Why We Avoid Longs in Corrections Even When Underlying Assets Act Bullishly

In our write up of August 28^th we urged taking a position in gold on a break out by buying the GLD ETF. We entered the position on September 2^nd as price began its move and have a comfortable cushion in the position.

The stock market has entered what appears to be its first significant correction of the bull market that began in March, but you’d never know it from the price of gold. Granted, price has traded lower, but unlike many bullish stocks there has been no panic stricken pullback and price remains comfortably above its 50 MA.

Not so gold mining stocks. A good proxy for them is the GDX ETF. Yesterday it broke below its 50 MA on volume and undercut a prior low, signaling that its uptrend is very much in doubt. Unlike gold itself it has surrendered the entire gain since the September break out. Price is bouncing today but it will have to close back within its recent trading range to escape technical damage.

Why the disconnect? Simply stated gold miners are companies that have underlying fundamentals that go beyond the price of gold. Their stocks are equities, not commodities, and will usually trade in sympathy with the stock market regardless of the price of the underlying asset.

O’Neil’s half century study of stocks’ behavior indicates that at least three out of four will follow the market’s general direction. Given the recent aggressive pullback that means long positions other than intraday trades face a headwind that puts them at a disadvantage from the moment you push the buy button.

Southwestern Energy (SWN)

Previously we profiled the energy space, which we’ve identified as a source of emerging new leadership. Of all the stocks in the sector only one has traded within 5% of its 2008 all time high: Southwestern Energy (SWN). The reasons are clear: SWN is a major player in natural gas with low cost of production and expanding supplies.

Incredibly, the company’s earnings barely took a hit this year as the price of natural gas simply collapsed. What’s more, analysts expect growth to resume next year as if it never trailed off. Estimates call for $2.17 next year as opposed to $1.54 last year. In other words, if you discount this year’s projection of $1.47, it would be as if SWN expanded earnings by 20% this year and would be projected to have 20% growth yet again next year. O’Neil says it’s a real sign of power when a company’s earnings hit a snag and then resume as if they had continued their acceleration all along.

These reasons, and the resurgent price of natural gas, are why SWN is within spitting distance of all time highs and has shown far greater resilience than other stocks in the sector.

Technically SWN has broken out of a 15 month cup and handle base, best seen on the weekly chart. The decline in the cup was a staggering 64%. That would normally be a red flag but growth stocks can correct 1 ½ - 2 ½ times the correction of the major market indices, and with the NASDAQ and S&P 500 both having corrected in excess of 55% SWN’s correction was not unusual.

The daily shows the ideal buy zone as price broke a trend line across the tops of the handle, which is also a cup with handle base by itself. This “base within the base” corrected only 26%, more in keeping with what we would perceive to be a healthy correction and one capable of sustaining a significant advance.

The dollar has rebounded a bit within its downtrend as the market corrects, bringing energy prices down and related stocks with them. We would consider entry on a constructive light volume pullback to minor support at the base highs or the rising 20 or 50 MA’s.

Note that if the market pullback becomes an intermediate term correction we wouldn’t want to initiate a position in SWN, but would look to position ourselves as the market appears set to rebound. Bear in mind a correcting market will often take down most stocks, even those that are commodity related.

Tessera Technologies (TSRA)

We have previously profiled this stock.

It had a powerful break out a few weeks back and an ugly volume pullback last week. If you took our previous entry advice you might well have stopped out.

But price is trying to turn ahead of what are expected to be powerful earnings this Thursday after the bell. Price has found support at its 20 MA and largely respected the "buy point" out of the recent base.

We'll enter long south of $30 on a move to intraday highs here in late morning trade.

Home Inns and Hotels Management ADS (HMIN)

HMIN is a Chinese hotelier. There would be nothing remarkable about this stock, nor would it attract us, if it operated in a mature market. But this is yet another Chinese company pioneering a sector in this industrializing economy, so it is reaping the benefits of rapid growth.

The stock is attempting to break out of a powerful pattern called an Ascending Base. Notice the three successive short cups on the daily, one on top of the other. O’Neil preaches that in a market that is correcting or having difficulty moving higher, as we have been in, strong stocks will pause to form bases, but very strong stocks will advance while they base. Thus, the Ascending Base.

