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Stock's Impending Breakdown Could Make Traders a Quick Profit

Serge Berger

In the past two weeks, both the materials and the industrial sectors (among others) have flagged negative divergences versus the S&P 500. In other words, while the S&P 500 continued its stampede higher, most recently led by defensive sectors such as health care and consumer staples, the more cyclically exposed sectors have lagged. 

In the chart of the Industrial Select Sector SPDR (XLI) below, we can see that it not only is close to breaking some near-term lateral support, but it is also on the verge of breaking its key November uptrend line.

XLI Chart

This impending weakness in the sector led me to search for individual industrial stocks with similar patterns, and in doing so, landed on machinery manufacturer Cummins (CMI).

Cummins' stock started displaying signs of fatigue in early February, as some concerning intraday trading action led to two sell-offs and subsequent bounces. 

CMI has been unable to work off overbought conditions in a healthy way, but rather, during the past two months, took its time to develop a meaningful top. And a break below key support at $111 in late February was the nail in the coffin of the October-to-February bull run, confirming the change in trend.

Currently trading just above $112, another break below the $111 area would almost surely send the bulls scrambling and the shorts chasing the stock lower. 

From a longer-term perspective, the stock displayed massive gains with the melt-up in most asset classes off the 2009 lows. In early 2011, its trading became choppier with multiple volatile swings, putting in a clear top in the first quarter of 2012. 

The weekly chart below shows three peaks (circles), the first and last of which came at lower relative highs versus the middle peak. It's too early to tell whether the stock will make another run at a new high over time or if the March 2012 highs will have been the best of times for the bulls. More intermediate term, though, a high-probability trade is setting up.

Cummins Stock Chart - Weekly

The daily chart below shows that CMI broke its October uptrend in February and, much like the industrial sector itself, has since carved out a topping pattern.

After two failed rally attempts during the month of March, the stock fell right back down to its support zone in April. A break below this lateral support would complete the topping process and likely accelerate the downside momentum for the stock. 

The support zone in question is around the $110.50-$111 area, which has been tested four times since the beginning of 2013. As I often point out, the more a level gets tested, the weaker it becomes as support or resistance. So with a fourth test of the support area, CMI increases its odds of dropping below it in a meaningful way. 

Cummins Stock Chart - Daily

At present, the support zone is also somewhat supported by the stock's rising 100-day simple moving average; however, historically, that moving average doesn't offer much support strength. Should the stock give us a daily break below the support zone, it may not take too long for it to test the 50% retracement of the October-to-February rally around the $104 mark, and potentially the previous breakout point around $102.

Recommended Trade Setup:

-- Sell CMI short at $110.50 or lower
-- Set stop-loss at $114
-- Set initial price target at $104 for a potential 6% gain in 2-6 weeks

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