Gilead's Head & Shoulders Top

08/26/05 12:22:34 PM

by David Penn

As signs of weakness emerge in biotechnology indexes, bearish reversal patterns appear in a number of biotech stocks.

Security: GILD, $BTK
Position: N/A

There is a certain paradox when it comes to top-down trading--trading that seeks to determine the general direction of the market or a key index and then drill into it to find stocks that are manifesting the behavior only hinted at by the broader picture. Often, by the time the focus switches from the market's big picture to the smaller one of the individual stocks in that market, those individual stocks have already been set in motion, reducing the number of ideal entry points available.

To a degree, this makes perfect sense. How else could the semiconductor stocks rally, for example, if it weren't for the fact that key or leading semiconductor stocks had already begun to move higher? After all, an index of semiconductor stocks is just that: a collection of semiconductor stocks. To expect the index to betray future price moves before the stocks within that index move is an unreasonable expectation.

Figure 1: Followthrough to the downside would help GILD reach the $35 price projection based on the size of its head & shoulders top and a breakdown level of about $42.50.

Graphic provided by: Prophet Financial, Inc.

I thought of this as I looked at the chart of Gilead Sciences (GILD) (Figure 1), a biotech company that has been a blessing to those investors fortunate enough to have accumulated shares this spring. Trading as low as $34 in March, GILD has gained a portfolio-pleasing 41% a mere five months later. However, in the later stages of that rally, GILD began to carve out the all-too-familiar designs of a head & shoulders top. The head & shoulders top is a bearish reversal pattern that is perhaps among the most commonly known and widely regarded of such patterns. It consists of three peaks, with the centermost rising significantly higher than the smaller ones to the left and to the right. The line connecting the lows that separate the left and right "shoulders" from the "head" is called the neckline, and may be sloped downward or upward (the latter being the case here).

As Figure 1 shows, however, the breakdown from this H&S top has been somewhat halting. Although sizable volume accompanied the initial break below the upwardly slanted neckline, prices have not made a similarly dramatic move to the downside as of yet. Because of this, I wanted to back up and take a look at the biotechnology index (with its topically unfortunate symbol of $BTK) to see if there was weakness in biotech stocks taken as a whole (Figure 2). If this were to be the case, if the $BTK revealed some weakness of its own--a head & shoulders top, a 2B top, a 1-2-3 trend reversal, and so forth--then the argument for weakness in GILD going forward would be fortified.

Figure 2: The Biotechnology Index or $BTK reveals both a 2B top (July highs versus August highs), as well as a negative stochastic divergence (also between the July and August highs).

Graphic provided by: Prophet Financial, Inc.

While still trading above its 50-day exponential moving average (EMA), $BTK is displaying tell-tale signs of weakness. The first sign of impending weakness for biotechnology stocks (seen through the lens of the biotech index) is in $BTK's 2B top. Compare the high in July with the one in August. $BTK makes a higher high in August vis-a-vis July, but then immediately reverses in a day that closes below the low of the day the July high was made. This, in short, is the 2B top reversal, and the inability of $BTK to follow through to the upside is what makes the 2B reversal so helpful in spotting turning points in markets.

The other sign of potential weakness in the $BTK comes in the form of a negative stochastic divergence. Again, note the July and August highs. Not only does $BTK make a higher high in August, but it does so at precisely the same time that the stochastic oscillator is making a lower high vis-a-vis July. As I have noted elsewhere, negative divergences do not necessarily lead to lower prices; sometimes, sideways price action will emerge instead--frustrating both bulls and bears. In the current case--given the 2B top--there is perhaps more likelihood that declines will take place rather than more sideways movement.

David Penn

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

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HEAD & SHOULDERS

Gilead's Head & Shoulders Top

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