To navigate the stock market today, investors tend to fall into two analytical camps; technical or fundamental. A fundamental analyst essentially believes that actual financial performance can help them determine the likelihood for future gains. A profitable company is likely to remain profitable in the future and its stock price should rise with that anticipated growth.
Technical analysts make an argument that anything that could be known about the fundamentals are already included in the price so the only thing that matters is the price trend of the stock. This isn’t that different from the primary assumption made by fundamental analysis. They are assuming that historical price trends (versus fundamentals) are likely to continue in the future.
It is pretty common for investors in either camp to dismiss the other’s analysis as nothing more valuable than “fortune telling.” However, actual historical statistics tell a different story. Trends aren’t random in the stock market today and, therefore, technicians have compelling historical evidence of the value of their methods. Similarly, indexes of profitable, fundamentally-stable companies are very tough to beat in the long run. The S&P 500 is a great example of a fundamentally-weighted index that the vast majority of active managers aren’t able to beat.
There is actually a small group of traders who fit into both categories. For example, although I am a member of the Market Technicians Association and have written two books on the subject, my education is in accounting/finance and I have written one book on the fundamentals of gold and gold stocks. I argue strongly that fundamental analysis contributes to more effective price-trend analysis and vice versa.
Historically, companies with growing top and bottom lines and a stable, positive price-trend outperform others. The fundamentals attract buyers, which makes it more likely that bullish price patterns will work out successfully. Technical analysis is beneficial as a way to determine how much and when to invest in a stock. If fundamental analysis tells you what to buy then technical analysis can tell you when and how much.
For example, almost a year ago we recommended UnitedHealth Group (UNH) because fundamental performance matched the positive technical trend. At the time, the stock was consolidating and looked likely to break out. The stock has moved higher nearly 50% since that time. We think that UNH is looking good again (technically and fundamentally) for another new entry or to add to the existing position.
UNH ran into trend line resistance in the mid-$70s through the fourth quarter of 2013. This can’t be much of a surprise considering the uncertainty around the ACA’s rollout. However, we still feel confident that healthcare spending will be on the rise over the next year or so. During this period, UNH maintained its strong fundamentals and has formed an inverted head and shoulders pattern. Once again the fundamentals are aligning with the technicals for an attractive entry opportunity.
The head and shoulders pattern is predictive enough that even the Fed admits that there is more to it than just some “technical voodoo.” The inverted version of the head and shoulders pattern is bullish and can appear at the bottom of a downtrend or as an interruption of an uptrend. Either way investors look to buy at one of two points – either at the initial break above trendline (the neckline) resistance or on a retest of the neckline as support.
United Health Group (UNH): Chart Courtesy of MetaStock Professional
As you can see in the previous chart, UNH broke above its neckline on Dec. 26, 2013, which is an attractive but riskier entry point in the head and shoulders pattern. If the initial breakout is weak, the price will return to the neckline where it may find support, which is called a “retest.” A bounce back up from the neckline is a strong confirmation that the bullish trend is intact and prices are likely to rise again.
The stock is currently sitting at the neckline and looks likely to bounce higher. Earnings will be released this week, which increases the risk of an entry at this point but we think it is worth it for the potential upside. More conservative investors playing the stock market today may want to wait for earnings to be released and then buy if the bounce remains intact.
Investors can establish a price target following the bounce that is based on the depth of the price pattern or the difference between the lowest point of the ‘head’ and the neckline. This pattern is $8 deep from the bottom of the head at $67 to the neckline at $75, which is then added to the neckline to create a short-term price target of $82 per share.
We recommend entries below $76 per share but not if the neckline is broken again following earnings. Stop losses can be set 3%-4% below the neckline but protective puts that expire this week may be more attractive for traders worried about the earnings report. That would allow you to offset most of the potential losses (outside the cost of the put) until Friday, Jan. 17.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.