Five ways to tell if a stock is about to take a dive

 

Last week I wrote about five characteristics of a winning stock, but as every seasoned investor knows, knowing when to sell a stock is just as important (some would argue more important), than knowing when to buy a stock.

Poor timing on an exit trade can be much more costly than poor timing on buying a stock, and a lot of profits can be left on the table if you miss the signs that a stock in your portfolio has started to run out of steam.

Taking this into consideration, this week we are going to look at five signs that a stock is running out of steam. Having a better understanding of the warning signs of a stock that is about to trade lower is a key ingredient to becoming a better investor, and will help boost returns down the road.

In some cases, it is not so easy to spot a stock that is losing its momentum, while in other circumstances, such as a big earnings miss, or weaker than expected earnings forecasts, it is easy to spot these stocks.

There is a wide-range of warning signs that a company can put off to signal rough times ahead. This week we will begin our discussion by taking a look at five signs that you can use as an indicator that perhaps it is time to exit a position or remove from your buy watch list.

Negative earnings surprise

A disappointing earnings report is a clear sign that things are not going as good as Wall Street expected for a company. A clear example is what occurred to Staples (SPLS) following its earnings miss in late-May. Looking at the chart below you can easily spot the point in May when the office-supply retailer disappointed investors with weaker than expected first quarter numbers. As you would expect, the stock got nailed following the news. Negative earnings reports are the easiest signal to spot, but they are the hardest to take advantage of because by the time you hear the numbers, the damage is already done. In the case of Staples, there is little you could have done to avoid the sell off. You could put in an order before the market opens to sell your position two or three percent below the previous close and hope to get lucky and blow out of the position on the way down, but that is difficult to do. In other cases, the selloff is less dramatic, and you are able to cut your losses without too much pain. The lesson here is that you should be aware of when you stocks report earnings. Set up some calendar reminders in your computer, or on your smartphone, or you could even have a spreadsheet your periodically check. If you can get the earnings numbers early enough, there is time to limit your losses in the event of a sell off.


Chart courtesy of stockcharts.com

Stock hits a double top

A double top is a chart pattern that stocks often form as they begin to lose their upward momentum. A double top occurs when a stock hits a high, followed by a little selling and then more upside. The key is that the second move higher hits a ceiling at or around the same level as the previous high before the stock once again moves lower. This is a major red flag, since it is apparent that Wall Street does not believe the stock warrants a valuation at that level. You can see an example of a stock showing a recent double top pattern in the chart below on Intuit (INTU). You can clearly see how INTU traded up to around $82 back in early March before falling all the way down below $73 before regaining its upward momentum. The stock once again traded up to $82 in early July, but appears to be coming down from that high. This is a warning sign that you should be able to spot and be aware of. It is still too early to know for sure which direction INTU is headed, but this double top  is a sign that the stock may be running out of steam. If I were a shareholder of INTU I would be watching this one very closely over the next few trading sessions. Should INTU break above $82, that would be a very bullish move, but if shares were to fall down to around $80, it would be a major bearish move, and I would lock in recent profits and look for a better place for my money.


Chart courtesy of stockcharts.com

Analyst downgrades / lower earnings forecast revisions

Research analysts are not perfect, and while they can make mistakes just as easily as you and me, whenever you see a downgrade, or a research firm adjust their forecasts lower for a stock, whether it be a lower price target or a lower earnings forecast, you should take notice. Consider a stock like Activision (ATVI), which has enjoyed solid gains over the last year. On July 7, S&P Capital IQ lowered its rating on the stock from 5 to 4 STARs, citing concerns over the stock's current valuation. In addition, it noted that the company's Chief Creative Officer announced plans to leave the company after 17 years, which S&P believes will be a big loss for the company. The downgrade knocked the stock down from its 52-week high, and could be a sign that the stock is about to give back some of its recent gains. Use the downgrade as an excuse to do a quick review of the stock, and you see it has risen to a P/E of 25.3, which does appear to be slightly high for the stock. Time will tell if Wall Street agrees that the stock has entered overbought territory, but the downgrade is a clear sign that at least some analysts have begun to express that opinion.


Chart courtesy of stockcharts.com

A clear technical breakdown

Some traders do not place a lot of importance in monitoring a stock's technical trends, but I for one do. I believe that you can use a stock's chart to predict a stock's future movement if you know what you are looking for. One thing that you never want to see is a “gap down” open. This basically occurs when something bad happens between one day's close and the next day's open, which causes the stock to open sharply lower from its previous closing price. This is a sign that something has gone horribly wrong with the underlying business. Unfortunately, this is nothing that we can predict as traders, but when you see it happen, you should be aware that something is wrong, and you may want to quickly move to lock in any gains you have made on the position. This recently happened to Delta Airlines (DAL), when the stock opened trading on July 8 down 3.5%. The move came in reaction to concerns over currency restrictions in Venezuela, where the company already cut back 85% of its flights last quarter. In addition to gapping down at the open, the stock also fell below its 50-day moving average. Both of these put together paint the picture of a fragile stock that Wall Street will be quick to abandon on the first sign of trouble. These are not stocks you need to have in your portfolio.


Chart courtesy of stockcharts.com

Unreasonable valuations

A general rule of thumb in investing is that stocks want to be priced at their fair value. The hard part is determining what a stock's fair value is, but one way to figure out whether a stock is above or below its fair value is to compare its price-to-earnings ratio to other stocks within the same industry or sector. One thing to always keep in mind, is that stocks with strong forecast earnings growth can warrant a higher valuation since traders price that future earnings growth into the stock, but when you see a high valuation, and low anticipated earnings growth, it is a sign that the stock may be running out of steam. Take for example Prudential (PRU), the stock has made a strong move to the upside in recent months, but at its current level, the stock has a price-to-earnings ratio of 32.5, which is sharply higher than its competitors. American International Group (AIG) has a P/E of 9.5, and MetLife (MET) has a P/E of 17.5. In addition, Prudential does not have the best forecast earnings growth, with analysts expecting earnings growth of just 7% in 2015. By comparison, AIG is expected to grow earnings 13%. We are already seeing signs that PRU may have lost its steam, and with such a high valuation, the stock could easily begin giving back some of its recent gains.


Chart courtesy of stockcharts.com

Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.


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Michael Fowlkes

Michael Fowlkes

Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.

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