The price chart of Caterpillar (NYSE: CAT) looks in many ways like the price charts of many stocks here in the final trading days of January: sideways trading to end 2011, then a near-45 degree ascent (or steeper in many instances) as the stock rockets up from bear market territory with hardly a single meaningful pullback.
Caterpillar, which closed higher by more than 2% on Wednesday and is trading at its highest levels since the summer of 2011, will be among the stocks most closely watched over the next few days. Scheduled to announce quarterly earnings on Thursday, the exceptionally overbought condition of the stock means that traders should not be surprised if those long CAT when the earnings announcement is made decide that the time is right to lock in gains and take profits – regardless of what the news from Caterpillar actually is.
This, by the way, is why some stocks sell-off on good news rather than continue to rally higher. While good news in some stocks trading near signficant highs will drive those stocks higher still, it is often the case that traders in an overbought market will use “good news” as an opportunity to sell positions into strength, potentially even benefitting from positive slippage.
And the more overbought the market is going into earnings, the greater the potential temptation for traders to take profits. In the case of Caterpillar, we have a stock that has been trading in overbought territory since the beginning of the month. And while CAT has occasionally slipped out of overbought territory, the stock has only closed lower three times in the past 18 trading days.
Moreover, CAT has a “consider avoiding” rating of 2 out of 10, suggesting that the stock already has advanced to levels where traders historically have been more aggressive on the sell side than the buy side.
The potential for near-term weakness in Caterpillar, it should be said, does not represent an “all clear” signal for traders looking to sell stocks short. Rather, with CAT trading above its 200-day moving average, traders may be better off waiting for the stock to pullback significantly and, should the edges be significant enough, following both the stock and the overall trend higher.
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David Penn is Editor in Chief of TradingMarkets.com