Why Flawed, Deep Bases Worked In Covid Bear Market

The summer 2020 breakouts for Tesla (TSLA), LGI Homes (LGIH) and Lam Research (LRCX) should have never worked. Yet, all three stocks’ breakouts were a success despite a glaring flaw in their bases.

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These and multiple other growth stocks earlier this year formed excessively deep bases, with declines from prior highs of more than 40%, 50% or even 60%. The problem with these chart patterns is that stocks have to work that much harder just to make up for recent losses. A stock that falls 30% has to bounce 43% to recover all losses. But a stock that falls 50% has to double.

That’s why proper bases — normal price declines that occur over a number of weeks or months — should show a decline of no more than 30% or 33% from the high. Yet last year, breakouts from much deeper bases worked about as well as those from shallower bases. Have the rules changed?

No, they haven’t. Rather, what we’re seeing is normal behavior for a bear market, plus some effects of the historic coronavirus market.

In weak market conditions, it’s normal for growth stocks to fall 1-½ to 2-½ times what the market averages do. A 20% market correction, for example, would mean many growth stocks will decline 30,% 40% or 50% during their base building. Yet the fundamentally strong companies have proven their next breakouts can work fine once the market is rising again.

Stock Charts In Bear Markets

“Your best choices are generally stocks with base patterns that deteriorate the least during an intermediate market decline,” IBD founder William O’Neil wrote in “How to Make Money in Stocks.”

“Whether you’re in a bull market or a bear market, stock downturns that exceed 2-½ times the market averages are usually too wide and loose and must be regarded with suspicion,” he added.

LGI Homes plummeted 65.5% from its Feb. 21, 2020, peak to the low on April 3. Homebuilders were hit hard as the pandemic took millions into the unemployment rolls. But extra-low interest rates helped the industry recover. LGI made up all of its losses and broke out of a handle buy point at 95.34 on July 7, 2020.

The Leaderboard stock climbed as much as 30% before giving back some gains. D.R. Horton (DHI) plunged nearly 60% in the bear market but still is rising from a buy point around 60.

Chip-equipment maker Lam Research tumbled 47% during its February-March 2020 sell-off. Shares climbed as much as 25% from a 310.10 cup-with-handle entry.

Quite a few other semiconductor stocks fell 40%, 50% or more and broke out successfully.

ASML (ASML) reached a 20%-to-25% profit target from its 319.32 buy point.

Stock charts and bases largely are a reflection of the broad market, and the historically steep decline and rapid recovery resulted in many V-shape bases. That’s considered a weak formation, but in the 2020 market those types of bases still worked.

KLA (KLAC), Tesla and PennyMac Financial Services (PFSI) were some examples.

This article was orginally published Aug. 14, 2020. Juan Carlos Arancibia is the Markets Editor of IBD and oversees our market coverage. Follow him at @IBD_jarancibia

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