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5 Relative Strength Trades Flashing Buy - views
BALTIMORE (Stockpickr) -- As fiscal cliff fears come to a head, it's easy to lose track of what's really going on with the stock market. After all, the headlines don't always synch up with how much your investments are worth.
But just to be clear, the S&P 500 could be looking a lot worse right now. As it stands, the big index is just a few points shy of the 1430 level, a resistance level that acted as a sort of "ceiling" for stock prices back in November -- if the S&P can crack through 1430, I think we'll probably see a test of highs. And yes, that could very well happen before the calendar flips to 2013.
As strong as the S&P may be, a select group of stocks is doing one better. They're the names that are showing outsized relative strength right now -- and more than a few are flashing the buy signal this week.
So, how does relative strength work?
Put simply, relative strength is a ratio of a stock's price to a broad market index. The ratio itself isn't important -- instead, it's the trend of the ratio over time that's investible. According to academic research, relative strength is a powerful strategy over a one-to-ten month time horizon; that's the timeframe we're focusing on today.
We're taking a technical look at the five setups that have the strongest price setups right now.
For the unfamiliar, technical analysis is a way for investors to quantify qualitative factors, such as investor psychology, based on a stock's price action and trends. Once the domain of cloistered trading teams on Wall Street, technicals can help top traders make consistently profitable trades and can aid fundamental investors in better planning their stock execution.
So, without further ado, let's take a look at five technical setups worth trading now.
HSBC Holdings Plc
It's been a stellar year for HSBC Holdings (HBC) -- shares of the London-based bank have rallied close to 34% since the first trading day of 2012. But with HSBC hitting new 52-week highs, it doesn't look like the upside is going to slow down from here. Instead, there's a buying opportunity in this stock.
That's because HSBC is currently bouncing higher within an uptrending channel, a price range that's bounded by trendline resistance overhead and trendline support below. This channel has been in force since late July, and over that time it's done a good job of identifying the likely extent of this stock's moves. Any stock in an uptrending channel presents a buying opportunity, but for risk-averse investors, the best time to buy comes after a bounce off of support.
That bounce is important because it shows that HBC can still catch a bid at support before you buy -- support levels do eventually fail, and when they do, you don't want to be left holding the bag. The relative strength line (at the bottom of the chart above) accelerated at the start of September, indicating that HBC's outperformance over the S&P was increasing even more. If you decide to be a buyer here, I'd recommend keeping a protective stop just under the 50-day moving average.
Japanese farm and construction equipment maker Kubota (KUB) is forming a channel of its own, but instead of a channel higher, KUB is consolidating sideways. That's not a huge surprise, though. KUB has been on a 30% rally of its own in 2012, outperforming the broad market by a big margin -- the recent consolidation channel gives shareholders a chance to catch their breath and figure out their next moves.
Kubota's channel is a price pattern called a rectangle. It's formed by horizontal resistance to the upside and horizontal support below shares. Unlike an uptrending channel, there isn't a whole lot of point in buying shares within the channel -- they're just meandering sideways, after all. So the breakout is the way to trade this stock.
As you can see in KUB, this breakout has already happened: on Friday, shares confirmed a breakout above the $53 resistance level, sending a buy signal for traders. Shares haven't moved much since that breakout happened, so there's still time to jump on this trade -- just keep a tight stop in place.
We're seeing the exact same setup in shares of Eni SpA (E) right now. The Italian oil and gas firm is, like Kubota, forming a rectangle pattern. The big difference here now is the fact that Eni's rectangle hasn't seen the breakout yet.
Typically, rectangles are continuation patterns. That means that more often than not, rectangles tend to resolve in the same direction as the trend that preceded them -- in this case, Eni started off in an uptrend, so traders should be looking for a breakout above $48 resistance. But the strong uptrend in this stock's relative strength line adds some extra confidence to an upside breakout in E.
When you're looking at price patterns, it's important to think of them in terms of buyers and sellers, after all patterns like the rectangle don't work because of magic or geometry. Instead, it all comes down to supply and demand in the market. The resistance level at $48 is a price where sellers have recently been more eager to sell and take gains than buyers were to buy. The breakout above $48 indicates that all of the excess selling pressure at resistance has been absorbed by increasingly committed buyers.
That's why it's critical to wait for $48 to get taken out before becoming a buyer.
TRW Automotive Holdings Corp.
Michigan-based TRW Automotive Holdings (TRW) is a relative strength trade that's forming a pattern called an ascending triangle right now. This setup is formed by horizontal resistance to the upside and uptrending support below shares. That horizontal resistance level is a good tip-off that TRW is another breakout trade to watch this week.
Essentially, as shares of TRW bounced in between those two levels, they were getting squeezed closer and closer to a breakout above resistance at $49.50. That breakout happened late last week, and shares have been sitting right above that level ever since. I'd recommend becoming a buyer on TRW's next leg higher -- since $49.50 has now become a support level for this stock, the next boost in volatility should push shares above Thursday's highs.
If you decide to take this trade, just make sure you keep a tight stop.
Last up is Cytec Industries (CYT), a relative strength performer that's forming another textbook ascending triangle pattern right now. For Cytec, the breakout comes on a move above $70 resistance.
$70 isn't just significant because it's the resistance level that this stock has obeyed since September -- it's also the 52-week high for this stock. Making new highs is significant from an investor psychology standpoint because it means that everyone who has bought shares in the last year is sitting on gains -- as a result, the "back to even" mentality is less of a concern than it would be for a name with a higher proportion of shareholders sitting on losses. That should help to accelerate breakout gains when buyers absorb that excess supply of shares at $70.
To see this week's trades in action, check out the Technical Setups for the Week portfolio on Stockpickr.
At the time of publication, author had no positions in stocks mentioned.
Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to TheStreet. Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes , Investor's Business Daily, and on CNBC.com. Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.