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Guest Blogger Mishlove: "Surfing" For The Right Dip

Guest blogger Jeff Mishlove is back--with more insights for you contest players. He's called this piece, "Surf the Waves and Buy the Dips." Here it is: You don’t have to live in California or Hawaii to surf the stock market. And, you can buy the dips without worrying about consuming too many calories or grams of fat. In fact, during the heyday of the 1990’s internet bubble, the rallying cry was “buy every dip!” And, it worked very well – until it stopped working almost completely for a few years. Today, we are in an era where this strategy can make money. The key is to find stocks with strong, positive momentum that have experienced a pullback. Here’s a recent example:

Symbol
Price
 
Change
%Change
PAA
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This is a chart of Plains All American Pipeline, an oil services company. Naturally, there’s a lot of momentum. Oil prices are rising. The summer driving season is about to begin. And, there’s concern about the safety of the middle-east oil supply. Still the stock has experienced a pullback. In fact, it dropped 2.16% on Friday. And, since there are no news stories to explain this drop, the logical explanation is that this is simply the result of traders locking in their profits – thus creating a buying opportunity. Since the short-term momentum is dramatically down, it may be worth watching this stock for a few more days, to find the ideal entry opportunity.

This particular situation is not one in which we’re likely to see a 10% price increase in a single day – as has been the case with some of the short squeeze plays I described in my blog for CNBC last Thursday. But, it is a pretty good bet that this company will see higher prices. Not only does this stock have good momentum; but, from a valuation point of view the price/earnings ratio of 19.98 is below that of the industry and of its main competitors. So, the stock is an attractive buy in general.

Here’s another recent example of a pullback buying opportunity:

Symbol
Price
 
Change
%Change
AXL
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This is a three-month chart of American Axel and Manufacturing Holdings, Inc.,. There is not only good momentum, but one can see some very strong single-day gains. Why? This stock has potential both because of the pullback, and also as a short-squeeze play. (The short-sellers assume that the American automobile industry will continue to decline. And, AXL’s biggest customer is General Motors.)

The stock float for AXL consists of 42,650,000 shares. Of these, approximately 9,707,400 shares or 22.77% of the float is in the hands of short-sellers. Given the average trading volume of 1,300,200 shares, it would take the short-sellers seven and a half days to cover their positions should they choose to do so. More likely, however, in the event of continued upward momentum, the short-sellers would attempt to liquidate their positions quickly, thus causing a dramatic rise in price. It’s also worth mentioning that UBS Investment Research recently suggested that AXL had potential as a merger or acquisition candidate. They put a target price on the stock of $31.

A third example of a pullback buying opportunity is illustrated in the following chart:

Symbol
Price
 
Change
%Change
NRG
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This is the chart of NRG Energy, Inc., an electric utility that owns nuclear reactors and operates internationally. NRG just released its annual financial statement over the weekend. This is a company that has been growing at a rate of over 21% per year for the past five years. And, future prospects continue to look strong, according to analysts for the utility industry in general – and even more so for NRG. Nevertheless, I would expect Friday’s 2.32% pullback to continue – especially because the company reported a fourth quarter loss of $0.37 per share. Analysts had been expecting a profit of $0.45 per share.

How can you determine when a pullback has reached its course, and the stock price is ready to regain its former upward momentum? Here’s a good rule of thumb: Draw a trend line just above the daily highs of the pullback. This line represents the level of resistance to higher prices. Once you see that a daily bar has completely broken through the resistance line, it’s a good bet that prices will move up rapidly.

The momentum strategy that I am describing here is consistent with the well-known trader’s maxim, “the trend is your friend.” It is also quite consistent, in a general way, with the Elliott Wave Theory notion that each trend can be broken down into five distinct waves. Elliott Wave practitioners often disagree as to how these waves should be counted. But, the general principle to remember is that trends do persist – in spite of pullbacks.

This is the fundamental principle behind a software package for traders known as Advanced GET. (The E in GET stands for Elliott.) Readers of the magazine, Technical Analysis of Stocks and Commodities, have for many years ranked this software as among the very best. Another interesting new service for traders and investors that utilizes this very same principle is called Dynamic Trend Profile. Tom Joseph, the creator of Advanced GET, also developed this system.

Incidentally, how can you determine whether an apparent trend is really a bubble ready to pop – such as the internet bubble in early 2000? Look for a dizzying vertical spike known as an “exhaustion peak.” The chart below, of Beazer Homes, illustrates what I mean:

The precipitous, near vertical price jump in November 2005 was already showing signs of being an exhaustion peak. Although the stock peaked again, for the last time, in January 2006, it was quite clear to almost all chartists that such an upward trend had reached its limit. Now, however, BZH is a very good “bottom fishing” turnaround candidate. That discussion, however, will have to be the subject of another blog.

So, by learning to recognize these patterns, you can surf the stock market without getting sand in your shoes. And, buying the dips can fatten your portfolio rather than your belly.

Jeffrey Mishlove is the creator of www.forecastingsystems.com. He is a registered Commodity Trading Advisor. He received his PhD in parapsychology from the University of California at Berkeley in 1980.

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