Bread Breakdown

01/16/06 07:47:12 AM

by David Penn

A head & shoulders top threatens to send shares of Panera Bread Co. lower.

Security: PNRA
Position: N/A

One of my favorite television commercials involves the what can only be described as the "carbohydrate counterrevolution" as waged by fast-food franchise Jack in the Box. Starring "Jack," the franchise's fictional founder and increasingly popular "mascot," these commercials had the 6'8", 195-pound "Jack" leading an army of bakers on horseback, Braveheart-like, in a mock siege of "the bread bashers." "So let us make a toast — to toast!" Jack proclaims, as his baguette-wielding army charges across the screen.

FIGURE 1: PANERA BREAD CO., DAILY. A head & shoulders top in PNRA suggests a correction of some magnitude as prices break beneath the downwardly sloped neckline between 66 and 64. Note also the 1-2-3 test of the trendline. The break below the December low marked stage 3 of that 1-2-3 test.

Graphic provided by: Prophet Financial, Inc.

Well, if Jack and his army had a hard time catching up with their quarry, then they might have better luck searching for "bread bashers" in the market for Panera Bread Co. (PNRA) stock. For after a great advance during the seasonal runup that began in the autumn of 2005 — a runup that saw PNRA climb from just under $50 a share to over $72 a share in about three months — it now appears as if the stock is well under way toward returning those gains whence they came.

As Figure 1 shows, the agent of the current correction appears to be a head & shoulders top. While this head & shoulders top in Panera — with its left shoulder developing in the second half of November, the head over the course of December, and its right shoulder over the first week of January — does not display well the characteristic volume patterns of head & shoulders tops (namely, the higher volume on the left side of the formation), in all other respects the pattern appears valid. With a high point of 72 and a low of 66 in this downwardly slanted head & shoulders top, traders should anticipate a minimum downside to at least 60 before the correction has run its course.

FIGURE 2: PANERA BREAD CO., DAILY. The bearishness of the top in December was underscored by the negative divergence in the stochastic.

Graphic provided by: Prophet Financial, Inc.

I've written frequently about how indicators like the moving average convergence/divergence (MACD) histogram and the stochastic can be used to complement signals provided by chart patterns. Here, a negative divergence in the stochastic occurs just as the "head" of the head & shoulders pattern is developing in December. Sometimes, the signals provided by indicators anticipate those from chart patterns, allowing aggressive traders to take partial positions ahead of potential breakouts and breakdowns, or simply alerting more cautious traders to the increased likelihood that a certain market move will occur.

Per my trading methodology, the negative divergence created an offer at 68.47 as of the close on December 15 (Figure 2). This offer was hit on December 20, on a day that closed with the trade in the money at 68.46. The maximum pain (MaxDD) occurred a day later, as PNRA closed at 69.86, leaving the trade down 2%. The decline resumed immediately afterward, however, with PNRA falling to a low close of 65.68 as the head of the pattern was completed. Even the bump in early January didn't take the trade into the red on a closing basis, and the action since then has gone the way of the sellers.

David Penn

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

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HEAD & SHOULDERS

Bread Breakdown

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