Pattern Analysis: Using Triangles to Spot Trends in Low-Priced Stocks
In my last column [May 1996] I discussed the potentials that arise from opportunities in investing in past “losers,” primarily low-priced and depressed stocks. I outlined the theories as to why low-priced and depressed stocks could turn into winners, reviewed the studies that support the theory, and commented on some sources for finding these stocks.
However, there is obviously a high risk premium in these stocks, as they are all low-priced and depressed for a purpose. Common sense tells us that if these stocks do indeed provide the better returns, it is reflected in the returns that flow to higher risk takers.
In addition, simply being on a list of low-priced stocks is no guarantee of success. For the unwary, buying into low-priced and depressed stocks is like trying to catch a falling knife.
Separating the wheat from the chaff is where technical analysis comes into play. Pattern analysis is a branch of technical analysis, and can be very helpful in judging trends and spotlighting both buying and selling opportunities. That’s because patterns are the result of the interplay between support and resistance. Patterns essentially represent the ebb and flow between buyers and sellers, and the implications of the eventual breakouts from patterns can be exceedingly important.
In the last issue, I alluded to the use of one particular pattern, the triangle, in identifying trends in low-priced stocks—a descending triangle in the example of a stock moving lower, and an ascending triangle in the example of a stock moving higher. This article will demonstrate more fully the usefulness of triangles and pattern analysis.
Using Triangles: An Example
U.S. Surgical is a good example of the interplay between support and resistance, and offers several examples of triangles.
U.S. Surgical is from the CalPERS (California Public Employees’ Retirement System) listing I reviewed in my May column. CalPERS, you will recall, annually issues a list of “underachievers” in its portfolio in an attempt to motivate management to improve performance; the list tends to be dominated by low-priced and depressed stocks. U.S. Surgical had the worst three-year average annual return in the February 1996 CalPERS list, with a relative (to its industry) return of –51.2%.
In many respects, U.S. Surgical was just the atypical typical low-priced and depressed stock. The stock had sold as high as $1341/ 2 in January 1992, but by February 1994 the stock had fallen to $157/ 8. An 88.1% decline over a two-year period certainly qualifies the stock as low-priced and depressed.
Importantly, however, while the troubles at U.S. Surgical were unique to the company, the stock acted just like the typical low priced and depressed stock beginning to base and rebound. The basic pattern of these stocks consists of four phases:
- A steep decline in the mark-down phase;
- The gradual bottoming or flattening out as distress selling runs its course and buying becomes more apparent;
- The stock begins to grudgingly work its way higher through resistance.
The concept of a gradually bottoming out, a rounding effect, is simple and logical. First, regarding selling pressure, a stock that is down sharply is bound to have considerable resistance. Many “value” buyers who prematurely bought U.S. Surgical simply because the stock had fallen in price stand ready to cut their losses short and bail out on rallies.
As to buying, stocks that have been heavily sold usually have very little buying interest at the bottom. It is a fact that most of these stocks lack analyst following. When a stock is down 75% or more, there is a dearth of bullish stories that can be made about the stock and thus few analysts and few buyers.
Thus it is clear that the interplay between buyers and sellers—support and resistance—will determine the ultimate outcome. But what investors often fail to realize is that these levels can be identified beforehand, by prior levels of trading. And, by judging the action of low-priced and depressed stock relative to prior support and resistance levels, trends can be determined.
Starting at the Top
Let’s start with U.S. Surgical right at the top, with the massive triangle distribution pattern in early 1992 (see Figure 1). Through the first six months of the year, support at 100 was evident in the stock, creating the horizontal bottom tangent of the triangle. Buying interest, though, was less and less over time, so the top tangent of the triangle was declining, hence a descending triangle.
In mid-1992, U.S. Surgical broke to new lows, falling below 100. The level that had been support would now become resistance. Investors who had been buying the stock every time it dipped to 100, and thus were providing support, were proven wrong when the stock broke lower. Thus, in the rational attempt to cut their losses short, they could be expected to sell as the stock rallied back to 100.
