It’s Never Too Late: Trading on Stock Upgrades

At some point in your investment experience, you will probably come across a stock you either hold or are considering buying that is upgraded by a brokerage firm or analyst, boosting its stock price by several percentage points, if not more. For a stock you are watching, the question is whether it is a good idea to buy the stock or pass on it, given the price spike. For a stock you already own, the question is whether or not this is the time to sell the stock.

Academic studies have shown that positive surprises, upward earnings revisions and analyst upgrades can result in outperformance that can be observed up to a year after the initial event takes place. But these studies assume that you are buying every stock with an upgrade or surprise.

Can you improve your performance by being more selective with your stock purchases? A recent study by Thomas Bulkowski in the May 2005 issue of Active Trader indicates that market reaction to an upgrade may help guide investors on how to act following an upgrade. Investors can use simple chart breakout analysis to determine the ultimate gain potential following an upgrade.

Upgrades & Price Breakouts

A price breakout occurs when the price of a security (this article focuses on stocks) moves or “breaks out” of some level of support or resistance or away from a defined pattern in which it had been moving. As their names may indicate, upside breakouts happen when prices move upward and downside breakouts occur when prices decline.

Bulkowski observed that in conjunction with an analyst upgrade, if the price breaks out to the upside, it is typical for the price to continue moving upward for a short period and then reverse course and eventually give up all its gains—and possibly more—following the upgrade. His study of price breakouts following an analyst upgrade showed that in half of price breakouts—both up and down—prices changed direction in less than two weeks.

Figure 1. Southwestern Energy Co: Upside Breakout CLICK ON IMAGE TO SEE FULL SIZE.

Ideally, we would all like price moves following an analyst upgrade to mimic that of Southwestern Energy Co. (SWN) shown in Figure 1. The company explores for and produces natural gas, principally in Arkansas, Oklahoma, Texas, New Mexico, and Louisiana. After gaining almost 109% in 2003 (split-adjusted), SWN shares had gained another 27% for the year when Raymond James upped its rating on the stock from underperform to market perform on July 1, 2004. This came the day after Southwestern announced that its production volumes would continue to grow nicely and upped its forecasted production past the high end of its previous guidance range. On the upgrade day, SWN shares gapped up and gained 6.1%. Since then, the stock has gained 193.0% on rising fuel prices through the close of June 22, 2005.

Figure 2. Abgenix, Inc.: Short-Term Upside Breakout CLICK ON IMAGE TO SEE FULL SIZE.

If the movement depicted in Figure 1 were par for the course, the demand for tropical islands to retire to would most certainly be high. Figure 2 gives a better representation of the real world. Abgenix, Inc. (ABGX) is a biopharmaceutical company engaged in the discovery, development, and manufacture of human therapeutic antibodies for the treatment of various disease conditions, including cancer. On January 7, 2004, Merrill Lynch upgraded Abgenix from neutral to buy; the stock gapped up that day (creating a breakaway gap) and closed 13.6% higher than the previous day’s close. The price continued to climb over the next few weeks, finally reaching an intraday high of $17.18 on February 12, which was more than 35% higher than the closing price on the day prior to the upgrade.

After peaking in mid-February, ABGX shares began to fall and on February 24 tested the price gap created on the day of the upgrade. Following this, prices rallied briefly but then fell again, this time completely filling in the gap on March 23, when Abgenix closed at $12.86, just below the high price of $12.88 onJanuary 6 (the day before the upgrade). Following a month-long rebound, prices gapped up over 20% on April 26. From there, prices went into free-fall, creating what some traders call an inverted dead-cat bounce, or an inverted cup-with-handle pattern. By May 12, the second price gap was filled in. The stock continued to fall until early August, when it finally found its footing after losing 58.7% from the intraday high of $19.50 on April 26 to its $8.05 close on August 6.

Downside Breakouts: Bad Things Turned Good

Figure 3. Komag, Inc.: Downside Breakout Followed by Rebound CLICK ON IMAGE TO SEE FULL SIZE.

The best prospect for a strong price rally after an analyst upgrade seems to take place where there is a downside breakout immediately following the upgrade, as shown in Figure 3. On April 28, 2005, Bear Stearns upgraded Komag Inc. (KOMG) from peer perform to outperform. On that day, the stock gapped higher and closed the day with a 5.4% gain. However, prices did not follow through with additional gains. Instead, the price retreated the next day to close below the intraday low of the upgrade day (indicated in Figure 3 by the horizontal line), thus completing the downward breakout.

This date also marked the ultimate low ($23.26) for KOMG following the upgrade. From there, prices rebounded over the next several weeks, eventually closing at $32.30 onJune 7—a 38.9% gain in less than two months.

