BALTIMORE (Stockpickr) -- Stocks sold off for the third straight day yesterday, probably a pretty unfamiliar sight to anyone who just started investing in the last year.
In fact, to find a much worse drop in the S&P 500 than the 3.1% decline over the last five sessions, you'd have to go all the way back to 2012.
A sudden slingshot higher doesn't look likely at this point. There's still room for stocks to slip lower before we even need to start worrying about the health of this rally. To skirt the selling, you've got to turn to the names that are showing signs of strength.
For the last few months, industrials have been one of the key bastions of strength in this market. That's why we're taking a closer technical look at five of them today.
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.
Without further ado, let's take a look at five technical setups worth trading now.
First up is homebuilder PulteGroup (PHM). In the last six months, this $7 billion builder has outperformed the S&P 500 by a factor of three -- and that makes it a serious relative strength winner to take advantage of for 2014. More on that in a minute.
In a nutshell, Pulte is showing traders a trading setup that's about as simple as they get. Right now, PHM is forming an uptrending channel, a bullish price setup that's formed by a pair of parallel support and resistance levels that PulteGroup has been bouncing between all the way up. When it comes to price channels, up is good and down is bad -- it's really as simple as that. If PHM can bounce for a fifth time off of support, that's our buy signal.
Relative strength is in a strong uptrend of its own right now (on the lower subchart). That fact makes Pulte statistically much more likely to outperform in the next three to ten months. As far as I'm concerned, relative strength remains the single most important indicator in any trader's toolbox while the market remains in correction mode.
We're seeing the exact same setup in shares of mid-cap composites maker Hexcel (HXL) this week. Like Pulte, Hexcel has been forming an uptrending channel with outstanding relative strength -- but HXL has been doing it over a much longer timeframe.
Shares are still a little bit above trend line support right now, but patience will be rewarded for waiting for shares to close that gap before jumping in. Buying off a support bounce makes sense for two big reasons: It's the spot where shares have the furthest to move up before they hit resistance, and it's the spot where the risk is the least (because shares have the least room to move lower before you know you're wrong). Remember, all trend lines do eventually break, but by actually waiting for the bounce to happen first, you're ensuring HXL can actually still catch a bid along that line.
Defense contractor L-3 Communications (LLL) has been another name that's delivered some strong outperformance lately. In the last quarter, the $9 billion firm has seen its share price move at six-times the speed of the S&P. That's some material outperformance during a time when gains were difficult to come by.
But the gravy train could be coming to an end in LLL. Here's why.
The pattern to watch in LLL is a "double top." Like the name suggests, the setup is formed by two swing highs that lose steam at approximately the same level. The sell signal comes on a move through support at $104, a price that's getting tested this week. If L-3 can't catch a bid at $104, it's time to sell (or go short).
Whenever you're looking at any technical price pattern, it's critical to think in terms of those buyers and sellers. Double tops and other pattern names are a good quick way to explain what's going on in a stock, but they're not the reason it's tradable. Instead, it all comes down to supply and demand for shares.
That support level at $104 is a price where there has been an excess of demand of shares; in other words, it's a place where buyers had been more eager to step in and buy shares at a lower price than sellers were to sell. That's what makes the breakdown below $104 so significant -- the move told us that sellers are finally strong enough to absorb all of the excess demand at that price level.
Don't get on the wrong side of the tape here.
Universal Forest Products
Things look a lot better in small-cap logging firm Universal Forest Products (UFPI). Universal Forest has been on fire for the last six months, driving 23.5% higher on a technical breakout back in October. Don't worry if you missed the move in UFPI -- shares are setting up for round two this week.
UFPI is currently forming an inverse head and shoulders pattern, a setup that indicates exhaustion among sellers. The inverse head and shoulders is formed by two swing lows that bottom out at approximately the same level (shoulders), separated by a deeper trough between them (the head). The buy signal comes on a breakout above the neckline, which is right at $54 for Universal Forest. Keep a close eye on that level in the next few sessions.
You don't have to watch UFPI too closely, though. Momentum, measured by 14-day RSI, should provide an early warning of a breakout in shares. Momentum has been bleeding off to neutral as the inverse head and shoulders in UFPI formed; look for momentum to break its downtrend right before this stock breaks out in price.
Last up is B/E Aerospace (BEAV), another inverse head and shoulders pattern -- but with a twist. Even though shares haven't looked particularly auspicious for the last two months, they've been forming an inverse head and shoulders with a downward-sloping neckline. Just like with UFPI, the buy signal comes when shares push through the neckline level, currently at $87.
It's critical not to try to be early to this trade. BEAV broke its medium-term uptrend when it started forming the inverse head and shoulders setup, so if the breakout never happens, it's just a run-of-the-mill trendline break (something you definitely don't want to own). If buyers can knock out the glut of selling pressure at $87, expect a significant leg up.
Lest you think that the head and shoulders is too well-known to be worth trading, the research suggests otherwise. A recent academic study conducted by the Federal Reserve Board of New York found that the results of 10,000 computer-simulated head-and-shoulders trades resulted in "profits [that] would have been both statistically and economically significant."
That's good reason to keep an eye on both UFPI and BEAV in the market sessions ahead.
To see this week's trades in action, check out the Technical Setups for the Week portfolio on Stockpickr.
-- Written by Jonas Elmerraji in Baltimore.