Hifn stock giving Hifn shareholders the choice to receive 0.3529 shares of Exar plus $1.60 per share in cash, or $4 a share. Based on $4/share, the deal is worth $58.9 million. It has been unanimously approved by both boards and is expected to close early in the second quarter.

The MANDA portfolio table will be updated to reflect these new additions.

Monday, February 23, 2009

The market in free-fall

First, my apologies for again harping on the dismal state of the market. I'm not trying to be boring; believe me, I'd much rather be reporting on something that's a lot more interesting and useful to my readers. However, I feel it's my fiduciary duty to impress on you how serious this downturn is and how likely it is to continue.

I mentioned last Tuesday that the Dow Transports (DTX), generally considered a leading indicator, broke major support. Two days later, the Dow followed suit. It's now trading at over a 10 year low. Since my charting service doesn't carry Dow data any further back, I can't even give you the next support level.

The S&P 500 broke major support today, closing at 743. There's minor support at 670; next major support is in the 470-480 range. Ugly.

Sector indications
Looking at sector ETFs shows most either breaking major support levels and/or making new all-time lows. (Note that ETFs are relatively new inventions and most haven't been around for more than several years.) All sectors are sucking big-time except for the metals. Gold bounced off of $1000/ounce and if it starts to trade above that, I'd be very bullish on it. As mentioned before, the pure gold play is the GLD, an ETF that holds gold bullion,* but the gold miners represented by the GDX is also doing well. (I'd wait until it tops $39 resistance before buying.) The only metal that has been outperforming gold is silver. One way to play it is to buy the SLV, the silver ETF.

Other market indicators
Two stocks that are considered market bell-weathers are Berkshire-Hathaway (BRK.A) and General Electric (GE). GE is down 85% from its $60 peak. It just broke $9 support. It's next support level is at $7.55; below that, there's no safety net. The Oracle of Omaha's managed fund (aka Berkshire-Hathaway) has broken through several support levels and is sitting right on its next major support at 75,600, 45% beneath its all time high. One CNBC analyst today said that at a P/E ratio of 15 the company is still way overvalued. A P/E of 10 is more inline with his estimates. That means the stock has to drop another 33% ($25,000) to reach that value. Now that's really ugly.

One good news/bad news scenario is playing out at Cabela's (CAB), an in-store and online retailer of outdoor wear and sporting goods. The company beat analyst expectations last Friday--the good news. The bad news is that they did it by offering fire arms at fire sale prices. One analyst thinks that this surge in sales could be a reaction to a change in gun policy by the Obama administration. That's one explanation. Another could be that people are fearful that a possible depression could result in an increase in theft, and they are buying guns to protect themselves and their possessions. I sure hope it's the former and not the latter explanation.

Tomorrow I'll have a "meatier" blog. Again, my apologies for another gloomy prognostication but please don't shoot me--I'm only the hapless messenger.

*According to CNBC, the GLD holds so much gold bullion that it's now the seventh largest holder IN THE WORLD!

Friday, February 20, 2009

Updated MANDA Holdings

Since my last update, two companies have completed their mergers: ANL on 2/18 and PSD on 2/6. Note that a prorated dividend of $0.04448/share was paid on PSD.

Needless to say that because of the uncertain market and credit climates, M&A activity has come to a virtual halt which is the reason for the paucity of portfolio holdings. At least the fund is operating in the black, but there's still the wild card of Dow Chemical's acquisition of Rohm-Haas. There's been no news from Dow as to what they're going to do but not closing the deal is costing them $90 million a month. Dow recently slashed its dividend and cut 5,000 employees as part of their cost-cutting efforts.

(Click on table to enlarge.)

Thursday, February 19, 2009

The Holland M. Ware system for making millions in the market

Are you wealthy? If so, are you tired of watching your investment returns shrink? Fearful that your money manager is a crook? Worried that you'll have to give up your private jet and a few vacation homes?

Well, my friend, fret no further because now it's possible for you to take the matter into your own hands and generate $millions$ in the market in just a short time.

Sound too fantastic? Believe me, it's not. And it's so simple even the E*trade baby could do it!