This pattern should be nine to 16 weeks in length. Each cup should correct roughly 10 – 20%. The break out of the third cup should come on heavy volume and is considered buyable. Today’s volume, as we publish, is nearly equivalent to the 50 day average in less than two hours of trading.

The market has been tenuous and we have been cautious about initiating new positions. Thus we’ll keep a tight stop on this, using a break of $32 as our exit, especially should the market’s move higher so far today deteriorate.

The Energy Patch Reascendant

A confluence of factors have combined to boost commodities of all types and Oil & Gas is suddenly the leading market sector. While we cannot say galloping oil prices are healthy for the market longer term, sector rotation, and the emergence of new leadership it implies, is critical to sustaining a bull market. The surge in energy shares on the 52 week high list is yet another reason we expect a market correction to be constructive, if deeper than we have experienced so far in the rally.

Why are energy prices running? Resurgent worldwide growth is a factor. So are inflation fears.

But preeminent is the fact that energy is priced in dollars and the dollar is, as Danny Devito said in the movie “LA Confidential,” “on the night train to the big adios.” With just a brief look at a long term chart of the US Dollar Index it is easy to understand why energy took off last year when the dollar broke below multi-decade lows. And with the dollar headed to test and likely break those lows you can see why prices are headed higher again.

The dollar is declining because of unsustainable government and trade deficits, massive liquidity furnished by the Fed to fight the deflationary effects of the financial melt down last year, and the inability of policy makers to reverse these trends. Traders are buying commodity stocks with impunity, secure in the knowledge that the Fed and Treasury both believe defense of the dollar is impossible at the present time.

The strength in the sector is in the less diversified companies that simply explore and produce (E&P). This group is up over 20% with companies that have the bulk of their activity in the United States leading the way with an average gain of about 23%. The fully integrateds, that refine and market as well as E&P have seen somewhat lesser gains, generally under 20%, as have the “pick and shovel” companies that drill, service and make equipment for the industry. Therefore for the most part our focus will be on domestic E&P companies. Indeed, when oil and gas stocks were running last year the greatest advances came from this sub-sector.

On our sister blog we’ve previously run the continuous contract of domestic oil which we repeat here. Price has broken from a base that is capable of supporting a further advance.

But if we are going to focus on domestic producers then another chart is more appropriate for our needs, that of Natural Gas. Three of the largest companies in the space, Apache (APA), Anadarko (APC) and Occidental (OXY) are primarily involved in oil. But most of the other significant domestic E&P’s are natural gas plays.

Natural Gas is a much different beast than oil. It’s not easily transported so it’s a local commodity, requiring a pipeline network for delivery except in cases where it’s liquefied, which is still a nascent niche. The gas market is therefore a parochial one. An excess of supply in Montana cannot be easily delivered to a customer in Europe.

Because gas is the cleanest of fossil fuels it has become the most politically expedient choice for new electric utility plants. With demand expanding less than supply price had been in a long term uptrend. But that all changed with new “fracturing” technology which made gas in heretofore difficult to access shale far easier to bring to market. The result was a rash of new supply coming to market last year, a resulting glut, and a crashing of prices to multi-year lows as "The Great Recession" throttled demand. Many producers have shut in wells with price dropping below the cost of production. Even so, analysts expect gas to be in oversupply well into 2010.

But we think the recent price move in gas is for real, and as it’s a local product price advances might not be contained even with a dollar that doesn’t depreciate further. Gas prices often have seasonal moves higher that start in the fall and last into the new year. And we expect that the market will begin to price in the anticipated drying up of inventories as the economy continues to recover.

We plan to profile specific stocks but bear in mind that while commodities don’t always trade in lock step with the stock market, commodity related stocks often will. Therefore we would not initiate positions early in a correction. Rather these will be trading ideas for when the indices resume their uptrend.

Taking a Wait and See Approach to Rovi Corp (ROVI)

One of our most egregious misses this year was not investing in ROVI, the digital rights management company (formerly known as Macrovision) that has transformed itself into a company with a broad portfolio of media related businesses. It was under consideration for posting as a buy recommendation as the market, and this stock, moved off the July lows, but we passed on it for what we thought were better opportunities. This stock gained about 50% from the buy point we were considering.

