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Educational Article

Predicting Sector Strength

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One of my market assumptions is that if a beaten down large cap stock in a certain sector gives a buy signal, then that sector might be in for an extended multi-quarter, even multi-year rally.

Just as there are many new uses for specialized chips, which help fuel the Semiconductor sector, so are there many new developments in biotech, such as tissue and organ regeneration, genome mapping, or new cures for cancer.

These sectors could be pre-eminent for the next decade because of all these new developments. In fact, one area to watch is the merging of these two technologies, such as Affymetrix (AFFX). An example of such "biochip" technology being developed by various companies is intraocular surgery for the blind, implanting a microchip that can "see" and transmits electrical signals that can be visually interpreted by the human brain.

Two stocks in late December 1999, alerted me to the fact that something major was going on in this sector. On 12/21/99, Genzyme (GENZ), gave a buy signal by closing above the 50 day moving average at the high of the day on double average volume, with follow-through the next day. This is a large cap stock that got clobbered, losing over 40% of its share price from its August 1999 high to the December 1999 low.

The second stock that gave a tell tale sign that something was going on in this sector is Gilead Sciences (GILD). Also on 12/21/99, GILD closed at the high of the day above the 4-day and 10-day moving averages on higher than average trade. Then on 12/28/99, it closed at the high of the day above the 50 day moving average on about five times the usual trade. GILD was a large cap in August 1999, but lost 50% of its value by December 1999.

Disclosure: I held positions in these two stocks, and they have been closed as of the time of this writing. Both options were double or better. And Gilead held up despite the market drop the first week in January. Genzyme dropped to break-even, but rebounded sharply by the second week.

Both trades are examples of low-risk entry points, because the downside is minimized, and the upside is maximized. Risk is also managed by being in the right sector at the right time.

These types of setups are usually optimal for 3-4 week trades. You can use a time stop, or a percentage stop of about 20% gain on the underlying, or a double or triple on the option. One such system trade, Enron (ENE) is up 30% in less than a month. Sometimes you take a trip but you may want turn it into a journey, i.e., turning a short term into a long-term trade.

One final note about the biotechs: they make great put plays when the market gets wobbly as it did in the first week of January 2000. Medimune (MEDI) can be a great moneymaker as the sell-offs are massive (40 points in two days starting 1/3/99). This is because the market makers and Electronic Communications Networks (ECNs) provide very little liquidity even though this is a large cap stock. If you have access to a Level II screen you will very often see 100 shares at each price level of the bid (left side). All it takes, then, is for a couple of traders to sell 1000 shares and a cascade effect takes place as more and more stops get hit!

Francis Chadwick
Research Analyst

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