Introducing the Holland M. Ware no-brainer “Get richer quicker!” system
In this system, you'll learn how Georgia-based timber baron Holland M. Ware recently pocketed a cool $7.5M and possibly more on the stock of Forestar Group (FOR), a Georgia real-estate holder and developer also involved in mineral and timber royalties. You'll also see how Ware's attorney, David Cook of the Jacksonville, Florida law firm of Foley & Lardner, netted $1.1M by riding his coattails.

Here's how they did it and how you can do it, too.

1. Purchase over 5% of a company's stock at a depressed value.

Below is a chart of Forestar.

The company made its public debut at the end of 2007 near $23. A month and a half later it made an all-time high of $29.49. After that, it hung around in the high-teens to mid-20s range, but it wasn't until late September, 2008 that it finally broke below $15. It sank like a ship's anchor until it hit bottom in November at a price of just under $3. Ware and his attorney begin accumulating shares in the company during this time period, according to three SEC Schedule 13d filings dated 2/12/09, 1/22/09, and 12/19/08.

Holland Ware: Purchases over 2.6 million shares for $14M between 11/30/08 and 1/5/09.
Purchase prices range from $3.50 to $9.00; average cost/share = $5.35.

David Cook: Purchases 231,500 shares for $1.5 million between 10/31/08 and 1/20/09.
Purchase prices range from $3.36 to $9.00; average cost/share = $6.10.

2. Make an offer well above the average price you paid for your stock but still below what the company is worth. (If for some reason the board actually accepts your offer, you can always rescind it. Maybe that's one reason why Ware's attorney was involved.)

On 1/22/09, Ware makes an unsolicited offer to buy Forestar at $15 per share, much higher than the average cost of his stock but well under historical price levels. The next day Forestar stock jumps to $12, 30% over the previous day's closing price of $9.24.

3. Start dumping your stock at inflated prices while the board considers your request.

Both Ware and Cook begin selling their shares starting 2/4/09.

A couple of weeks later on February 11th, the Forestar board rejects Ware's offer because it “significantly undervalues” the company. That day, Ware unloads more than 1.2 million shares of Forestar stock.

Ware's last filing with the SEC on February 12th showed that he had sold all but 444,230 shares for a total sales price of $21.5 million leaving a net profit (so far) of $7.5 million. We don't know if he's sold the rest of his shares, but I can't think of a reason why he'd want to keep them. Assuming he did sell them in the next few days at an average price of $8.90 (the middle of the price range), he'd gain another $4 million giving him a total of $11.5M yielding a nifty return of 80% in a little over two months. Looks like he can afford to keep that jet.

As for his lawyer, the same SEC document shows that Cook had disposed of all of his shares for a total of $2.6 million. This leaves him with a gain of $1.1 million for a return of over 70%. Sure beats trying cases for a living!

Be aware that the SEC could view this as stock manipulation, but the onus of proof is on their side, not yours. It helps that Forestar has significant timber holdings which Ware could use as the main argument for his acquisition offer. It's also interesting to note that on the very same day that the Forestar board denied Ware's offer, they also announced their commitment to increasing shareholder value by doing a share buy-back, slashing debt, and selling some 175,000 acres of timberland. Interesting, no? Maybe Ware can use the proceeds of his Forestar stock transactions to buy this acreage at firesale prices. Could that have been his intent all along..?

As an extra bonus
If you purchase this product today, we'll throw in Holland Ware's strategy on how to save millions in taxes. Here's how it goes. In 2007, Ware took advantage of a loophole in Georgia state law that exempted charitable institutions from paying property tax. What he did was to donate over $100M in timberland to his anti-animal abuse charity (aw!) that up until then had only $300,000 in assets. Unfortunately, the state legislature didn't let him get away with it, but I think if he could have been a bit sneakier he might have been able to pull it off. (See January 27th blog for more info.)

Can we tempt you further?
Okay, if you're still not convinced to buy this product we'll throw in the names of some top-notch white collar criminal defense attorneys just in the event something goes wrong. But nothing should. This is a time-tested formula used by Ivan Boesky and many others, so why not give it a try? You have nothing to lose but your reputation as being ethical but when was that ever a criterion for making money on Wall Street?

Tuesday, February 17, 2009

Danger Will Robinson!

A quick note on the state of the market. As we saw in my January 26 blog, the market at that time was at a critical juncture with the major indices testing major support levels. Well, folks, today we're right back down there and unless there's a significant turnaround in the last hour of trading, we could be looking at a complete market meltdown.

