Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
SOS: Bollinger Buys
06/04/2004 12:00 am EST
With his straightforward, unhedged advice, John Bollinger has an incredible ability to turn the complex and often arcane world of technical analysis into an easily understood outlook. Here, he looks at the overall market, the most promising sectors, and a package of gold stocks.
"The stock market has remained volatile with a downside bias that has gradually carried us into oversold territory. This is especially interesting in light of the steadily positive tone of economic reports. The oversold condition coupled with economic news running against the grain–stronger than expected– suggests one of two things. Either the market is fairly enough valued given the news and is being dominated by normal selling/profit taking, etc., or we are in a continuing environment where people feel that the economy and earnings are worse than is the actual case. If the latter is true, and we think it is, then a genuine contrarian opportunity is shaping up.
"Given the oversold nature of the market, we are looking for a sign of strength (SOS) to generate a buy signal. A sign of strength is a day on which price goes up on expanding volume. A more formal definition is: Sign of Strength = Greater than average volume and greater than average gain and/or greater than average range with a close near the high of the range. In addition it helps if the SOS is highly visible and commented on and some important technical event occurs too, such as the crossing of resistance, the break of a widely-viewed trendline, the crossing of a round number, a new high, the crossing of an important average such as the 50- or 200-day, etc.
"That's the technical point, but the real point is that everyone should realize that it is a sign of strength; a stealth sign of strength is just not of much value. A real SOS can be heard, people go ‘Wow’, the noise in the trading rooms goes way up, CNBC talks about it– a lot, Investor’s Business Daily and the Wall Street Journal make a front-page fuss about it. The point being that an SOS is a psychological phenomenon more than anything else. In order for it to be worth anything people must see it and react to it; the bigger the splash the better. Speculators take note! An SOS would mark a solid intermediate-term opportunity that could carry price nicely higher. The most interesting thing we see is that as the correction has progressed there has been some rotation out of small-cap stocks and into large-cap stocks. It isn’t enough to suggest a change in trend away from small-cap leadership yet, but it is enough to have caught our attention. Growth is drawing a bit of attention, but is not a dominant theme yet. I suspect that we are leading up to an important buy point in technology and telecom.
"Very interesting trends are developing in the Group-Power sector table. For the first time in a long time the S&P 500 is the top-ranked sector; we attribute this to a flight to quality. Technology and Telecom are scraping the bottom, an opportunity in the making to our eye. Basic Materials and Energy are pulling back, which looks like reentry opportunities. In short, a lot of potential ideas are lining up. It looks like time for a respite from the relentless energy surge, with natural gas setting the pace for the correction. What seems of most interest is that the oil service stocks have corrected while the big oil stocks are within contact distance of their old highs. Seems like it should be the other way around. There's going to be an awful lot of exploration driven by higher oil prices and the majors' cost of replacement does not stand them in good stead. A neat and interesting idea is a spread trade, long the oil service sector and short the major oils.
"Commodities, from a contrarian point of view, remain very attractive. The recent correction–and so far it seems like little more than that– has barely gotten underway and people are tripping over themselves in a huge rush to declare the rally at an end. Yet, in the marketplace there is no evidence of a big time reversal, just a normal correction that has taken back 10% to 15% of the advance. If one looks at some of the individual commodities the idea of a correction is supported, with logical pullbacks after primary up moves the major color from the market place. We've often heard this rally in commodities put off to Chinese demand for such things as copper, etc. This strikes us as good color, but it does not 'explain' the rally to us. We believe that the rally is the start of something and is directly in sync with a burgeoning inflationary trend. One way of thinking about this is the idea that virtually all commodity prices are rising in sync.
"As we survey the precious metals market, gold, silver, platinum and palladium, we see a picture of corrections completing, bases forming, and nascent rallies. The evidence suggests that it is reentry-buy time for gold and the gold stocks. The risk/reward ratio looks to be near 3-to-1, a 10% decline to a logical stop and a 30% rally to a retest of the old highs. Given the oversold nature of the sector the odds of success also seem quite good. So there you have it, a good/risk reward ratio and good odds, that, and some trade management, spell success. Here is a list of some candidates for the bounce.
"These are the most severely oversold gold stocks in the universe that we track. We are using a new low for the initial stop. Expect us to adjust those as soon as the trade starts working. The average loss for the 19 gold stocks in our universe is 42% off the recent highs and the highs were an average of four months ago. The gold stocks in our package were down an average of 52% at their lows and their peaks average a couple of weeks farther back than the mean. We haven't done a package in a while, but it feels right to do this one."