#$pgf

The chart of a preferred stock ETF is demonstrating a potentially bullish cup-and-handle formation.

While most major averages continue to churn somewhere between their post-2015 downtrend lines and the 2015 highs, numerous bullish setups in individual names and sectors continue to pop up. By bullish “setups” we are referring to chart patterns that have reliably preceded upward moves in the past. Now, by “reliably”, we mean a majority of the time, not all of the time. Nothing works all of the time. However, there are identifiable patterns that suggest greater odds of further gains going forward on a particular chart. One of those patterns is a “cup-and-handle”, and we have identified a present example of it in today’s Chart Of The Day.

We’ve noted the characteristics of cups-and-handles and the potential theory behind their bullish implications in the past. Let’s reiterate those points as applied to the chart of the PowerShares Preferred Portfolio ETF, ticker, PGX (unadjusted for dividends).

The Cup: This phase includes an initial high on the left side of a chart (e.g., the 2013 high in PGX just over $15), followed by a relatively long, often-rounded retrenchment before a return (e.g., early this year) to the initial high.

The Handle: This phase involves a shorter, shallower dip in the stock and subsequent recovery to the prior highs (e.g., the January-May period in PGX).

Now, PGX may not be a textbook cup-and-handle pattern with the rounded cup. However, rarely does one find a perfectly textbook cup-and-handle, or other chart pattern for that matter -- except in the textbook. All we care about is whether the conditions satisfy the 2 criteria and, in our view, they do. 

The bullish theory is predicated on the idea that after taking a long time for a stock to return to its initial high during the “cup” phase, the “handle” phase is much briefer and shallower. This theoretically indicates an increased eagerness on the part of investors to buy the stock since they did not allow it to pull back nearly as long or as deep as occurred in the cup phase. Regardless of the theory, the chart pattern has often been effective in forecasting an eventual breakout and advance above the former highs.

How high does the pattern suggest prices will go upon a breakout? As we’ve mentioned before, we are not big fans of setting targets. We prefer to deal with price should it reach a certain level as opposed to expecting or relying on price to hit said level. That said, there are rules of thumb pertaining to how far price may go upon a breakout above the highs (i.e., top of the cup). Such targets vary between 50%-100% of the top-bottom range of the cup. In the case of PGX, such a move would be roughly a 6%-12% advance.

Now, you may be thinking that’s not much of a move to get all excited about. However, considering the very low beta in preferred issues, that’s nothing to sneeze at. Remember, preferred shares are a hybrid between stocks and bonds. They provide a fixed dividend that takes priority over payouts on common stock. And they are among the various higher yielding instruments that have successfully served as competition for low-rate fixed income securities for several years now. So a 6%-12% high-confidence move would be very welcomed indeed for an income-focused investor. Speaking of income, neither the chart, nor the 6%-12% take into account PGX’s hefty yield of 5.73%!

Theoretically, preferred stocks and funds should continue to do well under the perpetuation of the “lower for longer” interest rate policy. However, even if the Fed should surprise and hike rates in June again, it may not be a death knell for preferreds. If you recall, the last time we mentioned these issues was in late December following the last rate hike. That post pointed out that, following a brief, sharp dip by preferred issues coinciding with the rate hike, they wasted no time in recouping those losses, even moving to new highs in very short order.

So our advice would be, don’t sweat what the Fed is or isn’t going to do or say. Any pertinent data or events will be filtered through the market anyway. Focus instead on the action in prices and the market. There are still plenty of constructive price patterns to be found out there. That includes preferred stock funds, whose potential cup-and-handle pattern is likely preferred by 9 out of 10 stock bulls.

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More from Dana Lyons, JLFMI and My401kPro.

Contrary to the prevailing wisdom, preferred stocks have excelled since the Fed’s rate hike.

While listed as stocks, “preferred” shares are a hybrid between stocks and bonds. They provide a fixed dividend that takes priority over payouts on common stock. At the same time, they are highly sensitive to interest rates like bonds, i.e., as rates rise, prices generally fall, and vice versa. As such, the conventional thinking approaching the likely Fed rate hike in mid-December was that preferred stocks would suffer along with other higher yielding instruments that serve as competition for low-rate fixed income securities. Indeed, in the days leading up to the Fed meeting, preferred stocks sold off sharply as an impending rate hike became more apparent.

Then a funny thing happened. After the rate hike occurred, preferred stocks began to rally. And the development has even gone somewhat beyond the “sell the rumor, buy the news” stage at this point. Judging by at least one popular preferred stock ETF, the PowerShares Financial Preferred ETF (PGF), preferred stocks have actually moved to new 52-week highs. And bear in mind that this does not even adjust for PGF’s hefty 5.63% yield.

So what is the deal here? Why is this scenario not unfolding along conventional wisdom? Well, for one, financial companies do stand to benefit in some ways from rising interest rates. Therefore, perhaps that fact is countering the ill-effects of the rate hike on the competitiveness of preferred stocks’ yields. Further, while the Fed did hike the short-term Fed Funds rate, the jury is still clearly out on a rising longer-term rate environment. If longer-term rates remain subdued, the attractiveness of securities like preferred stocks could persist.

Regardless of the underlying fundamental “reason” that preferred stocks have jumped in the wake of the Fed rate hike, here is the real reason as we see it: it was the least obvious, most counter-intuitive reaction. As the old market bromide goes, “if it’s obvious, it’s obviously wrong.” And as unsatisfying an explanation as that may be for most people, it is an utterly reasonable and adequate explanation to us.

This touches on the very core of the investment process, which is determined by human natural reactions. And, at least in the investment world, human nature will invariably dictate that one do the wrong thing at the wrong time. So while we don’t know if preferred stocks will continue to do well going forward, we do know one thing.

In investing, when faced with going the obvious route or the counter-intuitive route, counter-intuitive is the “preferred” way for us.

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More from Dana Lyons, JLFMI and My401kPro.