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Sector Fires

by Ken Wolff and Shawn Wolff   July 2008

Since being evacuated numerous times from both of my homes in the mountains of northern California over the last few weeks, I have learned quite a lot about wildfire behavior, and discovered that some of the action we have been seeing in hot stock sectors is surprisingly similar.

Sector movements in stocks tend to run in cycles. Sparked by news, we will see sectors suddenly ignite, and the upward momentum snowballs from there for a time, until eventually dying off when the market loses interest and the next hot sector takes over. We saw this in metal stocks, like Nucor Corp (NUE) and Arcelor Mittal (MT). We saw this in solar stocks, like First Solar (FSLR), Canadian Solar (CSIQ), and JA Solar Holdings (JASO). And we also saw it in agriculture stocks like Monsanto Company (MON) and Potash Corporation of Saskatchewan (POT).

One important factor affecting the behavior of a wildfire is the topography of the land. Fires travel very quickly uphill, and the steeper the slope, the faster it burns. The reasons for this are, wind is usually flowing uphill, and the fire is preheating fuel up the mountain when the smoke and heat rise in that direction. Once the fire reaches the top of a hill, it slows down and struggles.

This is the same thing that happens with hot sectors. When they are hot, and there is news adding fuel to the fire, they are travelling uphill very quickly. During that time, they become my “focus” stocks.

If I am day trading, I will be trading those focus stocks every day aggressively, buying every dip and riding the uptrend. When they gap up, opening above the previous day’s closing price, I expect to see very minimal selling at open if the strength is continuing. So I will look to buy the first dip, and from there it should continue the uptrend, up above the open price, above the pre-market high, and eventually above the previous day’s high. Quite often they simply trend right up along the 50 MA. Any sign of weakness, and I will jump out again.

If I am playing a longer-term uptrend, I will usually go long the first day that the fire ignites, with a stop below that day’s low. I like to catch them bottoming after a longer downtrend, on a day when they close strongly, with an increase in volume. From there, I just keep trailing stops up, making sure it closes upper range, never letting it hit below the previous day’s low.

If you look at a daily chart of Vulcan Materials (VMC), it is a perfect example of what I am looking for. It had a steady drop over the last few months from around 84 to 50. Then it suddenly ignited at the bottom, with an increase in volume, and has been up trending sharply over the last few days from 50 to 65.

Unfortunately it came into my radar too far off the bottom for a longer-term trade. It has had some great intra-day swings though, so we have been playing this one for day trades. Yesterday it topped off around 65, dropped to 57, then bottomed and climbed again to 64. That is 15 dollars potential in one day if you time it right. Can’t complain there.

Eventually though, all fires start to die off once they reach the top of the hill, and that is when we want to change directions and start shorting. Sounds simple enough, but how do you identify when you are arriving at the top of the hill?

The first sign is often a disconnection between the hot sector and the high momentum stocks within the market. Apple Computer (AAPL) is a good example of a high momentum stock that has been generally participating with the market, often leading direction. So if I see AAPL gapping up, opening above the previous day’s closing price, and the market in general gapping up, that is a bullish signal for a potentially strong day. If I then see the leading stocks in my hot focus sector gapping down on that day, against the market, that is a disconnection, and the first signal of a dying fire.

The solar sector was a good example of this yesterday. Although the market was gapping up, we saw a disconnection in the solars, with stocks like JA Solar (JASO), and Sunpower (SPWR) gapping down, after the SPWR earnings report. SPWR had been rebounding in the last couple weeks, from 61 to 81, and JASO had climbed from 14 to almost 18, leading the market’s attempt at a rebound. But yesterday we saw the disconnection before the market open, which told me that rebound might be over, and I should short solars early.

The next sign of a dying fire is when we see the hot sector selling down more than the high momentum stocks. Let’s say AAPL drops from open 50 cents, bottoms and starts climbing, but at the same time I see the solars selling down double that amount, with weak attempts at bottoming. I would then consider them candidates for a short. And if they close the day down, that might be the top of the hill, and the start of a downtrend.

Even after fires have died down, they can smoulder for weeks, or even months. In Indonesia there are smouldering peat fires that have been burning underground for years, sometimes sporadically reigniting forest fires during dry seasons. The same thing can happen with previously hot stocks and sectors. So once the stock reaches the bottom of the hill again and starts to strengthen, we want to watch carefully to see if the fire will reignite.

A couple that I have on my radar for potential bouncing soon, for longer term trades, are Monsanto Company (MON), which has sold down from 145 to 112 in the last month or so, and Canadian Solar (CSIQ), which has dropped over the last month from around 51 to 30. Remember though, I am a daytrader, so longer term for me means days, not years.

CSIQ is still a bit early. It gave us a false alarm Monday after raising guidance, but it hit resistance in the daily chart right at the 50 MA. So it turned into a great daytrade, swinging from 35 to 39, but I wouldn’t want to hold it longer with that resistance directly overhead.

It is also very important to be aware of what is going on in the news, because news is what will ignite, or reignite, the sector fires. If oil is dropping, then solar stocks are probably going to as well. If there is flooding in the Midwest, you will want to keep an eye on the agriculture stocks. If hurricanes hit us, we will have a group of hurricane stocks in focus. If Mad Cow Disease hits our meat supplies, you will want to watch beef restaurant stocks. Keep lists of previously active stocks grouped in sectors. The point is to be prepared and aware, because you never know when lightning will strike and create the next fire.






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