Be Wary Of V-Shaped Bases. Buyer beware. Know what you're getting into before you get into it. That goes for many things in life as well as stock trading. When scouting bases, watch out for flaws that can sometimes make or break a trade. Cup patterns that are V-shaped can be more failure-prone. On the surface, a V-shaped structure may seem good. After all, in such a pattern a stock promptly rebounds after a sharp sell-off. Think of it this way. You want to see the similar situation after a stock stumbles. Focus on cups that are more U-shaped, as these let a stock to go through a more constructive consolidating period. Ixia (XXIA) more than tripled from its August 2004 low and then peaked in late February 2005 1. Beware An Upward-Sloping Handle. "If your cup's handle doth upwardly slope, to buy that stock you'd be a dope. " (From the editor: sincere apologies to William Shakespeare.) If you're a seasoned investor, your eyes by now may well be trained to spot a cup-with-handle pattern from a distance.
But you need to know that even if you see a cup with a handle, it may not be a valid one. Look for the flaws. A proper handle should be at least five days in length, starting with a down session, but can go on for weeks. What's the picture here, and why care about these details? The handle should show the stock in a sort of stalling mode, falling ever so slightly. Why should volume be quiet? And that's why the upward sloping handle is a problem. Let's look at a base built by Actuant (ATU), a maker of hydraulic and mechanical tools for industry. Now connect the tops and, more importantly, the bottoms of that six-week handle.
The stock broke out past its 46.60 buy point Dec. 31 3, although volume didn't kick in until Jan. 6. Beware Of Low Handles In Bases. One of your top jobs as a stock investor is not only to see what's great about a stock, but to find the flaws. Today we'll examine the low handle, the sort of flaw that can presage an expensive mistake. A handle often forms on cup, double-bottom and saucer bases that show healthy accumulation by the big guns of the market.
It should slant lower along the lows and form in quiet volume. The handle also represents that quiet time before funds, banks and other large buyers aggressively chase a stock higher. Why is it important that the handle be in the upper half of the base? First, to be in the upper half is yet more evidence that the funds are lending support to the stock. The real test is how far the funds will allow the stock to fall during this time before they step in to buy those unwanted shares. If they wait too long, and let the stock fall too much, you're looking at a picture of unaggressive buyers — not what you want to see. The second reason is based on empirical evidence. 'Straight Up' Breakout Is Weak. When you see the description "straight up from the bottom" on a stock chart, it's time to be wary. A stock that rises rapidly from the bottom of a base is doing too much, too fast.
Ideally, a stock should build support as it climbs the right side of a base. A gap-up within the base is positive, but completing the entire right side in about a week or less is not a stable construction. Even a handle on a cup or double bottom needs at least a full week to form. Research shows that this kind of action is associated with failure more often than not.
When you see this flaw, study the base for other problems. Often the straight-up-from-the-bottom flaw will be accompanied by other problems in the base. As always, an investor should check out the fundamentals. Boston Scientific (BSX) increased annual earnings 11% in recessionary 2002, followed by a 24% EPS pop in 2003. In April 2004, the company reported that first-quarter EPS grew 64% on a 34% jump in revenue. Bear-Market Breakouts Fail Quickly. The big money is usually made in the first two years of a bull market. IBD has often made this point, but it's worth repeating given the market's current state. What's that state? Stocks are now more than two years beyond March 2009, the month when they picked themselves up and started a strong rally. The major indexes are well off highs that they hit in early May. And IBD's outlook had been "market in correction" for weeks until Tuesday.
In other words — and if history is any guide — this seems like the type of period when it will be tough to make money. You still might see some stocks break out of consolidations, but you ought to keep in mind that these issues could face resistance. You want to swim with the current when you take a dip, rather than against it. Buying breakouts when the market is against you rarely ends well.
Let's take a look at a breakout that fizzled after taking place at the end of a bull market. But the move showed other flaws. Flaws In Base Provide A Key Red Flag. A sterling No. 17 ranking in the IBD 100 just as it was preparing to break out. Triple-digit EPS and sales growth the past two quarters. Membership in the No. 2 sector in IBD's Research Tables. So why did NetLogic Microsystems' (NETL) breakout attempt in late July flame out so fast?
The 30% dive in the Mountain View, Calif., chip designer's shares since its July 27 high-volume reversal offers a good example of, first, the value of the 8% sell rule. Were there other clues to selling more quickly or simply refraining from buying shares? One clue was the low quality of the 13-week cup pattern. From the spring of 2006 until the summer of 2009, NetLogic made virtually no price progress. In late July 2009 1, the stock rushed to multiyear highs that also involved some big pullbacks. After the market's rough ride in May and June, the July 7 follow-through gave readers the go-ahead signal to search for new leaders. The strength of NetLogic's stock enabled it to start forming a new base. Steer Clear Of Deep Bases. A proper base represents a stock catching its breath before resuming an uptrend. It's just a break. You could even think of it as a "pause that refreshes," borrowing that old Coca-Cola slogan.
With that in mind, always look for a modest correction within any base. For example, a cup-without-handle or cup-with-handle base is typically no more than 35% deep. That means the stock corrects by that percentage or less from the pattern's top to its trough. Then there are the shallower bases, such as the square box or flat base. Be wary of bases that are too deep. Rather than a pause in an uptrend, these patterns look more like long, painful, near-death experiences. They often happen after a stock's already enjoyed a big advance. In 2000, dozens of former tech leaders etched deep cup bases. When these ex-leaders, such as JDS Uniphase (JDSU), attempted to leap to new highs, the breakouts didn't work out.
Ahead of another bear market — the one in 2007 and 2008 — U.S. U.S. During that week, U.S. Beware An Upward-Sloping Handle.