One of the First Stocks You Should Sell in a Correction
Last week’s hawkish chatter from the Federal Reserve put the kibosh on the market’s advance. And although more soothing rhetoric doled out Monday sparked a rebound, the market could not sustain it, and stocks fell on Tuesday.
What was once a calm, serene market has turned stormy, and one of the hardest hit sectors, at least from a technical perspective, is the homebuilders.
It’s easy for bears to look at the year’s biggest winners and think that’s where the easy money is in a market correction. However, it’s rarely a good idea to bet against winning stocks such as Facebook (NASDAQ: FB), as they tend to remain in strong rising trends. It’s far better to look for sectors and individual stocks that have not fared as well.
Within the homebuilding group, I like Lennar (NYSE: LEN) for a bearish play, as the charts show the stock is poised for a double-digit drop.
Lennar has been floundering since March, and unlike the broader market S&P 500, it never eclipsed its 2015 highs.
As you can see in the chart below, the trading range formed over the past few months showed increasing uncertainty as the upper and lower borders started to converge. This suggests that neither bulls nor bears wanted to press their positions as time went on. It also left the stock in a low-volatility state.
Periods of low volatility usually give way to periods of high volatility, and that suggests a breakout. While the direction of that break was not indicated by the range, other technical indicators foreshadowed the breakdown that occurred last week.
First, as mentioned, Lennar had been lagging the broader market for months. This behavior is a classic sign of stocks that are likely to suffer the most when the market turns lower. After all, if a stock cannot keep pace with the market on the way up, then it will have little power behind it to weather a storm.
Next, at the bottom of the chart above, we have on-balance or cumulative volume. This is my go-to indicator. It keeps a running tab of volume on up days minus volume on down days and serves as a proxy for money flows.
Lennar’s on-balance volume is currently near its lowest levels of the year despite the fact that shares are 20% above their February lows. This indicates there was no money flowing into the stock. In other words, traders were using rallies to sell, not buy.
Finally, after breaking down below the bottom of its narrowing pattern on Friday, LEN now trades below both of its major moving averages — the 50-day and the 200-day. This tells us that the long-term trend is still down and now the short-term trend is changing for the worse.
There is short-term support near $43 from the bottom of the trading range in May and June. However, the long-term chart below shows stronger support at $37.15 from the February 2016 low and several lows set in 2012 through 2014.
This support level offers a compelling downside target that could provide shorts with a 17% gain over the next two months.
Alternatively, there is a “backdoor” method that could allow you to earn 5-10 times as much as a traditional short position, while taking on less risk.
Recommended Trade Setup:
— Sell LEN short at the market price
— Set stop-loss at $46.75
— Set initial price target at $37.15 for a potential 17% gain in eight weeks
— Unlock the “backdoor” trade here