In my last blog, I spoke about two patterns that are common in many stocks that are bottoming after a long fall from grace with investors. I call such patterns “true bottoms” because they occur at multi-year lows (as opposed to an interim bottom in a long-term uptrend pattern). I mentioned that it is never easy to spot or call a bottom, but it becomes easier if we train ourselves to watch for certain set-ups which are common among bottoming patterns.
True bottoms occur in many unloved stocks, and they are key moments that if acted upon quickly, can lead to very big gains over a relatively short amount of time. The problem is recognizing these patterns, and more importantly, knowing WHEN to act. For if you do not know the proper characteristics of a true bottom, you may be buying into a stock that is about to lose even more value as it continues its descent toward oblivion. This is because some stocks are headed to zero, and this may come as a shock to those who ignore fundamentals, but the best way to separate survivor stocks from those headed to the morgue, is to understand a little something about the finances of a given company. I will have a little more to say on this before the end of today’s lesson.
My last blog showed a good example of the double-bottom, which I believe is the more common type of bottom pattern for most stocks that recover.
A less common one, is the capitulation bottom. The capitulation bottom pattern occurs after a long period of sell-off, just as with the double bottom stocks. In many cases, it will exhibit the same reactions on the way down, which includes a series of lower highs and lower lows (often showing up in a series of “bear flags”) while it bumps up against key descending moving average lines like the 3, 10, 13, 20 and 50 day ones.
But it’s at the bottom where these two stocks differ. In a capitulation bottom, there is often a gap sell-off day (or sometimes a couple days) where the stock not only plunges rapidly in price, but where volume rises to extreme levels. (In some cases, the gap down occurs on an intra-day chart like a 15 minute one, but it will look like a long lower wick on a daily chart with candles.) The pattern resembles a falling knife–that is it falls almost straight down for a day or so, hitting multiple new lows like a hot knife through butter.
Volume rises dramatically as stop loss limit orders are hit–many investors set stop-loss limit orders that are say, 10% or 15% below the point where they bought the stock or where they feel they could no longer bear the pain of owning a loser. Once these stop loss orders are hit, it begets more selling by those who are long term investors.
In effect, it is a wash-out of sellers. It’s a sign that almost anyone and everyone wants out of that stock. A good analogy is when the proverbial “fire” scream is heard in a movie theatre and everyone bolts toward the exits at once. No one wants to be the last one out in a burning building!
So, in the case of a complete wash-out of investors, suddenly, the stock that was so badly going down has lost its last strong supporters. In effect, everyone who wanted out….is out.
This leaves the wash-out stock with nowhere to go but up…and this is where the shrewd trader swoops in because he/ she knows that all the sellers are gone. There is no one left to sell it down further…and thus is born the capitulation reversal.
Hewlett-Packard (NYSE: HPQ) is a good example of the capitulation bottom. In the second half of 2012, this stock was getting dumped by more and more investors, both of institutional and retail types. The once proud stock was selling off because the perception was that HPQ was not going to survive the shift in technology from desktop computers to cloud-based appliances like smart-phones and tablets. Furthermore, HPQ had suffered from some leadership problems among its senior managers in recent years, and this led even once stalwart institutional money managers to question if HPQ was going to hold together, and so they sold too. Finally, in mid-November, after a long, rough series of lower highs and lower lows, the stock plunged to a new multi-year low of $11.11 (mid-day).
To many, including the final sellers, it looked like HPQ was destined to the graveyard of once great companies. However, when these final sellers had washed out, the way was clear for new buyers to move in; and there was little resistance to the upside because all the many “weak hands” (and even many once loyal strong hands) were no longer in the way to attempt to short circuit a rally by selling out at a higher price. This allowed HPQ to rally quickly and aggressively to the upside. There was no confirmation needed for the mid-November low. Notice in the chart below, that on the day that HPQ bottomed, volume was higher than on any other day of the year.
From that low, HPQ had rallied at least 130% by June of 2013 to become a best performing stock in the S&P 500 in the first half of 2013.
Once again, watch for lows that gap down on extremely heavy volume, and then watch to see if the stock mounts a strong reversal rally on the same day and into the next day. If so, then you may have a final bottom and the beginning of a long and strong rally. One shouldn’t wait very long to get in when this situation happens; do not wait for a re-confirmation of the bottom in this case.
One other point: when searching the rubble of badly beaten up stocks, be sure to look for a quality company with proven
revenues and products. Even though HPQ became a very unloved stock in 2012, it had lost only a small portion of its previously strong recurring revenues and the company label was still that of a well-known brand name. It also had established some new growth businesses meant to replace old revenue channels, but those growth segments were not yet prominent in 2012. By mid-2013, those new revenue channels were beginning to catch the attention of investors.
So, it pays to know at least a little about the fundamentals of a beaten down stock, if only so you can separate companies with potential strong profit ability from companies with no revenues, cash flow, or serious debt problems. If you don’t pay attention to fundamentals with beaten down stocks, then the bottom bounce that you jump on may only be a head-fake for a stock about to do a nose-dive toward zero.
However, though bottom patterns like the double bottom and the capitulation bottom can be very rewarding if timed right for entry, I do have to re-iterate the old maxim of stock trading, and that is, never invest more than you can afford to lose, because even in the most ideal situations, trying to catch a true bottom can be tricky–and can still cause you losses if you guess wrong.
…Wishing you a happy and safe 4th of July!
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