Generally lauded by technicians as a leading market indicator, the Dow Transports, the DTX, has broken major support at 290. The VIX, the volatility index, gapped up over 12% today--also a bearish sign. The XLF (the financial SPDR) and the RKH (the Regional Banks Holdr) are both testing their all-time lows.

Apparently, the fact that Japan, the world's second largest economy (still?), suffered the worst quarterly decline in 35 years along with the Empire State Manufacturing Index coming in at its all-time low didn't help the already sour mood on the Street where most folks believe the stimulus package will do anything but.

So, what should we do besides wring our hands? My recommendation is to move your longs into cash, if you haven't done so already. For the time being, cash is king. Gold is also looking very attractive and the gold ETFs have been stellar performers over the past couple of months. The most heavily traded pure gold bullion ETF is the GLD but the GDX which represents the gold miners is also worth a look. If you're heavy into gold, I'd suggest a mix of both ETFs to reduce your sector risk.

The more risk tolerant can buy LEAP put options on the DIA, the Dow tracking stock, or the SPY, the S&P 500 tracking stock. Remember that an increase in volatility also inflates the price of options, so a bear-put debit spread (buying the higher strike and selling the lower one) would help to offset that. An at-the-money or slightly out-of-the-money bear-call credit spread can bring cash into your account. For most of the near-the-money strikes, options are very liquid on both of these instruments. (Note your broker's margin requirements regarding these plays.)

That's about it for now. Just wanted to give everyone this important heads-up.

Friday, February 13, 2009

More on the dangers of leveraged ETFs

This wasn't supposed to be the topic of today's blog but in doing research that will now appear in Monday's edition I stumbled upon a very interesting video on Morningstar that backs up my observations made in Tuesday's blog concerning the dangers of leveraged ETFs. If you've never heard of Morningstar, they're the guys who do the mutual and ETF fund ratings. They have an excellent (and addicting) site that I don't visit often enough but when I do, I usually spend far too much time.

To continue, at the bottom of one page was a link to one of their videos (shown in two short parts) entitled “Returns at these ETFs Could Shock You.” Intrigued by the dramatic title, I watched them both, and am glad I did for they expand upon Tuesday's blog and explain in detail about the dangers of leveraged funds—the double longs and the double shorts and employ graphics to show how that even a sideways fluctuation in the market (due to extreme volatility) can produce significant losses on both the long and short sides.

In doing their research, they said these leveraged ETFs perform as stated in their prospectuses. Performances over one day mirror +2x/-2x that of the indices they track.

Their recommendations were that if you can't monitor nor afford to trade these ETFs on a daily basis, you'll most likely not be happy with your returns. My take is to look at the historical charts and compare them their underlying indices or comparable funds. If there's a divergence, stay away, and do make sure that the fund has a long enough track record—at least a year as well as over a period of abnormal volatility (like now).

I'm thankful for this diversion because the article I had intended for today wasn't nearly as cheery nor as easy to research as I thought. And I wouldn't want any of my readers to be bummed out over Valentine's Day.

Here's last year's Valentine image sent out from Bernie Made-Off. Have a lovely one!

Thursday, February 12, 2009

Correction and addendum to Tuesday's blog

As many of you know, I'm a contributor to SeekingAlpha, a website that is a compilation of many financial viewpoints dedicated to helping investors and traders gain insight into the financial markets. I feel especially honored to have my work included as their readers are savvy, sophisticated, and well-informed. Their ranks span the home investor to the institutional portfolio manager, analyst, and trader. In short, they're good and they know what they're talking about. And when they comment on my articles, I listen.

The DUG is out
I had several great comments concerning Tuesday's blog that I feel I should address here. The first one concerns the makeup of the DUG, the double inverse oil and gas ETF. I was wrong in my assumption that the fund tracks the price of oil and gas. I tried to find the fund holdings but since neither MSN Money nor Powershares, the ETF's fund family, listed any I erroneously assumed that it was tracking an index.

This is not the case. The Dow Jones Oil & Gas Index that it tracks is made up of oil and gas producers along with oil equipment, services and distribution companies. In short, the DUG is based on equities not the commodities, and as such I was essentially comparing apples to oranges. (Well, maybe lady apples to Rome Beauties as we're still talking about the performance of the oil and gas sector.) That was my mistake.

