The Red Flag That Warns “Do Not Buy”
07/27/2011 10:45 am EST
Sharp recent declines in a pair of big steel stocks caught many by surprise, but relative performance, or RS analysis, could have warned of the potential weakness in advance.
Every day, it is often helpful to analyze the stocks that are the biggest gainers, and those that are the biggest losers. From Tuesday’s trading, the 17.46% drop in AKS Steel Holding Corp. (AKS) stood out, and a bit further down the loser list was US Steel Corp. (X), which lost more than 8%.
When two stocks in the same industry group get hit that hard, I want to find out whether it is the start of a more serious decline. I also want to find out how the industry group looks from a technical standpoint.
In the majority of cases, when you see such a sharp drop, I have found that the relative performance, or RS analysis, for the stocks is already negative and has been warning of the weakness in advance.
Earlier in the year, the RS analysis on some of the big financial companies, as well as the Select Sector SPDR - Financial (XLF) indicated that the financials were a sector to avoid.
Hopefully a closer examination of Tuesday’s big winners and losers will show the importance of avoiding stocks with weak relative performance, or RS analysis.
Chart Analysis: The daily chart of the Dow Jones Steel and Iron Index shows that a classic continuation pattern was completed on Tuesday, as the uptrend, line b, was broken. The rally to last week’s highs tested the 50% retracement resistance and the former support at line a.
- The next support is at 275 and the June lows, which is about 4% below current levels. There is additional support in the 250 area
- The RS line violated its uptrend from last October’s lows (line c) in March. Additional RS support was broken at the end of April, line d, as a downtrend was clearly established
- The daily OBV also violated support (line e) in late April, and volume was very heavy on yesterday’s plunge. The weekly on-balance volume (OBV) (not shown) has been below its weighted moving average (WMA) since early April
- Major resistance for the index is now in the 300-305 area
AKS Steel Holding Corp. (AKS) gapped lower on Tuesday and then closed on the lows. The break completed the trading range, lines f and g. The width of the trading range has initial targets in the $9.60-$10 area.
- In 2009, AKS formed a double bottom in the $5.20-$5.40 area
- The RS completed a top formation in early 2010 (see circle)
- RS had formed lower highs, line h, while AKS was forming higher highs (line f). The RS has confirmed the price break
- At over 47 million shares, volume was almost seven times the three-month average, and it was the highest daily volume ever. The weekly OBV (not shown) has been leading prices lower since May 2010
- Major resistance is now at former support, line g, in the $13.80-$14.15 area
NEXT: See Early Warning Signs on Chart for US Steel Corp. (X)|pagebreak|
US Steel Corp. (X) was also hit hard on Tuesday, but it had already violated important support, line a, in the middle of June. The 2010 lows in the $37 area are about 9% below current levels.
- The daily RS topped out in early 2011 and broke major support, line b, on May 6 when the stock closed at $45.66. The weekly RS (not shown) has been forming lower highs and lower lows since early 2010
- Trading volume was also heavy on Tuesday, dropping the daily OBV below its weighted moving average. It is still in a downtrend, line c. The more important weekly OBV (not shown) has been below its weighted moving average since March 12
- There is first resistance now at $41.80 with much stronger resistance in the $45 area
W.R. Grace and Co. (GRA) is a well-known chemical company that was one of the top ten gainers on Tuesday, up 12.7% on the day to close at a new all-time high. This weekly chart goes back to the 2008 lows at $2.95.
- The weekly RS was above its rising weighted moving average by May 2009. The WMA was tested several times in 2009 (see arrows) and broke above resistance, line f, on October 17, 2009. GRA did not overcome its corresponding price resistance, line d, until four months later
- GRA corrected in early 2010, holding the major 38.2% support level. The uptrend had definitely resumed by October 2010 as the RS was above its weighted moving average and the OBV had overcome resistance at line h
- Both the RS and OBV have confirmed the recent highs and show no signs of topping out
- There is first support in the $48.60 area with more important support at $45
This goes to show that the RS analysis for an individual stock, and for that stock’s sector, can help you to avoid falling victim to similar downdrafts.
Using RS analysis can also be useful to spot—and stay with—winning stocks. This analysis will often also warn of corrections within major uptrends. For example, the RS analysis for W.R. Grace & Co. (GRA) dropped below its weighted moving average in early 2010 before the stock corrected 38.2%.
See related: Spot Leaders and Losers with RS Analysis
How to Profit: Anyone currently long either of the hard-hit steel stocks should get out now, as both still have significant downside risk. Often times, after such a sharp drop, prices will bounce for a day or two before resuming the decline.