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Fall Declines Offer Investors Low-Priced Stock Opportunities

by Richard Evans

Fall Declines Offer Investors Low Priced Stock Opportunities Splash image

Labor Day traditionally signals the end of summer. On Main Street vacations end, the swimming pools close, and kids go back to school. On Wall Street, analysts return to their desks.

However, for some reason, when analysts go back to work, they look more critically at their investment recommendations-and apparently tend to not like what they see. The traditional summer rally thus comes to a halt, with September being the weakest month of the year. October also has been known to serve up some nasty surprises.

However, as they say, one person's pain is another person's gain, and that proverb is especially true on Wall Street, as the stock market enters a period when falling stock prices can give an old-fashioned stock picker much delight in being able to buy stocks around their lows.

And nowhere is the opportunity for stock picking better than with low-priced stocks, as the seasonal weakness in these stocks extends well into November, followed by some rebound in December and then the traditional huge rally during the first quarter of the new year, commonly known as the January effect.

I've discussed the January effect before. It doesn't require too much thought to understand why this anomaly exists.

Individuals have long sold stocks at year-end to take losses, driving down stock prices. Mutual funds, having an ever greater presence in the market, start their annual tax-loss selling as early as October. And, just as tax-related selling drives down the price of stocks during the last quarter of the year, the abatement of the tax selling in January and subsequent several months accounts for a sharp rebound.

While some debate arises every year over the validity of the January effect, you only have to look at the plethora of real world examples of stocks rebounding off their lows in December, with the rally extending well into the new year. It makes you wonder whether the January effect naysayers are missing the proverbial "forest through the trees." In any case, while the debate goes on in some quarters, the seasonality present in the market, and especially in low-priced stocks, offers stock pickers a great opportunity.

Why low-priced stocks especially? Because by their very price and nature, these stocks typically are the stocks analysts dislike the most and have suffered the heaviest liquidation, and thus offer the greatest rebound potential.

As one measure of "best liked" versus "not liked," consider the Fortune annual survey of corporate reputations. Not surprisingly, the average price of the stock of companies analysts liked best in the 1995 survey was $58; the price of the "least liked" was $12. Similar price differentials are present in prior surveys.

And, since one of no less stature than Ben Graham said that the fundamental law of the stock market was that the market overvalues firms that have been showing excellent growth, and undervalues firms that are out of favor, it should not be too surprising that the better opportunities in the stock market have indeed been among the lower- priced and depressed stocks.

Of course, it helps to pick the right one, and that is where technical analysis fits in.

USAir Group

Take the stock that has posted the best gains through the first six months of the year-USAir-up 173.5%, from 4 at year-end to 115/8 by June 30. Was USAir just a fluke? Not at all. The decline and subsequent rebound in USAir was about as typical a pattern for low priced and depressed stocks as one could ask for, as can be seen in Figure 1, which shows USAir's stock price pattern over the last 18 months (through June 30).

First, USAir was unquestionably low priced and depressed. The stock had fallen from a 1989 high of 547/8 to a 1994 low of 4, a 92.7% decline over a five-year span. USAir had also certainly fallen out of grace on Wall Street.

Indeed, in Fortune's 1995 corporate reputation survey, USAir ranked third from the bottom, 393 out of 395-talk about out of favor. However, the period when a stock has declined sharply and is depressed and low priced is exactly when technical analysis can be helpful in identifying a potential winner like USAir.

Technical analysis conjures up many thoughts among investors, but in my perspective, technical analysis is simply how the stock is acting relative to prior trading activity. Investors usually think they buy and sell based on fundamental analysis, but it is surprising how many investors also react to the action of the stock price itself. Technical analysis needn't be any more complex than taking a measure of how the stock is reacting.

In any case, it is the nature of these stocks (like all issues) to move in trends, and one of the more important readings is what pattern develops in the stock following an intermediate downtrend, which in turn is composed of a distribution phase, followed by a mark-down phase, and then a selling climax. It is the action of the stock following the selling climax that gives us our first clue.

USAir had been in a steep markdown phase throughout September of 1994, as the firm's financial woes and questions regarding its ability to survive mounted. Then, on September 29, USAir deferred dividend payments on all of its preferred shares, and the bottom dropped out of the stock.

The mood of the market regarding airlines issues was not helped by the fact that Southwest Airlines announced on the same day a new series of price cuts in the airfare war, or by TWA's announcement that the firm may file for Chapter 11 again. Needless to say, the last of the true believers finally blinked, resulting in a selling climax. On Thursday, September 29, on volume of 4.7 million shares, USAir dropped one full point to close at 4 (volume is depicted along the bottom of the graph in Figure 1).