As it turned out to be the case, U.S. Surgical rallied back to 100, but the resistance at that level cut the rally short. The stock then began to lose ground quickly as the stock passed from the distribution phase to the mark-down phase. The stock dropped precipitously to the low 50s.
Note the overall symmetrical pattern, the decline from the top mirroring the preceding advance. Patterns are determined by support and resistance levels, which are in turn determined by existing trading levels. Thus, trading levels developed on the way up, acting as resistance, then came into play on the way down, acting as support. Such levels were at 90, 80, 70, 60, and then 50.
On the decline, note that the quickness of the declines increased as the stock moved below these support levels. And the extent of the semi-panics depended upon where the next support level, or prior level of concentrated trading on the preceding move up, would come into play.
On the way up, there is little trading between 80 and 90. On the way down, there would be little support and thus the stock slid quickly between 90 and 80, until some prior level was encountered. The stock would stabilize a bit at the next support levels, but once it fell through, selling out picked up speed.
Below 50, there were no concentrations of trading until the low 30s, back in late 1990. So note what happened in 1993 when the stock dropped below 50—it dropped like a rock.
Let’s view the panic in detail (Figure 2), as panics set the trading parameters for a stock for months, if not years, to come. April 5, 1993, was the last day for the stock to close above 50. On April 6, the stock opened at 521/ 2 and closed at
485/ 8; volume increased to 1.5 million shares. On April 7 the stock opened at 45, hit an intraday low at 433/ 8, and then rallied to close at 465/ 8; volume expanded to 3.1 million shares. On April 8 the stock hit the skids, opening at 34 and closing at 313/ 8; volume soared to 8.4 million shares. The following Monday the stock opened at 32 and closed at 297/ 8; volume was 3.8 million shares.
As typical of most panics, volume develops at the far side of the panic, or at around 30-32. The high volume at that level would make 30-32 significant resistance.
The stock sagged in the following weeks to 28¼ by mid-April, then staged the typical knee-jerk rally into May, probably caused by some bargain hunters, but also short-covering. However, these rallies never hold. The distribution pattern was of a symmetrical triangle.
When the stock broke support at 28, another panic developed and the stock gapped down to the next level of support at 25. After some attempt to stabilize, the stock continued to move lower. Through early October the stock would attempt to rally from time to time, but generally continued to sag to 20.
When stocks are so oversold, as they sag following a panic, it does not take much of a “spark” to “spike” the stock higher, and a rally quickly developed in early October. After a brief decline into December, the January effect carried U.S. Surgical higher into 1994.
However, note the rally high of January 31, 1994—32½—which coincided with the expected resistance at that level, as determined by the high volume panic of April 8.
If investors learn nothing else from this article, it should be to never buy a stock as it approaches resistance. Wall Street was probably turning a bit more bullish on U.S. Surgical, as the stock was up over 50% and appeared to be trending upward. However, in effect, U.S. Surgical had rebounded right up to its panic lows, and panic lows always imply significant resistance.
The formation of the December-January-February distribution pattern could be classified as a head-and-shoulder. A reader should be able to see why that formation is called such. The “neckline” developed at a prior support level, 25, and the formation was complete when the “neckline” was broken at 25.
This level had been support during the price plunge in mid-June, was resistance at the October rally highs, and had been acting as support as the neckline in the December-January-February distribution formation. When this important level of support was broken, the price plunged again.
In the aftermath of the drop the price hit its low, 157/ 8, and would trade at around 157/ 8 on several occasions over the next three months. At 157/ 8, U.S. Surgical has traded all the way back to an important support level which was determined by a level of trading as far back as November 1989!
Subsequently, U.S. Surgical would continue a pattern of bottoming or rounding out over the next two years, affording many examples of symmetrical, ascending, and descending triangles, each forming at various support and resistance levels. But the overall pattern of the stock during the rounding out process can be viewed as two major triangles, first a somewhat symmetrical triangle, with the top tangent connecting rally tops in May 1993, January 1994, September 1994, and April 1995.
