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Know When A Good Stock Is In Over Its Head: A Deep Base

Instinct advises us to stay away from certain things in life. An overhanging precipice of snow, for example, while you are skiing. Or maybe that driver obviously struggling to hold his vehicle in its lane just ahead of you.

Here's another for the list: deep stock corrections.

A deep correction is a base, most often a cup-shaped base, that goes well beyond the healthy maximum of 35% span from left-side high to its low mark.

Why is this a problem

IBD research shows such bases are prone to failure. Part of the issue is just a matter of distance: a stock that corrects 45% must turn and climb more than 80% before it can even exit the consolidation. By the time it has a shot at a new high, the stock's run — more often than not — is exhausted.

In contrast, when you find a base that shows just a 19% decline from high to low, the stock needs to rise 23% to make a new high. That's more feasible.

During bear markets, even leading stocks may dive 50%. But don't mistake that correction for a base. Except in rare instances, the thing to do is wait for the market to shift into an uptrend, wait for the stock to climb at least 30%, then form a proper base.

In a bull market, leading stocks normally fall 1-1/2 to 2-1/2 times the depth of an intermediate market decline. Corrections of more than 2-1/2 times the general market's correction raise a red flag.

At the same time, don't always write off deep corrections. There are qualifiers and loopholes regarding the allowable depth of cup bases.

Some top stocks can dive as much as 40% to 50% in a bull market and still execute working breakouts. These are generally stocks with very solid fundamentals, products and market prospects. Early investors may have reached their targets and are exiting the stock, but ranks of new institutions may move in when the price falls low enough.

Look at Lumber Liquidators (LL) starting in July 2011. It corrected 50%, then built a and broke out into a winning run. The 50% number was 2-1/2 times the S&P 500's correction during the same period.

But that is the exception. Scan back through the IBD 50 or Your Weekly Review lists and you'll see that deep bases among leaders are actually hard to find.

Gold miner Randgold Resources (GOLD) slipped into a correction as the market trended higher in February last year. The market turned down a few weeks later and corrected nearly 11% over the next four months.

Randgold scooped out a 39% divot, beyond the 2-1/2 times limit. (Gold prices corrected 13.5% during the same period.) Randgold's base was orderly, and much of it occurred above the stock's 10-week moving average. The stock broke out in strong trade Sept. 14. But it rose only 7% above the before veering lower, and into a long-term correction.