The DTO is in
Right now there are 131 ETFs involved in natural resources. I have ten on my oil and gas list which I must admit hasn't been updated in a while, so I missed the DTO which is a double inverse fund that came into being last June. It's specifically designed to track the spot price of oil* and is the correct fund to use if you're really bearish on crude. You can see from the charts below that the DTO does indeed accurately mirror the inverse movement of the USO, the US Oil Fund.

Since oil peaked on 7/11/08, the USO has lost almost 80% while the DTO has gained more than 800%! Wowie!

Why the DUG is bad and the DTO is good
In Tuesday's blog we saw that market volatility is a major influence on the DUG. So, how come volatility isn't an issue with the DTO? The difference here is that the DUG is based on an index of stocks while the DTO is based solely on the price of oil and is thus independent of the volatility that affects the equity markets.

Thanks to the acumen of those who commented on my article I was able to make this important correction. On a side note, I did receive a very misogynistic comment (from a fellow alum no less!) about how MIT is letting too many women graduate, among other things. A friend of mine who is in the media said that you know you've finally arrived when you get flamed in print. I guess Tuesday was my coming out party.

*The PowerShares DB Oil Fund (Symbol: DBO) is based on the Deutsche Bank Liquid Commodity Index - Optimum Yield Oil Excess Return™ and is managed by DB Commodity Services LLC. The Index is a rules-based index composed of futures contracts on Light Sweet Crude Oil (WTI) and is intended to reflect the performance of crude oil.

Note that the DTO is not optionable.

Tuesday, February 10, 2009

Beware the short and ultrashort ETFs!

What's the difference between a long ETF and its short counterpart? Theoretically, the price chart of one should inversely mirror that of the other, but as you can see from the charts below that is definitely not the case here.

The first chart is of the USO, the US Oil Fund. (The chart of the US Gas Fund, the UNG, is similar.)

The fund peaked July 11, 2008 and has fallen more than 70% since. Wouldn't it have been nice to have had a crystal ball so that you could have seen this coming and then done the opposite like, say, buy the ultrashort oil and gas ETF?

Let's examine this scenario and see what would have happened. Here's a chart of the DUG, the double-short oil and gas ETF.

The DUG did rise after oil began to implode. It returned more than 140% from July 11 to its peak price reached on October 10, 2008 where it formed a one-day island reversal (an evening doji star in candlesticking). No matter how you look at it, this is a bearish sign. The price turned around and fell 68% since then, but so did the USO. In fact, the USO has only fallen 60% since that date!

So what gives? Shouldn't the DUG be trading through the roof instead of scraping the basement floor right now? That's what one would expect. To clear up this mystery I went to the Proshares website where they explained why their short and ultrashort funds don't always perform the way they should.

There are two reasons for this.

The first, they say, is that their funds are designed to return their stated returns on a daily basis only. Here's their explanation: “Leveraged and short funds can be valuable tools for investors who want to manage their exposure to various markets and market segments. But investors considering these funds should understand that they’re typically designed to provide a positive or negative multiple of an index on a daily basis and not for greater periods of time. As a result, fund returns will not likely be a simple multiple (e.g., 2x, -2x) of an index's return for time periods longer than one day.” No kidding!

The second reason they claim is due to market volatility: “Additionally, investors should recognize that the degree of volatility of the underlying index can have a dramatic effect on the longer-term performance. The greater the volatility, the greater the deviation will be of a fund’s longer-term performance from a simple multiple (e.g., 2x, -2x) of its index's longer-term return.“

In fact, it's this second reason that explains much of the discrepancy between the two charts. Let's look at the market volatility index, the VIX.

You can see that the VIX has had quite a profound influence on the behavior of the DUG—much more than even the oil and gas index that it's supposed to track! Actually, you could almost use the DUG as a proxy for the VIX—who would have thought?

Lessons learned
There's a couple things that I've learned from this exercise. The first, and most obvious, is not to blindly assume that just because a fund says that it tracks the inverse or double the inverse of an index means that over the long haul it actually will. Because of this, one should be very careful of using these instruments as hedges, especially in highly volatile markets.

You learn something new every day. Class dismissed.