But we aren’t chomping at the bit for entry now that the stock has pulled back. And it’s not the ugly nature of the pullback that makes us reticent. Many winning stocks begin their corrections with high volume selling, the effects of which can be mitigated as fresh money buys into the stock and price “bases out.”

The reasons we’re taking a wait and see approach to ROVI aren’t on the chart. It has to do with who, or more correctly who doesn’t, own the shares.

Near the beginning of every quarter Investor’s Business Daily publishes their list of stocks that have had the largest number of top mutual funds buy and sell during the previous quarter. IBD considers a mutual fund a “top” fund if its performance over the preceding quarter was in the top 15% of all funds.

While this information might seem stale it’s an important record of stocks in which the best mutual funds are building and unwinding positions. Following what top mutual funds are doing alerts you to stocks that are often on pace to outperform the market.

We were shocked to find the most sold stock on the list last quarter was ROVI. A net total of 44 mutual funds sold the stock. That’s an incredible number for a stock still in an uptrend. But it is apparent on the chart that the second leg higher that launched in July came on lighter volume than that which started in March. This likely speaks to institutions selling into retail strength as many top performing funds decided the position had achieved full value.

Are they right? Only time will tell. But it’s notable that a simple analyst note could take the stock down so severely, as if the conviction of longs left with the smart money.

We’ll continue to track ROVI and if it sets up properly weeks or months from now we’ll again consider a position. But for now we’ll follow the smart money like always and stay on the sidelines.

Time to Sell Apple? (AAPL)

Apple has been one of the best performing stocks of the market rally, a true institutional favorite that professional money managers have favored.

Last night the company posted a superb quarter. The outperformance of the stock has promised a reacceleration of slowing growth and last night was the delievery of that promise.

The stock surged to all time highs in post market trading. This morning it opened higher but did not take out those highs. As we publish price is trading near the $200 level.

We think it's time to sell AAPL. This morning's gap up violated an upper trend line that spans the entire gain off the March lows. This is normally a key sell signal.

If you have been long this stock this could well be an excellent opportunity to harvest a terrific gain.

Momentum can often be maintained far longer than one expects. But when we see this key sell signal, we take profits first and ask questions later.

Tessera Technologies (TSRA)

TSRA is a semiconductor designer that licenses to chipmakers. The stock had been held back because of patent infringement issues.

Price burst higher in May on an important patent infringement victory. It then put in a second stage four month base on base.

Last week price broke out on good volume. We didn’t recommend the stock because of lagging Relative Strength and what we felt was a lack of accumulation in the base. It also faces further litigation on its patent victory. An adverse ruling could cause a significant gap down in the stock as many potential licensees continue to contest TSRA’s victory.

But the break out was impressive and powerful price action can encourage an investor to put aside his concerns over flaws in the pattern. The current market uncertainty is pressuring the stock and bringing it back towards its buy point.

As we publish price is trying to stabilize. We’d be buyers over $24.90, which would establish a second intraday leg off the bottom and signal a greater likelihood of a turn in the stock.

Bear in mind the market is suffering today and we would not be buyers should the indices continue deteriorating. We would use today’s low as our stop, meaning that if price falls back into its pattern we no longer desire long exposure.

Update and Trading Idea on STEC Inc (STEC)

On September 17th, with the stock’s uptrend under attack, we ran a piece about STEC. We discussed its power and market leadership. Given the market’s uptrend and the history of how market leaders behave we expressed the belief that it would form a buyable consolidation and urged taking a small position with a tight stop.

It is becoming increasingly likely that we were wrong.

We were encouraged this weekend when looking at the chart. Downside volume had slowed and the stock had closed tightly two weeks in a row, indicating the possible start of a bottom.

But today the stock exploded to fresh correction lows on huge volume. It traded as much as 45% off its high. O’Neil teaches that in a market uptrend a winning stock can correct as much as 2 ½ times the general market itself. With the market recently correcting all of about 6% lately we’d say 45% is a just a wee bit out of line.

