After what has been a near vertical rise from August lows, it looks like the general markets may be taking a break. The past few days have seen some distribution, and although the uptrend has remained firmly in place, it may be a good time to reduce long exposure. One way to do this is by increasing short exposure, and the best types of stocks to focus on in this case are stocks that have been unable to participate in the recent strength. This lack of participation shows an unwillingness on the part of institutional investors to back such stocks, even at a time when risk-taking is being rewarded.
Several stocks remain under important bases despite the strength shown by the general indexes. While many traders tend to attempt picking a top in runaway stocks, the safer play is to focus on stocks already showing weakness. Blue Nile (Nasdaq:NILE) is a perfect example of a stock that has been unable to make any progress even though many of its peers are outperforming. NILE fell under an important base in early August, and has been trading in a fairly tight range under this level since then. Every time it attempts to push back into its base, sellers step in. In fact, NILE still has an unresolved gap near $47.50 showing that sellers remain aggressive.
Urban Outfitters (Nasdaq:URBN) is another stock that has seen sellers overwhelming buyers even in a strong environment. URBN attempted to bottom after successfully holding support near $31 in September, but sellers quickly appeared near $35 and sent URBN back to the bottom of its base. The $31 level finally gave way, despite holding on several occasions over the past few months. This is now a key level to watch, as traders who were conditioned to buy this area are now under water.
Kirkland's (Nasdaq:KIRK) has been persistently showing weakness since May, despite being one of the better performers in the retail space earlier this year. Notice how sellers consistently appear as KIRK tests its declining 50-day moving average (shown in green). KIRK also broke down under an important support level in August on a high volume gap lower. Much like URBN, KIRK has been unable to make any headway back into its base or the gap. Sellers have begun to appear at even lower levels, and it appears that KIRK may be headed back to its September lows.
MEDIFAST INC Common Stock (NYSE:MED) has had a crazy ride in 2010 as it rallied from the $15s in February through the $37 level in May. Stocks that experience such a sharp run in a small time frame typically enter a wide consolidation as market participants struggle to find fair value. MED began this process in May and formed a symmetrical triangle pattern over the subsequent five months. However, rather than clearing the triangle and resuming its prior uptrend, MED has now broken under the triangle, which may be signaling a reversal. The $25 level is the area traders should focus on to see if MED can reclaim its base, or if it is in fact reversing on longer time frames.
The markets remain above support levels and continue to show strength. As such, it makes sense to focus mainly on the long side and remain aligned with the overall trend. However, traders should always be prepared for multiple scenarios, and with the markets showing a few warning signs, it remains prudent to have options in case things turn sour. Focusing on weak stocks should allow traders a larger margin for error if the recent strength continues, while still providing a great trading opportunity if the markets take a break.
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At the time of writing, Joey Fundora did not own shares in any of the companies mentioned in this article.