Ominous Chart Pattern Predicts This Stock Is Headed For A Correction

Although Canadian bank stocks fared extremely well after the 2008-2009 financial meltdown, their current outlook is far less sanguine.

One stock that seems particularly ripe for a sell-off is Canada’s fourth largest bank by market capitalization Bank of Montreal (NYSE: BMO). The shares are inter-listed on the New York and Toronto (TSX) stock exchanges and can be easily shorted by U.S. investors.

BMO recently formed a bearish evening star candlestick pattern on the weekly chart and subsequently broke an important intermediate uptrend line. Both technical events imply the stock should correct substantially.

In addition, the fundamental outlook for BMO is cloudy at best. Earlier this summer, Moody’s Investors Service lowered the outlook for Canadian banks as a whole on the assumption that the Canadian government would pass legislation that would restrict government support to banks in a future financial crisis.  

#-ad_banner-#Under the legislation, senior bank debt would have to be convertible to equity if the bank were facing insolvency. According to Canadian Finance Minister Joe Oliver, the proposed legislation would help insure “bank shareholders and creditors bear losses, rather than taxpayers.” 

On Aug. 8, S&P echoed Moody’s move, downgrading its ratings outlook to negative on several Canadian banks.  

Several economic statistics also show Canadian consumers may be close to being tapped out, which would put pressure on loan demand and bank profits. A Royal Bank study showed the average level of Canadian’s personal debt (excluding mortgages) rose a staggering 21% in 2013 to $15,910.  

Canadian housing affordability is also in decline. In May, it was 43.2% for owners of detached bungalows. That meant 43.2% of all pretax income was necessary to pay down the mortgage and cover utilities and property taxes. For two-story homes, it was 49%. Declining affordability should negatively affect consumer mortgage demand from banks.

This troublesome environment may already have affected bank performance. BMO’s revenues have declined on a year-over-year basis for the past six quarters. And they fell nearly 3% from 2012 to 2013. BMO has managed to keep earnings relatively flat through cost cutting and because of a lower tax rate, but growth is lagging.  

The three-year chart below shows BMO appears ripe for a significant correction.

The S&P 500 made a significant technical bottom in October 2011 when it reached its nadir at 1,074.77. It climbed 85% to its current peak of 1,991.39 on July 24 in an almost straight line with very shallow corrections.

In contrast, BMO hit a low near $45 in October 2011 and then spent almost an entire year going sideways in a prolonged rectangle formation with strong resistance in the $54 area.

It finally broke through resistance in November 2012, advancing above $60 before retreating back toward $50 and bottoming in June 2013. From there, shares finally gained some traction, advancing to about $70 in November 2013, but then declined to key support around $59 in February.  

From this low, BMO moved higher in a near parabolic advance, peaking at an all-time high of $76.72 in July. 

The first warning sign of a significant correction occurred in July when BMO formed an evening star pattern on the weekly chart. The evening star is a three-candle pattern that comes after a sustained advance. The first candle was a large bullish white one, the second a small shooting star, and the third a bearish engulfing candle.

Then, during the week of Aug. 4, BMO broke the steep intermediate uptrend line from the February low, providing a second important technical indication the stock is poised to decline.

While there may be some support at the previous resistance level near $69, my suspicion is the next key support will be provided by the major uptrend line drawn from the June 2012 bottom. 

The rising uptrend line should cap any rally attempts in the stock. That trendline currently intersects near $74, but will rise over time.  

Based on the intermediate trendline break and uncertain financial outlook, I think BMO will make a good short. 

Risks to consider: BMO is trading at just over 12 times trailing earnings and has a trailing 12-month yield of almost 4%. Both should provide a floor under the stock during a corrective period. However, the broken intermediate trendline convinces me the stock should trade lower, and a pullback to the major uptrend line at $65 is a reasonable target. 

Recommended Trade Setup:

— Short BMO below $75.68 
— Set stop-loss at $76.05
— Set initial price target at $65.05 for a potential 11%-14% gain by late 2014

This article originally appeared on Ominous Chart Pattern Predicts This Stock is Headed for a Correction​

This Stock Is A ‘Buy’ Now
The super-accurate Alpha Score indicator just tagged this stock as a “buy.” In fact, it gave it a score so high, only 1 in every 1,275 stocks can match it. Get its name here for FREE, and see how you could make 83% gains in 28 days.