Have The Internets Hit Bottom?

02/09/05 10:08:44 AM

by David Penn

Strength in mid-February could anticipate a positive stochastic divergence.

Security: HHH
Position: N/A

There's no denying the beatdown the market has administered on the Internet stocks of late. The Internet HOLDRS were off more than 20% from their early 2005 highs. While Google remained upright--if unable to advance--stocks like ebay, Amazon.com, and Yahoo! have been battered over the course of the first six weeks of the year. Lesser stocks in this cohort have fared as badly or worse.

But there are signs that the Internet sector may be close to putting in a bottom. Using the Internet HOLDRS as a proxy for the group, we can see a number of technical factors--from a potential sellout day to a developing positive stochastic divergence--that suggest that the correction these stocks have been experiencing for the past six weeks may be coming to an end. If that were the case, and if Internet stocks were to begin moving higher, then this bullish news for the broader market would be hard to ignore.

Figure 1: Drifting lower since a gap down on big volume in mid-January, the Internet HOLDRS dip a few cents lower toward a potential positive stochastic divergence in mid-February.

Graphic provided by: Prophet Financial, Inc.

First the downside: What has been tricky about the end of January bounce is that not all of the various equities markets have shown the sort of positive stochastic divergence that is often the sine qua non of true bottoms. And unfortunately for Internet bulls, most of those markets with positive stochastic divergences consist of larger, blue-chip stocks. The Dow Jones industrials and the Standard & Poor's 100 and 500 indexes all had clear positive stochastic divergences in January, while neither the Nasdaq Composite nor Nasdaq 100 did.

While this doesn't mean that the Nasdaq indexes won't continue to move higher, it does keep their February bounces under a bit of a cloud. For example, as the Nasdaq struggles to remain above its 10- and 50-day exponential moving averages (EMAs), the S&P 100, a fair sampling of blue chips, looks to make a new high for the year.

But there are a number of positive for the Internet stocks--which can only be a bullish thing for the Nasdaq. First, there are a number of Internet stocks that have held up while many others continue to lag. These are stocks that are likely to move higher faster once the correction runs its course.

Second, the stochastic in the Internets has continued to make lower and lower troughs since mid-December. However, it appears that in February the HHH stands a good chance of making the first higher stochastic trough in months. If this higher stochastic trough does develop while the Internets are making a lower low, then the positive stochastic divergence will be intact, setting up an opportunity to buy the HHH at its discounted price. While confirmation would probably require a move above the 60 level, there could be an entry as low as 58, depending on the close that the day the positive stochastic divergence is complete.

Third, there are a number of smaller things that underscore the argument for a reversal in the Internets. The group is very extended to the downside--the gap between the 10- and 50-day EMAs is wider than it has been at any time since before September--and it is hard not to suspect that the Internets won't bounce back. There also appears to have been a washout-selling day back in mid-January. That huge volume spike on the gap down day likely drew a tremendous amount of those interested in selling these stocks off the benches and into the game. And it is often in the wake of such selling frenzies that buyers, however ready to retreat at a moment's notice, step in to turn losers into bargains.

David Penn

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

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