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In terms of fundamentals, the outlook was very bleak indeed. But, in terms of technicals, support did enter into the stock at 4. A selling climax does represent wholesale selling, but by definition, every seller has a buyer, and buying support did develop at 4. How the stock would subsequently react to support at 4 in future trading sessions would be key in judging the outlook for USAir. Based on fundamentals, analysts (as evidenced by the Fortune corporate survey) had thrown in the towel, but technically speaking, the question of the moment was whether the support at 4 would hold.

Following any selling climax there is a reversal of just a temporary nature, and then the stock typically tests its lows. In the three weeks following the typical knee-jerk bounce, USAir just drifted lower.

Support entered the stock at 4, right where it would be expected, during the week of October 23, and the stock rallied briefly. The stock then declined back to support during the week of November 21. The stock then rallied with a little more authority to 5«.

However, as the expression goes, "first rallies don't hold"-it is not too surprising that the many investors who still owned USAir at higher prices would use any rally to sell. Subsequently the stock fell back, and by the last week in December was selling at 4 once again.

So here is a stock where the fundamentals are terrible, yet support keeps entering the picture at 4. Investors can see from this one example alone why I think more investors should watch the action of stock prices relative to past trading levels.

During January and February one of the most important patterns developed-a bullish minor zigzag pattern. Most of the time this zigzag pattern should be considered the least important of the trends. After all, it represents the minor trend. But, after a stock has experienced a long decline, then moves more or less sideways reflecting support, and then begins to trend upward in a minor zigzag with very little fanfare, it is very bullish.

USAir had rallies in the past, such as late November. During the prior July there was a sharp rally; during the prior May there was a sharp rally. And, there were other less notable rallies throughout the prior 12 months as well. However, these were all spikes, not zigzags. Not to belabor the point, but as USAir's pendulum had come to a rest at 4 in December, and then the stock began to move up in an orderly zigzag fashion, just like climbing a set of stairs, the outlook was turning bullish.

Support and Resistance

One reason why I like to look at depressed stocks, besides the potential for rebound, is that investors have an excellent roadmap, determined by support and resistance levels, by which they can judge the action for the stock.

For instance, consider the extensive level of trading between 6« and 7 between April and September the prior year. At the time, 6« represented support. But, once the stock dropped below that level in early September, that 6« level then became resistance. As such, any rally from lower levels can be expected to encounter resistance at 6« and would indicate to investors when not to buy the stock.

So, as the stock rallied through January and February, the outlook for USAir appeared on the surface to be better, but in fact the stock was coming up against resistance at 6«. As it was, the rally from the December lows stopped right at 6« in the last week of February.

The stock retreated into mid-March, finding support at about 5 to 5«, which coincided with the support levels as defined by the late November and late January rally highs at 5«. Just as a low becomes resistance once a stock declines below it, a high becomes support once a stock moves above it. In many situations, nearly all of a stock's movement can be explained by knowing prior support and resistance levels.

On March 27 USAir rallied sharply, but again hit 6«. It was constructive, however, that the stock had rallied right back to that resistance level, indicating that buying support was nearly as strong as selling at the resistance level. The stock then traded right below 6« for three weeks.

A most important rally in USAir then occurred on April 19, as the stock cleared 6«, on a pick-up of volume. The trend was undoubtedly bullish, as the stock had broken above a key resistance level, and buying opportunities were presented to investors in late April and mid-May.

In Figure 1, note the symmetry in the stock. Many low-priced stocks take on a saucer effect, as did USAir. The pattern of the rise on the right reflects pockets of resistance on the left during the prior decline.

Note also the explosive rise during June. The rise was not so much because analysts were warming up to the stock, which they were doing again, but because of the lack of resistance at those price levels.

The January and February 1994 reversal was typically characterized by active trading, with support at 14. In March, the stock plunged after it fell through support at 14, with the issue gapping down. Some trading developed at various price levels during the meltdown in the stock, but significant trading activity did not in effect again develop until 9. The relative lack of trading between 9 and 14, and hence lack of potential resistance, explains why in June of 1995 the stock skyrocketed after the 9 level had been passed on the upside.

On July 23 USAir reported a sharp jump in net earnings-a profit of $112.9 million or $1.47 a share for the quarter ended June 30-the first quarterly profit in years. The fundamentals were improving and so analysts' outlooks were brightening as well.

However, the improvement in fundamentals has come at a time when the stock had already advanced 150%, an advance off the lows which was as clear to read as investors could ask for, to a level where resistance can be expected at 14 to stop the advance, which it did. There is nothing random about USAir's stock pattern at all.

Conclusion

With the last quarter of the year approaching, investors should think about searching through some of the rubble that Wall Street will begin to abandon. Start to look for stocks that have had an extensive decline, and look for any stock patterns that suggest accumulation.

Investors will find that every year brings a new crop of USAirs.


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