Summer Shorts: A Basket of Less than Desirable Stocks By: By Jeffrey A. Hirsch & Christopher Mistal | July 02, 2015 | Email | Print

I just updated my “count” on George Lindsay’s old Three Peaks and a Domed House Top Pattern (3PDH). While I am becoming increasingly concerned that the long averted 10% correction has even greater potential to occur over the next few months, I am not expecting a bear market to ensue just yet.

 

This illustration below of the potential current 3PDH is not what I believe. This is my interpretation of how 3PDH could play out should it continue. I think we are primed for a correction this summer or fall maybe ~10% give or take a few percentage points. But the U.S. market remains resilient. We are defensively positioned at the moment with solid positions on hold, tightened stops, and some downside positions. And today we present some overvalued weak stocks in weak sectors to consider shorting. 

 

 

The term “Three Peaks and a Domed House Top” is just an easy way to remember and recognize this recurring market pattern. Occurring at nearly every major U. S. equity market top, the pattern illustrates consistent market behavior.  The Domed House Top is akin to a head-and-shoulders top. 

 

The pattern describes how markets tend to come off a low and move up until a resistance point is reached (point 3). Then after two attempts to move higher (points 5 and 7) there is a sell-off to point 10. This is the “Separating Decline” that separates the Three Peaks from the Domed House. Point 10 is always lower than either point 4 or 6, often both. If is not lower it does not qualify and the pattern is nullified. The Domed House starts with a base between points 10 and 14. A rally usually ensues and forms another higher base (points 15 to 20, Roof of the First Story). Then from there the final surge to the high creates the Dome from points 21 to 25. The drop-off returns to the vicinity of point 10.

 

Lindsay based these formations after studying 150 years of market charts back in 1968. When looking at the point 23 dates in Lindsay’s original work we noticed that they all matched up with a bull market high in the Stock Trader’s Almanac (2015 page 131). Additionally, Lindsay stated that the pattern “may occur on either a major or minor scale. When it is of major scope, a typical formation begins at a bear market low.” 

 

Lindsay noted that minor and major formations of Three Peaks and a Domed House often overlapped with a Peak of one being a Dome of another. Sometimes Three Peaks followed a Domed House. Some tops could not be fit into the pattern and do not qualify. But Lindsay did find that, “…the market has followed [the formations] at least 60% of the time…” and that, “The majority of all major advances ended in a pattern which resembled the Three Peaks and a Domed House.”

 

 

This basket of 14 possible stocks to short spans the three market cap ranges in the Almanac Investor Stock Portfolio. There are three Small-Cap stocks (less than $1 billion), three Mid-Cap stocks (greater than $1 billion but less than $5 billion) and eight Large-Cap stocks (greater than $5 billion in value). Our screening process involved an in-depth review of fundamentals, such as revenues and earnings, valuation metrics like price-to-earnings and price-to-sale ratios, each stock’s technical situation as well as price and daily trading volume. Seasonally weak sectors, like materials, transports and cyclicals were also given extra attention and produced nearly half of the stocks in the basket. 

 

The broad criteria for inclusion on this list relied primarily on revenues and earnings (past and future estimates). Generally, stocks that are exhibiting decelerating, flat or negative revenues ranked high on our list of short candidates. From this batch earnings also needed to be decelerating, flat, negative or estimates are weak. Out of this trimmed list, stocks with elevated P/E and/or P/S ratios were retained. Finally share price and volume were considered. From a list of several thousand stocks, these 14 remained. There are worse stocks out there, but many of them had already fallen a substantial distance. Whereas, this basket still offers plenty of downside potential in coming months. Some are trading near 52-week lows while others maybe just a few percentage points off of 52-week highs. 

 

Be patient as the first half of July is historically bullish, but afterwards the worst-two-consecutive-month span, August through September, begins. Like past short trade ideas, there are two possible prices presented to establish a short position. The first is labeled “Short @ Resistance” in the table below. Should a stock rally toward this price then stall and loss momentum a short trade can be considered. Look for corresponding weakness by MACD, Stochastic and relative strength indicators to confirm. If a stock is shorted at or near the price in the “Short @ Resistance” column, use the higher stop loss adjacent. The second price to consider shorting the stock is listed in “Short on breakdown below”. This is the stock’s current projected support level. If the stock breaks support a short trade can be considered. If you short on a breakdown, employ the lower of the two stop losses listed. All 14 short stock ideas will be tracked in the Almanac Investor Stock Portfolio.