The US markets are on a roll as we head into the last quarter of the year. The S&P 500 continues to record new lifetime highs on a regular basis. While a section of the trading community has been skeptical of the rally, it has not deterred the bulls from buying on every dip. The correction still eludes the bears.
- The markets are at new lifetime highs.
- The fourth quarter is the strongest quarter for the stock market.
- Historically, five stocks of the Dow Jones industrial average have traded positive about 80% of the times in the fourth quarter.
- We analyze the charts of the five stocks to determine whether they offer a good risk to reward trading opportunity this year.
However, the current bull rally, which is already the second longest in history calls for caution but traders should continue to participate because no one can predict the exact top in the markets. It is only in hindsight that one comes to know about the top.
Therefore, in this article, we shall analyze the historical performance of the stock markets and a few stocks in the fourth quarter of the year, which have rewarded the investors handsomely.
Though it is not necessary that history will repeat itself, chances are that it may rhyme. These studies help the trader improve his odds for success.
The Dow Jones industrial average has risen for eight straight quarters, the longest winning streak since 1997. The S&P 500 has also rallied similarly, while the Nasdaq composite has risen for five straight quarters.
Though the September quarter is cyclically one of the weakest, this year, the Dow rallied 4.9%, the S&P 500 4%, and the Nasdaq composite 5.8% respectively. The stock market has entered its strongest quarter with a favorable tailwind.
The fourth quarter is the strongest for the markets
The fourth quarter is the best quarter for the stock markets by a huge margin. In the last 25 years, it has been positive 80% of the times. This is no small achievement. Also, the returns have been impressive.
Therefore, it is appropriate to expect the markets to close the year with strength. That is what most of the analysts also forecast.
Analysts expect 2017 to end on a strong note
In a recent poll by CNBC, majority of the analysts were confident that the S&P 500 will rise from the current levels and end the year with strength.
Along with the rise, they were extremely bullish on the pace of rise. About 79% believed that the rally will be more than 5%, which gives a year-end target of 2635 on the S&P 500. Considering the rally of the past few days, it certainly looks achievable.
But it is not only the US markets that are creating new records. The global stocks have also equaled the record for consecutive monthly gains – 11 straight months, last achieved in 2003, during the rebound from the dotcom bust.
Therefore, historical evidence suggests that we should see a strong fourth quarter, which will be good for stocks.
However, in the current bull run, the rally has not been broad-based. Only a handful of stocks have led the rally. Therefore, in order to profit, one has to pick the right stocks. Just buying any stock in the markets will not guarantee returns.
A study by CNBC has identified five stocks in the Dow Jones industrial average, which have rallied in the fourth quarter majority of the times.
While these are positive numbers over a long period of time, still, before investing, it is always prudent to analyze whether the performance can be repeated this year.
Let’s look at the chart patterns to find out whether the stocks offer a good risk to reward trade opportunity or not.
The stock is currently trading within an ascending channel. It has traded in the upper half of the channel for most of the times, however, in September, it fell to the lower end of the channel. Since then, the stock has again rallied back to the highs. We can expect the stock to continue trending higher until it breaks down of the channel. Therefore, we have a clear stop loss at around $190.
Also, considering the stock’s performance of the past few months, we can expect a rally to the upper end of the channel, which should be around $207. However, for that, the stock will have to first rally above the highs of $200.76. If we buy at the current levels, our immediate profit objective is around $10, whereas, the possibility of a loss is $8, which leaves us with a risk to reward ratio of 1:1. Traders can take 50% position at the current levels and add the remaining 50% once the stock breaks out of $201. The initial stop loss should be kept at $190, which should be trailed higher once the stock moves up.
The stock has broken out of an inverse head and shoulders pattern, which has a pattern target of $176. However, most breakouts retest their neckline, which in this case would be the $162.5 levels. Therefore, traders can buy 50% of the position at the current levels and 50% on a retrace to $162.5.
The stop loss should be kept at $159 levels, just below the neckline because the pattern weakens when the stock starts to trade below $162. This gives us a risk to reward ratio of roughly 1:2.
The stock has formed a large base after falling from the peak made during the dotcom bubble. A breakout of the overhead resistance zone of $33 to $35 can be very bullish for the stock, as it has no major resistances ahead. Therefore, we can assume that the stock will gain momentum once it sustains above $35.
On the daily chart, we find that the stock has a stiff resistance at $34.5, where the stock is likely to stall its current rally. However, if the stock breaks out of the resistance, it will be very positive for it. Therefore, traders should wait for a close above $34.5 and enter at $35. The stop loss for the trade can be kept at about $32.5 levels. The rally can easily extend to $39 and higher, which gives it a risk to reward ratio of about 1:2.
