This Diamond in the Rough is Set to Rally

Prognosticating on stocks in the wake of an election is fraught with peril for writer and reader alike. Just look at how the Dow Jones Industrial Average went from being down 800 points overnight to closing Wednesday up more than 250 points. That's some swing! 

However, the market seems to be adopting a new structure already as it anticipates what a Trump administration might bring.

Health care, the worst-performing sector since the summer by a wide margin, erupted on Wednesday. It was the second-strongest group of the day, behind only financials, and the only sector to change from strongly bearish to strongly bullish this week. 

President-elect Donald Trump has been quite vocal about repealing the Affordable Care Act, a move that is likely to favor drug companies. But I'll leave it to pundits to weigh in on the specific reasons why health care stocks, and pharmaceutical stocks in particular, are suddenly so in demand. 

I'm only concerned with the charts, and the SPDR S&P Pharmaceuticals ETF (NYSE: XPH) sported a gain of more than 6% on Wednesday. 

Chasing such moves is always risky, even when the market is not feeling the shock waves of the election. But traditional drug stocks as well as biotechs are likely to have the wind at their backs in coming months. 

To mitigate risk, I like to mine leading sectors for lagging component stocks that are just starting to show a little moxie. These stocks must prove that they are ready to catch up to their peers rather than just simply being behind in price, and Israel-based Teva Pharmaceuticals (NYSE: TEVA) is doing just that.

As we can see in the chart below, it's been a rough 16 months for the stock, as it slid from above $70 to below $40. 

Trying to bottom fish in TEVA proved to be a futile endeavor, but I see three reasons that suggest things have changed.

First, TEVA appears to have had a final washout last week in which the last remaining bulls threw in the towel. This is known as a selling climax, and it is clear on the charts as the price range and trading volume ballooned after a protracted bear run. 

The catalyst for the selling was news that that the U.S. Department of Justice was on the verge of issuing criminal charges against drugmakers for suspected price collusion.

However, drug stocks bounced the next day and held their ground into the election before taking off in the post-election rally. And even though Teva closed well off its highs of the day, it still ended with a healthy 3.1% gain.

The next noticeable change is that momentum indicators bottomed in October, and despite the big sell-off in TEVA last week, they set higher lows. That divergence with price action is bullish, as it tells us downside momentum is waning. 

Finally, all of this took place at major support from the 2012-2013 trading range. Basically, the entire bull run from 2013 to 2015 has been erased and investors essentially get to start over. 

To be sure, the official trend is still to the downside, and price action has not moved above any important moving averages. But sentiment in the stock has been extremely negative, and now that all of the bad news has likely played out, TEVA is ripe for a rally on any bullish news. Given the more favorable overall environment for pharmaceutical stocks, I think it's worth the risk.

Resistance doesn't come into play until we get above the $50 level, making the upside potential significant. The 200-day moving average should soon drop down into that same zone, making the target even more attractive. 

A move back below the bottom of the selling climax would negate the signal, so we will set our stop-loss just below the Nov. 2 low. And if you're interested in reducing risk even further, there is a "backdoor" method that could cut your dollar risk to a fraction of what it costs to buy shares. Learn more here.

Recommended Trade Setup:

-- Buy TEVA at the market price 
-- Set stop-loss at $37.75
-- Set initial price target at $50 for a potential 25% gain in eight weeks

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