The 3rd Times (NOT) the Charm

I always keep an eye on small cap stocks as they tend to lead the overall market both in up and down markets. As you can see in the daily chart below, IWM, the small cap ETF, each time it has attempted to cross above the 169.5 level it has failed. Yesterday’s failure had a different look than the others as it was marked by relatively large volume and a bigger price swing (size of candle) than the prior attempts.

While its normal to have prices stall and reverse more than once when approaching prior breakout levels, yesterday’s failure nothing to be alarmed about. But it is nothing to ignore either and requires a cautionary approach in case it turns out to be more than just a minor pullback. We know the markets are capable of just about anything.  On the plus side price is above a rising 200 day moving average, it has formed and within a well formed cup and handle continuation pattern while RSI momentum is still in the bullish zone and has no divergence.

So why the cautionary approach? When following price movement it’s not just about specific levels and where it’s headed but, more importantly, where you have come from. In the case of small cap stocks they have risen 12% in less than 3 months, which is really too far, too fast. They need a breather. Why do I say this? A good way to recognize this possibility is to look at how far they are away from their 200 day moving average (dma) and how they have reacted in the past to that level. The further they are from their mean (the 200 dma) the higher the chance and often the greater the size of the pullback towards that mean will eventually occur. You can see that each time price has been above the 200dma by high single or double digit percentages, IWM has had a pullback. Don’t get me wrong, this is not they only warning flag with stock prices right here and why I am currently erring on the side of caution. This is just one piece of a weight of the evidence approach. With respect to IWM, we are not too far away from finding out whether the current consolidation will be worked through by further sideways movement or a deeper pullback. If I were a betting man, I would be looking for a deeper pullback, which will lead to a nice buying opportunity allowing investors the opportunity to capitalize on the expected year-end rally

The Arc

Parabolic Arc chart patterns form when a steep rise in prices caused by irrational buying and intense speculation hits its apex. Parabolic Arc patterns, formed in strong bull markets are rare, but they are reliable. These patterns trend gradually, making higher highs and lower lows in the beginning stages, but irrational buying and speculation generates a strong rally to push prices vertically which is always followed by a steep sell-off.

A Parabolic Arc is a reversal pattern and has a very predictable outcome ,,,, a significant correction. Usually ranging from 62% to 79% of the parabolic price rise and why those lucky enough to be in one on the upside, need an escape plan when the rug eventually gets yanked out from under them.

Why they repeat – Human Psychology

Parabolic Arc patterns consist of both panic buying and panic selling scenarios. As a stock breaks out and starts to rise, investors tend to feel its rising cycle is never going to end and build confidence based on hysteria. This misjudgment provides a blind faith in investors as the stock chart takes on an exponential curve-based shape. In the state of a rising Parabolic Arc, they typically see price continuing to rise without pause and quite often with a series of upside gaps. In its last stage, Parabolic Arcs move vertically as panic buying (blow-off tops) extends in an absence of sellers quite often on some unfounded expectations/news/events. Most of this climactic buying is driven by momentum and neophyte traders who fear being left behind. Finally, reality sets in, momentum diverges with price and buyers dry up. This usually coincides with a negative event or unfavorable news. This initiates panic selling and cause prices to reverse dramatically. The initial buyers and smart money take profits quickly, followed by the more patient owners and then the buy-and holders who eventually give up and throw in the towel (just about the time the smart money is starting to accumulate shares). A great example of smart money picking the pockets of the retail investors. Wash, Rinse. Repeat

I have shown completed examples of these in past blog posts but wanted to bring one to your attention that is still rising and not yet reached its upper apex. As you can see in the chart of FTNT below, price has been in a relentless uptrend since breaking out of the (blue) consolidation box and created its second touch of the parabolic arc. Price sits at the highest point above its rising 200-day average ever at the same time it RSI momentum is waning and diverging from price.  The stage is set.