DIS is range bound between $90 and $120. Currently, it is trending down, as price is quoting below the downtrend line and the 50-day simple moving average (SMA). Any rally from the present levels is likely to face a slew of resistances between $101 to $106, from the 50-day SMA and the downtrend line. Therefore, we don’t find a buy setup here that can be traded.
The stock has been in a well-established uptrend, trading inside the ascending channel since 2010. However, at the current levels, the stock is right in the middle of the channel. Its support is at $110, whereas, it has resistance at $130 and thereafter at $140. The stock has not reached the upper end of the channel since November 2015. Therefore, the chances of a rally to the upper end of the channel in the fourth quarter look dim. At the present levels, we don’t find a good trade setup, which offers an attractive risk to reward ratio.
After analyzing the charts of the five stocks, we find buy setups only on three stocks. We don’t find any reliable buy setups on the other two.
Though the fourth quarter is the strongest, October gives jitters to the history students of the stock markets because two major crashes started in this month. First was the crash on 29 October 1929, commonly known as ‘Black Tuesday’ and the second was the crash on 19 October 1987, also known as ‘Black Monday’.
Though we don’t expect a similar crash this year, there is no running away from the fact that the markets are trading above their average price to earnings ratio. Additionally, the geopolitical tensions and the news on the tax reforms will keep the markets on the edge. Therefore, traders should be cautious and reduce their position size. Participate in the markets but with a lower allocation and keep a generous amount of cash in the portfolio.
Buy FDS, PPC, BERY, and IIVI for the short-term
The US tax reforms received a major boost on Thursday when a measure approved by the Senate, enabled the Republicans to proceed with the tax cuts, without the support of the Democratic party. Suddenly, passage of the tax cuts looks more plausible.
- Positive news is flowing on the tax reforms front.
- Tax reforms are likely to boost the S&P’s earnings significantly
- The stocks are likely to remain buoyant in the final quarter of the year
- Buy FDS
- Buy PPC
- Buy BERY
- Buy IIVI
Goldman Sachs believes that if corporate tax rates are reduced from 35 percent to 20 percent, it will increase the annual per-share earnings of the S&P 500 by $15. Consequently, the stock market will look a lot less richly valued on a forward price to earnings basis.
With this bullish backdrop, the stock markets are likely to remain buoyant in the short-term. However, we don’t advise investing for the long-term at these levels. We believe that the markets will fall within the next few months, offering an opportunity to buy stocks at lower levels.
Therefore, we shall trade this market and attempt to ride the momentum. We have selected stocks that are making new 52-week highs because they have a favorable tailwind and are likely to participate in the rally, along with the S&P 500.
So, without further ado, let’s check out the stocks.
FDS – Buy 185.76, Stop Loss (SL) 174, Target 204 and 216
The stock’s history shows that it tends to rally for a few years and then enters into a shallow correction or consolidation. We find three such instances in the past decade. The stock has been in a consolidation since end-2015. Two attempts, one in September 2016 and the second in March 2017, failed to sustain the breakout.
However, the stock again broke out in end-September and extended the rally last week. It is likely to start a new uptrend now and we plan to hop along for a ride.
The stock broke out of the bullish ascending triangle formation on September 26. Thereafter, it faced resistance at the $184 levels, from where the bears attempted to sink the stock, back into the triangle.
However, the bulls provided support at the $176 levels and the stock broke out of the overhead resistance on Friday. It is now likely to rally towards its first target objective of $204. The pattern target on a breakout from the ascending triangle, however, is higher at $216.
Therefore, we recommend a buy on the stock at the current levels with a stop loss of $174. We don’t want to hang on to the stock if it falls back into the triangle once again. The stock has a risk to reward ratio of 1:1.5 at the first target objective and a ratio of about 1:2.5 at the second target objective.
PPC – Buy 31.04, SL 27, Target 37
The stock rose sharply from end-2012 to end-2014. Thereafter, it corrected and entered into three-year long consolidation, during which, it remained range bound between $17 on the lower end and $27.5 on the upper end. PPC formed a double bottom at $17.3 levels and the pattern completed when the stock broke out of $27.5 in mid-August of this year. Subsequently, the stock completed a successful retest of the breakout levels of $27.5 and rose to multi-year highs last week. We, now, expect the stock to start a new uptrend.