The bottom tangent was formed by key lows in February 1994, December 1994, and June 1995. During July 1995 the stock broke out to the upside.
According to triangle theory, there is often a pullback after the breakout rally, with the expected level of support defined by the apex of the triangle. When the stock pulled back in January 1996, support developed right about at the apex.
Another major triangle was unfolding in the form of an ascending triangle, with the horizontal lines formed by important resistance at 28 (determined by the post-panic lows of 28 in April 1993), and the key support lows in February 1994
(157/ 8); December 1994 (18¼); June 1995 (193/ 8); and January 1996 (19¾) reflecting the ascending bottom tangent.
The overall bottoming formation was very bullish. The question would be when the stock would finally break out. Actually, during any bottoming out of major importance, the breakout is more of a process or a series of taking out various resistance levels.
For instance, after the stock had found support in January 1996 at 20, where it should have found support, and then rose in February to take out important resistance at 25, the picture grew definitely more bullish. Buying on pullbacks was in order.
After a pullback to support, the stock rose again and took out the resistance at 28. At this point, the trend was decidedly bullish. Look at the sharp move higher as the stock moved past 28.
After another spurt higher the stock ran into the important resistance at 32. The stock consolidated during most of the month of April in a symmetrical triangle. On the breakout the stock moved above the resistance at 32 and skyed, nearly three years exactly from the April 1993 panic!
Now, not to get too far ahead of ourselves, major trends are comprised of intermediate trends, and these intermediate uptrends tend to only last two to three months, and have three to four minor rallies, before an intermediate correction develops.
Thus, while U.S. Surgical in early 1996 has clearly established a bullish major uptrend, the intermediate trend is getting a bit long in the tooth, and the little symmetrical triangle at the top of the knee-jerk rebound rally in May 1993 may provide just enough resistance to halt the uptrend for the time being.
An intermediate trend correction of one-third to two-thirds of the January to May advance would be in order, and 32 and 28 would be the logical support levels.
However, after some degree of intermediate trend correction, look for the major trend to resume. Whatever may be the future of U.S. Surgical on a fundamental basis, from a technical standpoint, the outlook appears positive.
Conclusion: Gauging the Trends
The point of this article is not to highlight U.S. Surgical, but rather to illustrate the use of triangles.
There are many considerations that investors should look at when buying stocks. Pattern analysis is one tool that can be used to judge the interplay between buyers and sellers of a stock.
Triangles represent patterns that can develop, and while the shape may be simple, the implications for the future trend of low-priced and depressed stocks can be useful.
How to Check Up on a Financial Planner
The following list, compiled by The Certified Financial Planner Board of Standards CFP, contains several professional organizations and their addresses and phone numbers where individual investors can inquire about financial planners and their credentials. The CFP Board is a non-profit professional regulatory organization.
The Certified Financial Planner Board of Standards (CFP Board). 1660 Lincoln Street, Suite 3050, Denver, CO 80264, (888) CFP-MARK (toll-free). Confirm if a financial planner is currently CFP licensed, check on disciplinary action, or lodge a complaint.
National Association of Insurance Commissioners NAIC. 120 W. 12th Street., Suite 1100, Kansas City, MO 64105, (816) 842-3600, web site: http://www.naic.org. Obtain name of state insurance commissioner where you can verify if a financial planner is licensed to sell insurance in your state or check on any insurance violations.
National Association of Securities Dealers NASD. 1735 K Street, N.W., Washington, DC 20006, (800) 289-9999. Obtain disciplinary history of registered representatives and broker dealers in your area.
North American Securities Administration Association NASAA. One Massachusetts Avenue, Suite 310, Washington, DC 20001, (202) 737-0900. Obtain phone number of state securities commissioner in your state for record of securities-licensed financial planners.
Securities & Exchange Commission SEC. 450 5th Street, N.W., Washington, DC 20549, (800) 732-0330. Check whether a financial planner is a registered investment adviser, obtain information on an individual or firm providing securities and investment services, or lodge a complaint.