There have been several posts on this blog where I talk about how I look at technical analysis. I am often offended, like most technicians, by being lumped into a world of black magic and crystal balls, as if looking at charts was somehow equivalent to reading tea leaves or tarot cards. Technical analysis is a large umbrella that covers many different methods and techniques, some which reek of hocus pocus and some which are grounded in real human psychology. I try to use the techniques that are grounded in the later.
Let’s take a look at the classic “cup with handle pattern” made famous by William O’Neil and Investors Business Daily.
Courtesy of StockCharts.com
This pattern is usually applied to high growth stocks that have made large moves up during a bull market. Every once and a while a market correction comes in and the cup with handle pattern begins to form. The entire basing process serves one single purpose, to rid the stock of weak hands and replace them with strong hands. Weak hands are the retail investor or jittery hedge fund that bail on a stocks at the first sign of trouble. A strong hand is stock owner that has strong conviction about the future of the company and has a high tolerance for risk. This part of market psychology is even why we look for the handle in the base pattern. Typically, the weak hands get into a stock late in its run and as a result they are often stuck riding out the correction. As is so common, the weak hands tell themselves that once the price gets back to ”break even” they are selling out, happy to exit with a very small loss or gain. The sad thing for those weak hands is that once they are flushed out of the stock, there is no longer anything holding the price back and a breakout and strong move higher results.
Now let’s take a look at the carnage of last week. The exchange of weak and strong hands is not always visible in the broader markets, but every once and a while an event happens that flushes out moderately strong hands and replaces them with even stronger, and likely smarter, hands. I think this last week can be considered such a time. Look at the charts of some of the most unglamorous names out there. Heinz Co (HNZ) went from about 48 to 38 in two days. Is this because the credit crisis has somehow caused Americans to hate ketchup? Has the socialization of losses made us more European, perhaps resulting in the side effect of craving mayonnaise on french fries? Nope. The chart of HNZ is a clear sign of margin calls, liquidation, and the failure of hedge funds. These highly levered funds have now been forced to sell their holdings for ridiculously low prices, prices that those smart enough to raise cash early can take advantage of.
The signs of hedge fund failures are everywhere. Look at some other “safe” companies like General Mills (GIS) and Kellogg (K). Both of these are places were funds hide during economic downturns. Well there is no where to hide when your clients are pulling out their cash and you are forced to liquidate. The good news is that the ultra strong hands, like Buffett, can buy these and put a real floor under the market.
The real moral of the story here is that the selling cannot last forever and the weak hands are being replaced by the ultra strong hands. Thank God this doesn’t happen all that often because it is sure hard on the stomach.
Side Note:
Look at the chart of Potash (POT) and CF Industries (CF). While they both have been destroyed since the summer, they held up relatively well this last week. Why? I like to think it is because these were the leaders with the most hedge fund ownership and were also the first to be sold off in the early parts of the bear market. Right now it looks like those funds have already been flushed out. These two stocks, and others like them, might be ready for a powerful bounce.
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