The stock broke out of the overhead resistance on August 15. However, the stock faced considerable resistance following the breakout. It remained sandwiched between $28 and $30 for almost two months. Finally, on October 18, the stock broke out of the range and extended its rally on October 20.
It has a pattern target of $37, which is close to the lifetime highs. There is no significant resistance in between, therefore, we recommend a buy on PPC at the current levels of $31.04. The stop loss can be kept at $27, a level not seen for more than two months. The trade offers us a risk to reward ratio of about 1:1.5.
BERY – Buy 59.88, SL 56, Target 67
BERY has been in a strong uptrend since 2016. It has a clear pattern. It rallies and then corrects towards the 20-week exponential moving average (EMA) and occasionally to the trendline drawn. On completion of the correction, it again resumes its uptrend.
Recently, the stock had again corrected to the trendline, from where it found support and broke out to new lifetime highs last week. We expect this trend to continue until the stock breaks and closes below the trendline support. We want to enter this stock as it has re-established its uptrend.
The stock broke out of the overhead resistance of $58.95 on October 06. Afterwards, it successfully retested the breakout levels and has resumed its uptrend. We can buy the stock at the current levels of $59.88 and keep a stop loss of $56. We shall close the position if the stock falls below the trendline. Our target objective is $67. The trade offers us a risk to reward ratio of about 1:2.
IIVI – Buy 43.3, SL 39, Target 52
The stock bottomed out in October-2014 around the $10.78 mark. Thereafter, it started a new uptrend that continued till February of this year, after which, the stock entered a period of correction. $41.1 has acted as a stiff resistance on the way up. However, last week, the stock broke out to new highs and we expect it to continue higher.
On the daily chart, we find that the stock has formed a bullish inverse head and shoulders pattern. The pattern completed with a breakout of the neckline on September 27. Thereafter, the stock successfully completed a retest of the neckline. The stock has a pattern target of $52. We want to enter the stock at the current levels and keep a stop loss of $39, which is just below the low created on October 19. This gives us a risk to reward ratio of greater than 1:2.
Buy TRUP, NWBI and GRPN for the short-term
While most traders, including us, have been waiting for a dip in the S&P 500, it has not materialized. Forget about a 10% correction, the index has not seen a 5% drawdown for more than 325 days, according to Goldman Sachs. Since the 1930s, there have been only two instances when the index has bettered the current performance.
- The S&P continues to make new lifetime highs, which is a sign of strength
- Traders should continue to trade stocks with a suitable stop loss
- Buy TRUP
- Buy NWBI
- Buy GRPN
It has been particularly hard for traders who have been sitting on cash to invest at lower levels. The elusive dip is nowhere to be seen. While the possibility of a correction is real, it should not stop us from riding the next up move in the markets because it is impossible to predict the top in the markets.
It is only in hindsight that we come to know that a top is in place. Therefore, we suggest traders to continue trading in stocks that show a reliable chart set up.
However, considering the risk of a correction, the allocation size should be reduced to half and stop losses should be strictly adhered to. Please don’t hold on to a losing position with hope that eventually it will come up.
Though it’s true that the markets have rebounded sharply after every fall in the past few years, one of those falls will break its back because nothing goes straight to the sky. And, whenever it falls, most stocks will be affected.
Therefore, please book the loss at the recommended levels if the markets turn against you. The first loss is always the best loss.
For the past few days, the intraday volatility in the S&P 500 has reduced drastically. The intraday range has also shrunk. This is unlikely to last long. The markets will expand its range, either to the upside or to the downside within the next few days.
Though it is difficult to predict which way the markets will breakout, we want to be a part of the rally, if the markets breakout to the upside. Therefore, we have chosen a few stocks that are likely to participate in the rally, if it happens.
TRUP – Buy 28.5, Stop loss 27, Target 31.5
The stock has been in a strong uptrend, rallying over 80% returns year-to-date. This shows that the bulls have the momentum in their favor. In April of this year, the stock rallied for three weeks, followed by a two-week consolidation. Once the stock broke out of the consolidation, it ended up with two weeks of strong gains.
Currently, the stock is in a similar kind of a consolidation, after having risen from about $20.52 levels. If the stock can breakout of the consolidation, it is likely to resume its uptrend with vigor. Therefore, we like this stock. Let’s locate its buy and stop loss levels.
The stock has been in a tight consolidation for the past six days near the lifetime highs. An attempt by the bulls to breakout of the range on October 12 was unsuccessful. However, if the stock breaks out and closes above the overhead resistance of $28.3, it is likely to resume its uptrend.
