Knowing when to purchase a stock is one of the most difficult decisions an investor can make. No one likes to see a company's stock immediately drop in price after buying and, while it may be the right decision in the long term, it isn't fun to see a loss in your brokerage account.
To help me decide when to buy stock, I include technical analysis in my decision process. Patterns tend to repeat in the stock market - giving us clues as to the future movement of a stock.
Right now, there's a clear technical pattern showing on the SPDR Health Care ETF (NYSEARCA:XLV) and two of its components. In addition, there's a third health care stock that, while not an XLV component, also has this same pattern on its price chart.
The Cup & Handle Pattern
One of the best-known technical patterns is the Cup & Handle. With this pattern, the price of a stock forms a bowl shape (the cup). Ideally, volume is higher on the right-hand side (where the stock price is moving up) of the cup than on the left-hand side (where the stock price is moving down). The increased volume is driven by institutional investors and it's these large investors that power major moves in stocks and ETFs. Individual investors simply don't have the heft to create large volume days on a given stock. This is why a pullback on light volume isn't necessarily bearish and why technical analysts use not only the price pattern of a stock but also volume pattern as a secondary indicator as well.
Having returned to its prior highs, often times investors will take profits at this point of resistance. This selloff (again, ideally on low volume, indicating that the institutions are maintaining their positions) is what creates the handle on the right hand side of the chart. At this point, all that exists is an unconfirmed Cup & Handle pattern. To confirm the pattern, the stock price needs to break above the prior high and continue upwards.
If this occurs, many investors and traders consider the pattern complete once the stock makes a "measured move." The measured move is calculated by taking the difference between the high and low of the cup. For example, if stock XYZ forms a cup & handle pattern where the high of the cup is at 90 and the low of the cup is at 80, the measured move would be 10 points. On a break above 90, stock XYZ would be likely (but not guaranteed) to move another 10 points to reach 100.
Let's look at the pattern on the chart of XLV:
I've annotated the chart a bit, but you can see the price since the August high fell as much as 13% before recovering to new highs in mid-March. Since then, the ETF price has pulled back about 2.6%, forming the handle portion of the pattern.
Note that this is currently an unconfirmed pattern. The pattern becomes confirmed after a break above the prior high of 76.47. Until then, the potential for a measured move exists, but shouldn't be acted on.
For XLV, the measured move is about 9.2 points (the difference between the closing high of 74.70 on August 1st and the closing low of 65.49 on November 3rd). This sets XLV up for a potential gain of as much as 12% - if the pattern is confirmed.
Three Dividend Growth Stocks with Cup & Handle Patterns
As I mentioned, there are three dividend growth stocks - all of which are S&P 500 Dividend Aristocrats - that have or are forming this pattern on their price charts:
ABT is the one stock of the three that is not part of the XLV ETF. However, the potential cup & handle pattern is clear to see on the chart:
Like XLV, ABT's pattern is unconfirmed. After becoming overbought on the RSI and Stochastics indicators, the stock has pulled back and is now showing as oversold on Stochastics and with a moderate RSI of 46. When a stock is in an uptrend, RSI values between 40 and 50 can be good places to take a position with lower risk.
ABT has a long record of dividend growth, with 45 years of increasing dividends under its belt. Dividend growth has been slowing however, as earlier this year the company increased its payout by less than 2% to an annualized $1.06. Abbott currently yields 2.39% and has a forward P/E of 16.
If confirmed, ABT's price pattern has a measured move of 7.3 points or 16% over the high of 45.84.
AbbVie - the 7th largest holding in XLV - was spun off from Abbott in 2013. As far as the Dividend Aristocrats index goes, it inherited Abbott's dividend growth history, making it the youngest Dividend Aristocrat. Since 2013, AbbVie has compounded its dividend payout by nearly 12.5% annually. This company focuses on pharmaceuticals, not medical devices and nutrition like ABT does. This gives ABBV a lower forward P/E of 10; this lower valuation is also reflected in the relatively high yield of 3.93% (the 4th highest among all Dividend Aristocrats).
The Cup & Handle pattern on the chart above isn't the best-formed pattern, but it does show the same high to the left of the cup, the bottoming in the middle and a run right back up to the same level on the right-hand side of the cup. ABBV's price movement is now creating the handle portion of the pattern. The stochastics are not yet oversold, meaning that we could see the handle continue to develop. A break above the prior high of 66.83 sets the stock up for a potential advance of 17.5%.
A note: In a previous article, I had noted that the stock's reaction to earnings did not bode well for the biopharmaceutical company. The stock price dropped 9% on earnings and had completed a bearish Head & Shoulders pattern, with the possibility of a further drop. My advice was to take a partial position for the then-current yield, recognizing that support lay about 4 points below the price at the time. In hindsight, it turns out that point was very close to the low on the current Cup & Handle pattern.
Johnson & Johnson (NYSE:JNJ)
With nearly 12% of XLV, JNJ is the ETF's #1 holding. JNJ's price pattern formed a Cup & Handle pattern, which was confirmed with a breakout on Election Day.
JNJ's price ran up about 4% and has since pulled back almost to the breakout point. This is not uncommon with a Cup & Handle breakout and provides a lower risk secondary entry point if you've missed the initial breakout. While there are no guarantees, it's likely that we'll see a bounce at the breakout point, particularly since the stock is oversold based on its stochastics. If the stock doesn't bounce and breaks back below the previous high of the cup, look for technical traders to sell, driving JNJ lower.
The measured move on JNJ's price pattern is more than 13 points, or 10.7%, to just shy of 136.
With 55 years of increasing payouts, JNJ is a dividend growth granddaddy. The company has compounded dividends at about 7% over the last 5 years and currently yields 2.57%. Like ABT, JNJ's forward P/E is around 16 - 17.
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Full Disclosure: I am currently long ABBV and may take a position in any of the stocks mentioned in this article in the near future.
Disclosure: I am/we are long ABBV.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.