The Yahoo Gap

10/24/05 08:56:42 AM

by David Penn

This is not a pipe ... and Yahoo is not Google.

Security: YHOO
Position: N/A

"This is not a pipe," wrote the celebrated deconstructionist philosopher Michel Foucault about a famous painting by Rene Magritte, "but rather a text that simulates a pipe." I have a similar sense of the "aesthetics of contradiction" when listening to a particularly famous former hedge fund manager encourage those who feel that they can't buy shares of Google to instead purchase shares of the former Internet search champion, Yahoo.

Maybe this is a great idea. All I've got to go on is a graduate education spent pondering the musings of far too many decadent French philosophers -- and the price charts of YHOO. And if the former is of little utility, the latter provides plenty of reason for pause before loading up the proverbial wheelbarrow with shares of Yahoo.

FIGURE 1: YAHOO GAP. The July gap in Yahoo is closed in October by a pair of candlesticks, including a shooting star in October.

Graphic provided by: Prophet Financial, Inc.

The positives for Yahoo exist. As the moving average convergence/divergence (MACD) histogram shows, October saw the continuation of the rally that began in mid- to late September. The sharp move higher in mid-October not only brought the stock convincingly above the $34 level, but it also served to close a gap that has persisted for months. The lower edge of that gap, in fact, provided resistance to at least three attempts by YHOO to move higher: once in the first half of August, again in the first half of September, and finally in the first half of October (Figure 1).

The MACD histogram also shows that there is significant bullish momentum in Yahoo right now. Even though the MACD histogram peak in the second half of October is lower than the peak in the first half (a point to which I will return shortly), there has not been much MACD histogram evidence at all of selling pressure. If anything, the dip and reversal in the histogram on October 17 signaled at least a short-term buying opportunity.

So why worry? There are a number of technical factors that traders looking to participate in Yahoo's autumn advance should keep in mind. The first is the gap mentioned at the outset. In two days near mid-October, buyers bid Yahoo with sufficient aggression to close a near $2 price gap. While we are reminded by Robert Edwards and John Magee in their classic tome, Technical Analysis Of Stock Trends, that demanding that gaps be closed by subsequent price action is often a losing case for the average trader, the two also point out that:

If you will think the matter over for a moment, you will see that the probabilities we have stated above for a gap's being closed apply just as well to a stock's returning to any price range at which it has once been traded, gap or no gap.

This means that while insisting that gaps must be closed is not a defensible position, it is as reasonable to speculate on prices retracing to a gap level as it is to speculate on their returning to a former support or resistance level, or a former breakout or breakdown level. Moreover, the way prices return (or, in other instances, do not return) to these levels can be indicative of future price action.

In the current context, those indications have a negative tint. The gap was closed by two candlesticks, a relatively bullish one and a decidedly bearish one -- that latter candlestick taking the form of a shooting star (Figure 1). The latter, shooting star, candlestick tends to represent exhaustion in the direction of the trend, which is upward in this case. With the subsequent day's price action also finding resistance at the $36 level (intraday highs on the shooting star day are what actually "closed" the gap), the argument that Yahoo will have difficulty moving significantly higher from current levels only grows.

In addition, there are negative divergences in both the MACD histogram and in the 7,10 stochastic. While neither of these indicators have turned downward, Yahoo's demonstrated difficulty in moving higher from its current levels (so far, at least) suggests that there might be something to the bearishness these negative divergences represent.

David Penn

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

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GAPS

The Yahoo Gap

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