Editors' pick: Originally published May 20.
Mr. Market giveth, and Mr. Market taketh away. That's the reality investors are facing in May. After a colossal rally from February's lows that peaked in mid-April, the last month has given back about 4% of the upside in the S&P 500.
In the process, the S&P has eroded all of its gains year-to-date, reversing from being up mid-single-digits back in April to slightly in the red this week. But while corrections can be frustrating for investors, the big ebb and flow in the S&P 500 isn't what you should be worried about. Instead, it's the "toxic stocks" -- the worst quintile of publicly-traded performers -- that you need to be worrying about right now.
That's because, while the S&P is down around 4% since April's highs, the worst 20% of stocks in the big index are down double that or more. Put simply, not owning the wrong stocks is arguably more important than owning the right stocks this spring.
The question that investors need to be asking themselves is: Which stocks are set up to be a drag on performance in the months ahead. And more important, do you own any of them?
To find the stocks waving red flags here, we're turning to the charts today for a technical look at five big stocks that could be toxic to own.
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 entry and exit points.
Just so we're clear, the companies I'm talking about today are hardly junk. By that, I mean they're not next up in line at bankruptcy court -- and many of them have very strong businesses. But that's frankly irrelevant to what happens to their stocks; from a technical analysis standpoint, sellers are shoving around these toxic stocks right now. For that reason, fundamental investors need to decide how long they're willing to take the pain if they want to hold onto these firms in the weeks and months ahead. And for investors looking to buy one of these positions, it makes sense to wait for more favorable technical conditions (and a lower share price) before piling in.
So without further ado, let's take a look at five toxic stocks to sell.
American Equity Investment Life Holding
No doubt about it, 2016 has been a pretty awful year for shares of American Equity Investment Life Holding (AEL) - Get American Equity Investment Life Holding Company Report . Since the calendar flipped to January, shares of American Equity have lost almost 40% of their market value, trailing the broad market by a wide margin. The bad news for American Equity shareholders is that this billion-dollar insurance stock could be ready to kick off a second leg lower in the weeks ahead.
American Equity is currently forming a textbook example of a descending triangle pattern. This price setup is formed by a horizontal support level down below shares at $13, and downtrending resistance to the top-side. Basically, as American Equity bounces in between those two technically significant levels, it's been getting squeezed closer and closer to a breakdown through support. If that $13 level gets violated, look out below.
There's an extra red flag showing up on American Equity's chart: relative strength, an indicator that measures American Equity's price performance vs. the rest of the stock market. AEL's relative strength line has been in a downtrend since last fall, signaling that this stock is continuing to underperform the rest of the market long-term. As long as that line keeps pointing lower, American Equity is positioned to keep underperforming.
We're seeing the exact same price setup in shares of beleaguered clean power generation stock TerraForm Power (TERP) - Get TerraForm Power, Inc. Class A Report . Like AEL, this $1.3 billion stock has been showing investors a classic descending triangle pattern, only TerraForm's price pattern is a much longer-term setup. For TerraForm, the big price level to watch out for is support down at $7.50.
Why all of the significance at that $7.50 level? It all comes down to buyers and sellers. Price patterns, such as this descending triangle setup in TerraForm, are a good quick way to identify what's going on in the price action, but they're not the actual reason a stock is tradable. Instead, the "why" comes down to basic supply and demand for shares of the stock itself.
The $7.50 support level in TerraForm Power is a place where there has been an excess of demand for shares; in other words, it's a spot where buyers have been more eager to step in and buy shares than sellers have been to take gains. That's what makes a breakdown below $7.50 so significant -- the move would mean that sellers are finally strong enough to absorb all of the excess demand at that price level. If $7.50 gets materially busted this, then Shake Shack becomes a sell.
Philip Morris International
Moving up the market cap scale brings us to global tobacco giant Philip Morris International (PM) - Get Philip Morris International Inc. Report . Philip Morris has actually had an attractive price run in 2016, up more than 11% since the calendar flipped to January. But traders might want to think about taking some of those gains off the table at this point because Philip Morris International is starting to look "toppy" here.
PM is currently forming a double top pattern, a bearish reversal setup that looks just like it sounds. The double top is formed by a pair of swing highs that top out at approximately the same price level. The sell signal comes on the violation of the price pattern's support level, in Philip Morris' case down at $96.
Price momentum is the extra red flag to watch in PM right now. Our momentum gauge, 14-day RSI, made lower highs on each of the two peaks in the double top pattern. That's a bearish divergence from price that signals buyers have been quietly fading in this stock. Remember, like with any technical price pattern, you want to be reactionary with the PM trade -- it doesn't become a high-probability sell until shares fail to hold $96 support.
$2 billion biotech stock Tesaro (TSRO) - Get TESARO, Inc. Report has been under pressure for a while now, selling off about 23% of its market value over the course of the last 12 months. The bad news for investors is that this stock isn't showing any signs of changing that primary trend in 2016. It doesn't take an expert trader to figure out what's happening here; the price action in Tesaro is about as basic as it gets.
Tesaro is bouncing its way lower in a downtrending price channel, a setup formed by a pair of parallel trend lines that have corralled most of this stock's price action since last summer. Every test of the top of the channel so far has provided shareholders with an optimal selling opportunity before the subsequent move lower -- and there's no reason to think that shares are going to act any differently this time around as they test resistance for a seventh time.
Waiting for this week's bounce lower before clicking "sell" is a critical part of risk management for two big reasons: It's the spot where prices are the highest within the channel, and alternatively it's the spot where you'll get the first indication that the downtrend is ending. Remember, all trend lines do eventually break, but by actually waiting for the bounce to happen first, you're confirming that sellers are still in control before you unload shares of Tesaro.
Last on our list of potentially toxic trades is $50 billion Chinese energy company CNOOC (CEO) - Get CNOOC Ltd. Report . CNOOC is another stock that's started the year strong, rallying 10.3% so far in 2016. But that rally is beginning to show some cracks thanks to a classic reversal pattern that's been forming in shares since March. From here, the sell signal comes on a breakdown through $112.
The bearish pattern in CNOOC is a head and shoulders top, a classic price pattern that signals exhaustion among buyers. The setup is formed by two swing highs that top out at approximately the same level (the shoulders), separated by a higher high (the head). The sell signal comes on a move through CNOOC's neckline at the previously mentioned $112 level.
Momentum is confirming the down move in CNOOC as well. 14-day RSI, our momentum gauge up at the top of this chart, made a series of lower highs on each of this stock's price peaks, signaling that buying pressure is waning in this stock. If this stock fails to hold a bid above $112, it's time to click "sell."
Disclosure: This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.