I don’t have a clue on when FTNT’s rise will terminate, it really doesn’t matter as all you have to do is follow price. From the appearance of the chart price and volume patterns it looks as if it might have some legs and could run a bit more. Either way, it is getting close.  Those lucky enough to still own this (congrats Nick), make sure you have an exit plan that will insure you keep the majority of your gains. I would expect a swift and dramatic decline and as such those nimble enough to short the stock will likely have a high probability profit setup on a confirmed breakdown below the arc.

Times They Are A’ Changin’

A decade ago, not one Chinese company made it in the list of the worldwide top 20 tech giants (based upon company valuations). Now, they hold 3 of the top 10 and 9 of the top 20.

Is this a temporary passing like what happened with Japanese companies in the ‘80s? Or is just the beginning of a longer term shift of power eastward?

A Change in Character?

After peaking just before Christmas of last year with negative RSI momentum divergence, NTES, has gone on to fall more than 40% before it bottomed in late May. Since that time, it has begun to make higher highs and higher lows, the indication of a change in character. Price currently sits just under the neckline of an inverse head and shoulders (IHS) bottom reversal pattern and the long-term (red) downtrend line. While price is still under a falling 200 day moving average it recently crossed above its 50dma which has now curled higher.  These are all constructive elements an investor would like to see before attempting to catch this falling knife

A confirmed (with higher volume) break and hold above the green horizontal resistance, the upside target for NTES is the March high (at T1), a nice 20%+ gain. A confirmed entry with a stop just below July 11th ‘s low provides a better than 4:1 reward to risk ratio.

While the NTES setup is compelling, the recent move off the right shoulder was not ideal.  from a volume standpoint so it makes this IHS pattern suspect. While volume plays an important role in the Head and Shoulders Top, it plays a crucial role in the Head and Shoulders Bottom. Without the proper expansion of volume, the validity of any breakout becomes suspect. Volume levels during the first half of the pattern are less important than in the second half.

• Volume on the decline of the left shoulder is usually pretty heavy and selling pressure quite intense. - Check
• The intensity of selling can even continue during the decline that forms the low of the head. - Check

After this low, subsequent volume patterns should be watched carefully to look for expansion during the advances.

• The advance from the low of the head should show an increase in volume – Check
• After the reaction high forms the second neckline point, the right shoulder's decline should be accompanied with light volume as it is normal to experience profit-taking after an advance. - Check

Volume analysis helps distinguish between normal profit-taking and heavy selling pressure.

• The most important moment for volume occurs on the advance from the low of the right shoulder. – Sort Of

The most recent advance from the right shoulder started well but is ending with lighter volume than desired. For a breakout to be considered valid, there needs to be an expansion of volume on the advance and during the breakout.  While increasing volume confirms the breakout and pattern, just because it isn’t there does not mean the pattern won’t play out to completion, it just means the probability is not as great and why it is suspect.

Looking for LUV in All the Right Places

After failing at 3 attempts to break and hold above the $66 level late last year, Southwest Airlines stock, LUV, was eventually taken out to the woodshed and beaten with a stick. Price fell ~25% as sellers had their way until it hit the $50 mark where willing buyers showed up in numbers and provided a respite for the decline. As you can see in the chart below that support level acted was important the past too as the 2017 correction found a bottom twice in exactly in the same area.

Since bottoming in May, price has retested that same $50 level and each time buyers have stepped in pushing prices higher, where sellers take back control at $53. For now, LUV is stuck in a $3 range and looking for a catalyst for that to change.

Picking bottoms is hard but I have found that a downtrend followed by sideways consolidation that last for at least 6 months and then break higher provide a much high probability trend reversal follow-through and investment gain opportunity.

It doesn’t mean it won’t turn out to be a good investment opportunity if the consolidation is cut short. In fact, in the case of LUV, if the market wants to move higher from here right away, the first upside target is the 200 day moving average, a near 7% gain.  A bullish market tailwind that would push prices even higher, point to the chance of it filling both open gaps made during the most recent decline which makes it a much more compelling (20+%) opportunity.