Monday, February 9, 2009

Sector summary

Lately, CNBC has been squawking about how well bank stocks have been doing lately in anticipation of the stimulus package. Sure, many of them have rallied recently, but their charts for the most part hardly scream "buy!" As proxies for this group, look at the charts of the financial spider, the XLF, and the regional banking ETF, the RKH. (In the interest of saving space, I'm only showing the chart of the RKH, but the XLF chart is very similar. )

You can see that the price has been channeling downwards. A breakout above this channel and above its $60 resistance on strong volume would be the signal to go long in this group.

The financial media has also been crowing about the comeback in the materials sector. Say what??? One certainly wouldn't get that idea by looking at the PYZ, the materials ETF. It's been doing a lot of nothing for the past several months as you can see if you look at the charts of its top ten holdings. The only bright spot in that group is the gold miner, Newmont Mining (NEW).

The PYZ has been channeling between $17 and $20. If it eventually manages to fill its exhaustion gap at $24, then that's the time I would be convinced of a turnaround in the materials.

Utilities, Energy, and Agribusiness
The utilities (UTH), energy (XLE), and agribusiness (MOO) sectors have been in the process of consolidation for months. They all sport similar charts, so I'm only showing that of the energy spider, the XLE.

Upper resistance on the XLE is at $53; for the UTH it's $100, and for the MOO (don't you love that symbol?) it's $30 and change. A break through these levels would be bullish.

Drugs & Health Care
The charts of the biotechs (BBH), health care (XLV), and the pharmaceutical companies (PPH) have also been consolidating and they are all threatening to break overhead resistance anytime now. Resistance levels for these sectors are as follows: BBH is $180; XLV is $27.50; PPH is $63.

Gold & Silver
Lately, the precious metals have been among the better performers. The GDX tracks the gold miners, the GLD holds gold bullion, and the SLV tracks silver. (Note that the SLV is a new fund and has only been around for two months.) Of the two gold ETFs, the GDX has been the hands-down winner lately, more than doubling in value since its October low. (GLD has "only" recovered 30% since then.)

The GDX needs to clear $39 resistance to continue its upward progress.

Consumer Staples & Consumer Discretionary
There are many sectors out there that look ugly, but I was mildly shocked to see consumer staples, the XLP, among them. The usual thinking is that in tough times people still need to buy food and toilet paper but apparently this time is, indeed, different. This sector has been consolidating, too, but to the downside rather than to the upside. It's sitting right near it's local low at $22 and I fear that a break through that will spell disaster for this group.

Interestingly, the chart of the consumer discretionary sector, the XLY, is better but not by much. The ETF is currently trading just over $20, two bucks above major support.

Internet Technologies
The charts of the internet ETFs are looking as if they're poised to break out of their consolidation patterns. You can check out the charts yourself: Internet (HHH), Broadband (BDH), B2B (BHH), Internet Infrastructure (IIH). Most of these are thinly traded so bear that in mind when entering a position. It's a good idea to use limit orders in these instances. For an overall look at this sector, check out the XLK, the Technology Spider. It's been consolidating in the $16 range; a break above $18 would be your signal to start taking long positions.

You can see from the above charts that the financial media may be over-hyping the recent gains in some of the these sectors, especially in financials and materials. The future direction of the market will depend on how successful the stimulus package will be in putting money back into consumers pockets and confidence back into the financial system. Until then, there's nothing wrong with keeping your cash stashed under your mattress.

Friday, February 6, 2009

Market mishigos

The current Mercury retrograde has been hitting me hard. My car broke down not once but twice. To add insult to injury, my computer crashed necessitating a complete re-installation of all software. That took a better part of two days, which is why my blog has been dark this week.

But today I was able to do a little chart-surfing and found some interesting specimens that illustrate some aspects of technical analysis (TA). If you’re a novice in this area, you might find these charts educational; for you experts, you might glean some viable trades.

Channeling stocks
Some of the homebuilders seem to be in a channeling mode, meaning that the price oscillates between a lower level of support and an upper level of resistance. The way to play this type of pattern is to buy the stock when the price begins to bounce off its support level and sell when it nears resistance. As soon as the price starts to head back down, a short position can be taken and covered when the price nears support. (See Recipe #3: Chocolate Channeling Bars for further info.) Stocks don't channel forever and when they do break one of these levels, chances are good that they'll continue in that direction especially if they break to the upside on heavy volume. (Volume doesn't have as much meaning on the downside.)