But that doesn’t mean STEC cannot mount a powerful countertrend rally. We think one is brewing and are willing to take a stab at it as early as tomorrow.

After the bell Tuesday Intel (INTC) reported earnings that were well received by the market. At the least the semiconductor sector, which includes STEC, should react well in Wednesday’s trade.

Besides the INTC catalyst two things attract us fundamentally to STEC at this juncture. First, volume swelled today to the highest level since the breakdown began. That’s an indication of possible selling exhaustion and an invitation to longs to try their luck.

Second, the stock slammed into an area of trading congestion from June. This series of opens and closes in this general price area means there was a lot of activity at this price in the past and is likely to provide some level of support for the stock.

Given INTC’s report we expect STEC to gap up at the open. As long as the gap is not too severe we’d pursue it at the market with a stop under the day’s low. Should price open flat we’d first make sure Tuesday’s low is respected and then purchase over an early high. Should the stock gap below Tuesday’s close or trade below it from a flat open we’d ignore the setup and wait for a more compelling set up.

Should the trade trigger we believe it can trade back around the $30 area, into the trading congestion from September and the 20 MA. Our outside target would be the declining 50 MA.

Human Genome Services Inc Revisited (HGSI)

Sometimes the best trading strategy you can apply is to be persistent, focusing on it until you achieve your goal or the setup invalidates itself.

Our suggested trade set up in HGSI, a “Shake Out Plus Three” entry, never really triggered. Price traded into the area where we were looking to buy but volume was conspicuously absent. It doesn’t surprise us that price retreated to its 50 MA. But we still like the set up.

Trading has been orderly, so orderly that the last three weeks have tight closes, usually a bullish sign. And price gives an indication that it is turning off the 50 MA, likely to make another attempt at the buy zone.


We’d still recommend long entry on any move into the zone on volume with the goal of early entry on a break out from this double bottom base that is almost the minimum required seven weeks in duration.

The Chinese Gaming Sector Acts Poorly but Perfect World Tempts Us (PWRD)

Recently we ran a summary of stocks trading in the sector. The bottom line: many stock are breaking down or acting poorly and the sector might not be ripe for a long.

But we liked what had been constructive trading in Netease.com (NTES) and saw a low risk long entry. We took it and were rewarded with a small loss stop out. While we admit the sector looks technically poorer by the day we are tempted by PWRD offering us a similar low risk long entry in a stock that still acts well.

PWRD has had an incredible run without forming a proper base. It is extended. It has not touched its 50 MA during the bull run off the March lows and is trying to turn out of another correction above that line now.

PWRD reached its most recent peak on solid volume on September 23rd, the day the recent market correction started. While the stock has pulled back distribution has been light. The weekly shows a high volume reversal week, but all the volume came on one strong up day and the weekly shows relatively unchanged closes. In fact, PWRD has closed rather tightly for the past five weeks.


Last Thursday price broke below its recent consolidation on a bump in volume and closed below the 20 MA for the first time during this correction. Friday, however, showed no further price progress to the downside. Volume was higher than Thursday as price put in an “inside day,” where trading was contained within the boundaries of Thursday’s bar.


This sets up a low risk entry above Friday’s close with a stop under Friday’s low. We’re looking for a move back into the consolidation on its way to fresh highs.

Coinstar (CSTR)

We’ve profiled this company numerous times and still believe it has a chance to join the cast of market leaders. Our last trading post in September never triggered. You can read our original write up on the company and rationale behind having it in your portfolio here.

CSTR appears to be triggering a legitimate long entry today. The stock has carved out a double bottom pattern and is moving higher today on volume past a “Shake Out Plus 3” buy point, which is defined as about 13% or so above the lows of the first leg of the “W” pattern. This is just north of $34. Our ideal entry point would be above the highs of the September shelf around $33.50.


The pattern is odd shaped, but bears a striking resemblance to WMS that gave us an excellent trade earlier this year. In a field where history often repeats, this could augur well for the trade.