As this is a momentum play, we don’t want to keep a deep stop loss. We want to buy at $28.5, which is a new high. The stop loss for the trade should be kept at $27. We don’t want to stick to the stock if it turns down after breaking out of the consolidation. The target objective is $31.5 and higher. This gives us a risk to reward ratio of 1:2.
NWBI – Buy 17.7, Stop loss 17.2, Target 18.6 and 19
The stock has been an under performer in 2017. In fact, it has hardly participated in the bull run since 2010. However, in November of last year, the stock embarked on a strong run after the US election results. Thereafter, the stock entered a correction. However, the talks of tax reforms have again boosted the stock from the lows of about $15.5 to the current levels.
The stock rallied sharply from $15.06 to $17.61 within a few days. Since the beginning of October, the stock has been trading in a tight range. We expect a breakout of the range to carry the stock towards the highs of $19. Therefore, we want to enter the stock at $17.7 and our stop loss will be $17.2. This trade has a risk to reward ratio of greater than 1:2.
However, the stock has a resistance at $18.6. If TRUP struggles to breakout of this level, traders are requested to sell 50% of their positions at these levels and hold the rest with a stop loss at breakeven. Even if the stock stops at $18.6, the trade has a risk to reward ratio of about 1:1.5.
Groupon has lost a huge amount of money for its investors. Even after the recent rally from its lows, the stock is down about 84% from its lifetime highs. Hence, at every rally, the stock is likely to face selling pressure by the investors who have invested at higher levels. However, we have chosen this stock because it is showing signs of life. Let’s zoom to the daily time frame.
The stock has been rising in an ascending channel since mid-June of this year. Though the stock had broken out of the channel on September 29, it could not sustain above it and the bears pushed it back to the channel’s support line. However, the stock has risen from this support five times in this leg of the up move thereby cementing its strength.
We expect the stock to move back to the overhead resistance of $5.35 and attempt to breakout of it. Hence, we can buy it at the current levels and keep a stop loss of $4.55, just below the channel. Once the stock reaches the $5.35 levels, the traders should raise their stops to break-even and watch for a day or two. If the stock breaks out, please trail the stop higher with a target objective of $6. However, if the stock struggles at the resistance, please close the position. If the stock stops at $5.35, we get a risk to reward ratio of 1:1, however, if the stock reaches $6, the ratio improves to greater than 1:2.
These stocks can offer more than 50% returns in a year
Usually, the stocks are beaten down for a specific reason. Therefore, it is not a good strategy to buy the stocks when they are falling. However, at times, fear takes over, sinking the stocks to mouth-watering levels, from where the downside risk is limited but the upside opportunity is huge. So, without further ado, let’s look at the two beaten-down stocks that offer a good upside potential.
- Och-Ziff Capital Management stock price has plunged following its bribery scandal
- Its assets under management has fallen about 33%
- However, things look to be turning around as AUM increased marginally in August
- Rite Aid has sold 1932 stores to Walgreens Boots Alliance for $4.375 billion
- The remaining stores and business of Rite Aid are valued much higher than its current market cap
- It is a good takeover candidate
Och-Ziff Capital Management (NYSE: OZM)
OZM is a multi-style hedge fund, which has mostly outperformed its peers over the past decade.
Due to its outperformance, its assets under management (AUM) increased from $22.6 billion in 2006 to $47.5 billion in 2014. Between 2009 and 2014, its AUM doubled. However, since then, we find a consistent drop in its AUM. But why?
The firm was charged with bribing officials in various African nations, including the Libyan Gaddafi regime. As a result, after a two-year investigation by the Securities and Exchange Commission and the Department of Justice, the African subsidiary of the firm, OZ Africa, pleaded guilty and a settlement was reached, where OZM agreed to pay a fine of $413 million.
This led to a series of withdrawals by various pension funds, foundations, and endowments. As a result, the AUM of the company fell by about 33% from July 2015 to May 2017.
The hedge fund’s main sources of revenue are management fees and incentive fees. The management fees increases as the AUM increases, while the incentive fees depends on the fund’s performance.
Therefore, if we believe that OZM will turnaround, it will have to generate better returns than its peers to attract new capital, which will increase its AUM. If the hedge fund is successful in doing this, it will earn more revenues and therefore signal a turnaround, which will reflect in its prices.
Withdrawals have abated
The company reported that its AUM increased to $32.3 billion as of 01 September 2017, an increase of approximately $0.3 billion since 01 August 2017. This shows that the hedge fund has been able to attract some capital, though small and is retaining its existing investors. Considering its strong history of outperformance, we believe that it will be able to attract new investors and increase its AUM
OZM’s latest performance of its three funds is given below.