Below is a chart of Meritage Homes (NYSE: MTH). You can clearly see it bounce between the $10 and $15 levels. (There's also an island reversal at the left side of the chart which is discussed below.) If you want to play any of the homebuilders, do note that their price directions will be directly tied to stimulus strategies so please be careful and read the news before you take any action.

Island Reversals
An island reversal is formed by two price gaps that separate the “island” segment from the rest of the chart. The left gap is called an exhaustion gap because that's literally the last gasp of investor interest. The right gap is the breakaway gap signaling renewed interest, especially if it's accompanied by strong volume on the upside.

The gaps themselves should be in the same price range, although some technicians broaden that requirement to include unequal prices. To me, that doesn't look like an island, and I do think that equal price points are technically more significant, although I don't have anything except experience to back me up on this.

Island reversals can look pretty much like anything; they can take the form of double tops (or bottoms), head and shoulders formations, or flat periods of consolidation—you name it. They can span up to several months or as little as one day. Generally, island reversals aren't all that meaningful just by themselves but they do tend to add conviction to other patterns such as the ones listed above.

Below is a chart of i2 Technologies (NASDAQ: ITWO). It has just broken out of its island pattern on strong volume indicating a probable continuation in that direction. FYI, another stock that has just broken out of its island reversal on strong volume is Art Technology (NASDAQ: ARTG). (Chart not shown.)

Head & Shoulders Pattern
We've looked at H&S patterns many times before, so I won't get into too much detail. (See Cooking Tools #1: Chart Pattern Reversals for more info.) An H&S pattern looks exactly like it sounds—three bumps on a chart where the middle bump is larger in magnitude than the other two. In bull markets, most H&S patterns look “normal,” meaning that the chart bumps are pointing up. In bear markets, inverse head & shoulders patterns are more the norm, and that's what we have here with the chart of Ampal-American Israel Corp. (NASDAQ: AMPL).

The profit expectation for an H&S formation is given by the neckline value plus or minus the distance between the neckline and the top of the head (+ if it's an inverse pattern and – if it's a normal one). In the above case, the neckline is at $1.20 and the top of the head is at $0.55, so we should expect to see the stock rise to at least $1.85, which it has.

Another interesting inverse H&S pattern is shown in the chart of Ilumina (NASDAQ: ILMN) where an island reversal separates the H&S pattern from the rest of the chart. It broke its neckline on a breakaway gap accompanied by six times normal volume two days ago. With the neckline at $32 and the head peaking at $20, we're looking at a $12 rise in the stock to $44, although I'd watch to see if it can break resistance at $40.

Well, I hope you've learned something on our mini-excursion into Chartland. Mercury is supposed to go direct soon and I'm praying that the god of electronics again smiles on me so I won't have to keep my faithful readers deprived of their daily dose of the StockMarketCookBook.

Tuesday, February 3, 2009

MANDA Portfolio Addition: PharmaNet (PDGI)

PharmaNet Development Group Inc. (PDGI), a drug development services company, announced earlier today it has agreed to a $100 million acquisition by affiliates of JLL Partners Inc., a New York-based private equity investment firm. This is an all-cash deal set at $5 per PDGI share. The acquisition has the approval of the PDGI board and is expected to close by the end of the first quarter.

The transaction, which values PharmaNet's stock at about $100 million, will be financed by a $250 million equity commitment from JLL. The company said the financing includes the funds to retire the $144 million principal of its outstanding convertible notes.

This looks like a solid deal to me so I picked up some PDGI shares for my MANDA (M&A) portfolio today for $4.60 giving a return of 8.7%.

Other MANDA news
MANDA component Rohm-Haas (ROH) yesterday declared a quarterly dividend of $0.41/share payable on March 2 to shareholders on record as of February 13. (So far in the portfolio, ROH has paid $1.23 per share in dividends.)

Company officials, miffed at acquiring company Dow Chemical's toe-dragging in regards to closing the deal, today sent a strong “Get your act together or else!” message to Dow's board. If push comes to shove, it doesn't look good for the big guy as the terms of the deal put all of the onus on Dow. On the flip side, you can't withdraw money from an empty bank, so where this deal stands at the moment is anyone's guess.

Here's the updated MANDA portfolio (click to enlarge table):