Figure 4. Alaska Air: Downside Breakout Followed by Rebound CLICK ON IMAGE TO SEE FULL SIZE.

A more impressive outcome after a downside breakout following an analyst upgrade is shown in Figure 4. On May 2, 2003, Merrill Lynch upgraded Alaska Air Group (ALK) from neutral to buy. On that date, ALK gapped up and closed the day with an 11.6% gain. As was the case with KOMG in Figure 3, ALK share prices did not continue their upward climb. Instead, prices declined until a downward breakout took place on May 19 when the price closed below the intraday low of $18.30 (indicated by the horizontal line in Figure 4).

The intraday low of $17.30 onMay 19 was also the absolute low for the downside breakout. From there, prices began a steady climb, with extra fuel added by a Goldman Sachs upgrade on August 25 from underperform to in-line. Prices reached their apex on October 13 when ALK closed at $31.67, an 83.1% increase from the ultimate low of May 19.

Fighting the Trend: Upgrades in a Downtrend

Figure 5. ImClone Systems: Upgrades in an Overall Downtrend CLICK ON IMAGE TO SEE FULL SIZE.

One must always be aware of the context within which an upgrade takes place. Trading on an upgrade in a vacuum is a quick way to lose money. Figure 5 and Figure 6 demonstrate this.

Figure 5 is the chart of a stock many of you may know—ImClone Systems Inc. (IMCL), in the news since 2002 along with its famous shareholder, Martha Stewart. On September 10, 2004, IMCL closed at $49.64, having lost over 43% since reaching an intraday high of $87.24 on July 1. On July 20, the company reported disappointing second-quarter 2004 financial results due, in part, to the fact that sales of its Erbitux cancer drug failed to meet investors’ raised expectations. The following day Smith Barney Citigroup downgraded the stock from buy to hold.

Figure 6. Amtel Corp: Upgrade at Price High CLICK ON IMAGE TO SEE FULL SIZE.

Beginning in August, shares of IMCL entered into a downward-sloping trading channel—some may call it a descending triangle—during which time three favorable analyst events took place: On September 13, Sun Trust Robinson Humphrey upgraded the stock from neutral to buy and Fulcrum initiated coverage with a buy rating; and onSeptember 28, Friedman Billings upgraded ImClone from market perform to outperform. None of these events caused the price to break out of the trading channel to the upside, but by mid-October a definitive line of support been established at around the $45.00 level.

On October 29, yet another analyst change took place as Smith Barney again downgraded ImClone, this time from hold to sell. This pushed the stock price below the support level, where it has since remained. This downward breakout below the support level is a bearish signal to sell a long position or go short, as ImClone reached a low of $30.11 on June 6, 33.1% below the $45 support level.

As shown in Figure 5, the analyst actions throughout September 2004 did provide momentary boosts to ImClone’s share price. However, the overall trend in the stock was down. If analyst upgrades fail to reverse a downward trend, it is probably best to exit your position.

Falling Off the Mountain:Upgrades at the Top

While Figure 5 showed us an example of analysts issuing upgrades during a downtrend, perhaps on the notion that the stock price was more attractive given its recent decline, Figure 6 shows two upgrades that may have been fueled by a strong price run-up. Atmel Corp. (ATML) had gained 935.7% between its November 10, 2002, close ($0.70) and its close onJanuary 16, 2004 ($7.25). On January 20, ATML shares gapped up and closed the day with an 8.6% gain after the company announced that it had developed a new set of chips for TVs and other video devices and W.R. Hambrecht raised its rating on the stock from hold to buy. The following day, prices gapped downward and on two occasions following the upgrade met resistance at around $7.50. On March 8, First Albany raised its rating on ATML from neutral to buy with little positive reaction by the share price. In April, the stock tested resistance at $7.50 and was again turned back. By this time, a right-angled, descending broadening wedge had formed. After failing to break through resistance on its third attempt, shares of Atmel began a decline that culminated onAugust 26 when the stock closed at $2.05—a 72.7% decline from the $7.50 resistance level. In situations such as this, it is best to close out of a position if stock prices do not behave as expected following an upgrade.

Conclusion

Just because you missed a big price move following an analyst upgrade does not mean that significant gains cannot still be had. Analyzing the price movement of a stock following an upgrade may provide insight into how you can capitalize on it. Stock breakouts to the downside—where prices close below the intraday low on the upgrade day—are often followed by a brief decline, after which the price usually experiences an even larger rise. Price breakouts to the upside—when prices close above the intraday high on the upgrade day—following an upgrade may yield minor gains over a span of typically a few weeks, but they are usually followed by a decline that erases those gains.

It is always a good idea to paper trade such strategies and make sure you understand the concepts before risking your own investment dollars.