The Decision Support Engine is on alert for a peak and reversal of the rally that began at least at the May 12 low near $77 if not the April 2014 low near $45. Early in Wednesday's session, shares were up 70 cents, or 0.8%.
History shows there are certain mathematical and statistical principles that can be applied to stock prices with higher-than-normal probability-ranked outcomes. One of these is that when a stock trades above or below its 200-day moving average, or DMA, by more than three standard deviations. The percentage of normality that is contained within three standard deviations is 99.7%.
The chart below shows how the DSE integrates standard deviations into its composite formula, which is represented vertically, rather than horizontally. As the chart shows, above 87.33 represents Facebook being priced by the crowd beyond the three-standard-deviation band that is calculated above and below the 200 DMA. In addition, it shows the two-standard-deviation bands, as well as the Bollinger Bands (shorter-term calculations of standard deviation extremes). Yellow boxes highlight each time in the past seven months that the price of Facebook was in the vicinity of the two-standard-deviation band, as well as when the stochastic study, in the lower pane of the graph, was in the vicinity of the 90% level.
As you can see, from a completely objective perspective, when these two conditions were met, holding a long position in the stock quickly became suboptimal, leading to declines of approximately 10%, 9%, and 11% in the eight weeks that followed. Certainly, there is no way to know for sure whether another decline of similar magnitude will happen. Tuesday's thrust went to a deviation extreme that should not be ignored -- three standard deviations, rather than only two.
The DSE never uses only one of its components to warn of a looming change in direction. But, when two give a similar warning, one must take note. And, when three do, one must take action (or prepare to). Here, the message is clear: With stochastics back above the 90% level, price above the upper Bollinger Band and price above the upper three-standard-deviation band, long exposure must be prudently reduced or eliminated.
Remaining long requires a disregard for the extreme rarity of a 99.7% normality test. In other words, you'd have to believe that "this time it's different" (the four most dangerous words in investing), and be betting that you can make money in the 0.3% of the bell-curve tail. "The market" has historically used these opportunities to teach late-joining bulls the meaning of the word humility.
Therefore, according to the DSE, several actions should be considered. First, protective sell stops could be set for the first closing price back below the upper Bollinger Band ($85.46 as of Tuesday's close). Second, additional sell stops could be set for the first close back below the upper two-standard-deviation band ($84.38 as of Tuesday's close). Third, aggressive traders could enter short positions on the first close back below the upper three-standard-deviation band ($87.33 as of Tuesday's close).
Once the peak is in place, a typical correction would be back into the zone between $55 and $72, which was the depth of the last "big" correction, back in early 2014, which occurred after a much stronger rise from late 2012, which only achieved a two-standard-deviation band extreme. This next correction could take prices back to around $55, plus or minus $5, which would be a haircut of nearly 37%.
So, if you are feeling like you are late to the Facebook party, and need to take action, consider the above with an objective mind, which is how the DSE looks at everything. Nothing personal, just business!
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.