Now, let’s see how this scandal has affected the price of the OZM.
The stock is down about 80% from its 2014 highs. This shows that the investors have severely punished the stock due to the scandal. However, since touching a low of $2.15 in April of this year, the stock has started a base formation. Though the stock is unlikely to rally back to $14 to $16 levels in a hurry, it can easily start a recovery, which can carry the stock to about $4.78 levels within a year, which is a 48% rise from Friday’s levels.
The stock has formed a cup and handle formation, which will complete on a breakout above $3.22. This pattern has a minimum target objective of $4.3. However, once the stock breaks out of $3.8, it doesn’t have any major resistance until $4.8. Therefore, we recommend buying the stock at $3.25 with a stop loss of $2.6.
The investor sentiment can sour due to geopolitical reasons or due to the failed tax reforms in the US. A risk-off trade will reduce the possibility of increasing OZM’s AUM. OZM can underperform its peers, which will make it difficult to attract new investors.
Rite Aid Corporation (NYSE: RAD)
RAD is a pharmacy chain, which recently sold 1932 stores, including three distribution centers, and related inventory to Walgreens Boots Alliance (NASDAQ: WBA) for $4.375 billion on a cash-free, debt-free basis.
Even after the sale, RAD is left with nearly 2600 stores along with six distribution centers, pharmacy benefit manager Envision Rx, RediClinic, and Health Dialog.
After valuing the remaining business of RAD, we find that the stock price offers a good risk to reward ratio.
Our investment thesis
In its latest Conference Call, Darren W. Karst, SVP, CAO, and CFO of RAD said: “Over 70% of the stores we are retaining at our wellness or customer world locations and per store sales and adjusted EBITDA at these stores is higher than the current chain average”.
This shows that RAD has not been left with unprofitable stores.
On calculation, we find that Walgreens has paid about $2.26 million for each store of RAD. Therefore, if we assume the same valuation for the remaining 2600 stores, we arrive at a figure of $5.87 billion.
Another major business that Rite Aid holds is the pharmacy benefit manager (PBM) Envision RX. RAD had paid about $2billion while acquiring the firm back in 2015. Though the jury is out whether RAD had overpaid for the acquisition, we shall consider the existing market metrics to value it.
Envision Rx generates an income of about $6 billion. If we consider a pure play PBM, Express Scripts, the market values it at about 0.4 times of sales. Even if we take a conservative estimate of 0.3 times sales, we arrive at a valuation of about $1.8 billion for Envision Rx.
Adding the two, we arrive at an asset valuation of $7.67 billion.
The company has a total gross debt of $7.20 billion. Let’s assume that the company uses about $4 billion of the total cash received from the sales of its stores to pay down the debt. That leaves a total liability of $3.2 billion.
By deducting the total liability from the asset valuation, we arrive at a figure of $4.47 billion. The total outstanding shares of the company is $1.05 billion. Therefore, even if we take a conservative estimate, RAD’s shares should be valued at $4.25. That is a good 116% higher than the closing price of $1.96 on September 29.
A good takeover candidate
There are rumors that Amazon is exploring options to enter the pharmacy business. If it does, RAD can be a good fit for it to kickstart its operations. Even otherwise, RAD’s valuation is likely to attract the private equity players or other suitors.
Though the management has not been able to put up a credible performance in the past many quarters, with a fresh cash infusion, they have numerous opportunities to turnaround the company.
What do the charts forecast?
The weekly chart shows that the stock has been a huge underperformer. Every once in a few years, it rallies close to $8 levels and then gives back its gains. The long-term chart doesn’t show any trend in the stock. Let’s see if we can get any clue from the daily charts?
The stock has fallen from above $8.5 levels in January of this year to below $2 levels. The stock is in a strong downtrend and it continues to make new 52-week lows. We don’t want to catch a falling knife. Therefore, we shall wait for the price to stop making new lows for three days and then buy about 50% of our total allocation. Remaining 50% position can be added once the stock sustains above $2.2 levels. The stock should gain strength once it breaks out of $2.8. A move to $4 is likely within a year. We can keep a stop loss of $1.
RAD, with its reduced size, will find it difficult to compete with the larger players. The management doesn’t utilize the cash received from Walgreens effectively. Amazon or any other player doesn’t show an interest in buying out RAD, which will deliver a further blow to the sentiment. RAD can continue to dig itself into bankruptcy.
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