Defying The Divergences

09/28/04 11:22:25 AM

by David Penn

Everybody hates drug stocks. But for weeks, the pharmaceutical HOLDRS resisted succumbing to repeated negative stochastic divergences. At least, until now.

Security: PPH
Position: Hold

Back during the 1996 Presidential election, New York radio personality Don Imus featured a spoof of Bob Dylan's "Everybody Must Get Stoned" that had as its refrain: "Nobody Likes Bob Dole." Aside from the fact that the current Democratic nominee for that office, John Kerry, has been compared (unfortunately) with the 1996 runner-up, I found myself thinking of Imus's satirical cancion as I heard commentator after commentator urge investors to avoid drug stocks like, if you'll excuse the reference, the plague.

In the near term, it is hard to argue against the drug stock bears. The pharmaceutical HOLDRS (PPH) peaked out in January, falling almost 10 points from 84 to 74. After a rally going into June that retraced much -- but not all -- of the decline, PPH collapsed again, taking another 10 points off of the peak until it bottomed in August near 72.

Figure 1: After four consecutively lower stochastic peaks, a rising PPH finally gives in.

Graphic provided by: Prophet Financial Systems, Inc..

The August/September rally in the PPH has again seen a significant retracement of the previous decline (though not as significant as the bounce from earlier in the year). This rally/retracement has brought PPH back up above its 20- and 50-day exponential moving average (EMA) into September, but appears to have broken down once more, falling beneath both of those moving averages by mid-month.

This most recent decline was anticipated in some respects by the serial negative divergences between price and the stochastic. In fact, I'm having a hard time recalling a more extended series of negative stochastic divergences. PPH formed four consecutively lower stochastic peaks from mid-August to mid-September, and each one of those consecutively lower stochastic peaks was matched by a higher peak in prices for PPH. An incautious or impatient short-seller of PPH might likely have been repeatedly stopped out by the ability of the PPH to defy negative divergence after negative divergence.

The past few trading days may have broken the back of PPH, however, as the move below the 20- and 50-day EMAs will now turn those levels into resistance zones that will work to inhibit any price advance. Although deeply oversold based on the stochastic -- and while volume on this leg of the decline has remained modest -- it is hard to see how the PPH will avoid a testing of its year-to-date lows near 72.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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