Netease.com (NTES) and the Chinese Gaming Sector

The recent IPO in the sector, Shanda (SNDA) spin off Shanda Games (GAME), has not been all that well received. Indeed with a number of the stocks in the sector blowing up of late [SNDA itself and Sohu.com (SOHU) spin off Changyou.com (CYOU)] we are left to wonder if we are not better off moving on rather than considering the stocks in the sector that continue to hold up.

Those would be Perfect World (PWRD) and Netease.com (NTES). Clearly PWRD has been the outperformer in the group, but it seems to have put in an intermediate term top after a tremendous run. NTES, however, recently broke out of a cup or cup with handle base (depending upon your interpretation) and has been beaten back on mixed volume.

Given the loose trading in NTES we would normally avoid it. But we see a low risk entry in a stock that has been a big winner and, in spite of some erratic trading, has held up.

Yesterday price undercut the 50 MA on a bump in volume. But today not only has there been no follow through, price has move over yesterday’s high. While volume is light we’re willing to trust the price action here and would recommend a long at the market (stock trades around $44.30 as of this posting) with a stop under today’s low.


The idea, of course, is to get an entry that might be an easier hold in what has been a difficult stock to take, and keep, entry.

WMS Industries (WMS)

This stock has gained about 34% since we purchased it in July. Its initial gains were so rapid that it became an automatic eight week hold. Since that time it has slipped into a second stage flat base and appears to be a prime buy candidate should the market resume its uptrend.



Casino stocks have been market leaders, and with analyst talk of business turning around at casinos like LVS and WYNN a pick and shovel company like WMS (they sell gaming equipment) should continue to enjoy upside surprises on the earnings front. The current quarter is forecasted at 30% YOY EPS growth on a 10% sales gain.

WMS’ second stage base features low volume, a hallmark of a constructive flat base, where price trades tightly because existing holders are unwilling to sell and newcomers buy any small dips.


The base is a bit unorthodox when viewed on a daily chart. Price has been wedging higher the last few weeks, generally a no-no for this type of pattern. The base should contain price.

But on the weekly it does. Although price has spiked to new highs the last four weekly closes have all been contained within the base.


Yesterday, the start of the seventh week of the base price once again climbed towards the highs. We believe WMS is an excellent buy candidate on a high volume break out that occurs concurrent with a market reversal.

Human Genome Sciences (HGSI)

Here’s another profitless biotech stock that appears on the doorstep of transforming itself into a profitable enterprise on the back of a drug with blockbuster potential. After years in the wilderness HGSI scored a tremendous success in July with release of Phase 3 results for their Lupus drug that they dub Benlysta. Some analysts project it as having sales potential of $2.5B a year.


There are risks here. The market priced huge success into the stock off release of these results and the price rocketed from below $3 a share to better than $20. Yet success of the drug, no less FDA approval, is not guaranteed. Benlysta might help as little as 8 – 14% of patients and is expected to cost between $20-30,000 a year. Further data due next month are expecting to clarify Benlysta’s prospects and whether or not the company will pursue FDA approval next year.

Since the news broke the stock has eased into a constructive looking base that is taking the form of a double bottom, given Friday’s undercut of the September lows.

IF (we capitalize purposely) the market reverses, we’d look to go long HGSI on a break out move. O’Neil teaches that the best entry on this type of formation is what he deems the Shake Out Plus 3. This allows for earlier entry than over the mid-point of the W, which is more traditional and often fraught with volatility.

Shakeout Plus 3 entry is $3 above the first low of the pattern on a $20 - $30 stock. For stocks out of this range he recommends using a price 13 – 14% above the first low. The move through this point should come on volume and presage a break out.


For HGSI that would suggest entry above the late September pivot highs around $19.40, which is an advantage over the traditional entry at $20.63.

E-house Holdings Ltd ADS (EJ)

E-house Holdings (EJ) is a Chinese real estate brokerage and is a clear play on the burgeoning middle class in that country.

The company has endured a string of poor earnings but is in turnaround mode, posting an outstanding report last quarter with excellent forward projections.

Technically price has formed a cup with handle base. It bounded off the 50 MA on very high volume yesterday and this morning has gapped up and traded over a trend line connecting the August and September highs.

In spite of the poor market open we are initiating a position around $22.50 and would add on a move over resistance at $22.95. We'll use today's low as our stop.