Choosing stocks isn't as simple as picking the ones with the best fundamentals. A sound base pattern is important, too.
Cup bases are the most common. They should look like a cup's silhouette — smooth and symmetrical, with a gradual decline on the left side followed by a similarly paced recovery on the right. These U-shaped patterns have a better chance of success than V-shaped bases.
Well-shaped cup bases form over a minimum six to seven weeks, enough time to correct and consolidate for a few weeks and shake out uncommitted holders. On the other hand, V-shaped cups correct too quickly and rebound too quickly, preventing the stock from laying a foundation for future growth.
V-shaped patterns typically form late in a market uptrend, or after a stock has already enjoyed a long run. They often take shape when institutional investors bail out of a stock, sending it lurching downward. Then a wave of less informed traders piles in thinking the stock is at a bargain price.
Warning signs include high-volume selling on the left side of the pattern as the big money exits, followed by low-volume weeks on the right side.
Tibco Software (TIBX) formed a pair of V-shaped bases starting in May 2011. At the time, earnings growth was strong, ranging between 31% and 36% over the prior five quarters. ranged from 17% to 23% over that period.
But the stock had already enjoyed a big run-up after clearing a nicely shaped base-on-base pattern in early 2010. Trading was tight as the stock climbed ahead of its 10-week line until it formed the first V-shaped base.
The first base corrected 24% over five weeks, (1) followed by three sharp weekly gains in heavy . But the stock rolled over, along with the general market, shortly after it broke out and cleared a 30.85 .
The second featured a deep 41% correction over six weeks, followed by a quick rebound off the bottom. But volume on the left side (2) was much higher than volume on the right, and trading was wide and loose. The stock cleared a 29.66 entry in the week ended Nov. 18, 2011.
Yet volume following the day dried up. The stock reversed and finished the week below the buy point. It then headed south even as the market trended higher. By Dec. 21, it dropped 32%. Tibco has traded mostly sideways since then.