The S&P 500 finally managed to close above the psychologically important round number of 2,000 last week. However, on both the daily and weekly chart, there is troublesome momentum divergence, with indicators such as Moving Average Convergence/Divergence (MACD) and the Relative Strength Index (RSI) at lower peaks than when previous new highs were reached. In other words, it is a challenging time to be a bull or a bear.
One way to trade this kind of market is to search for pockets of strength.
According to a recent Commerce Department report, new home construction rose nearly 16% in July to a seasonally adjusted rate of 1.09 million houses. Applications for building permits increased 8.1% last month to an annual rate of 1.05 million.
That leads me the country's leading home improvement retailers, Home Depot (NYSE: HD) and Lowe's (NYSE: LOW). Both companies recently reported sales and earnings growth for the second quarter. And while both look attractive at current levels, for my money, I like Home Depot based on its stronger second-quarter EPS growth, more optimistic full-year guidance and better-looking chart.
HD broke out last week after the company delivered an earnings beat. For the second quarter, EPS jumped 23% year over year to $1.52 compared with estimates of $1.45. Revenue rose 6% to $23.8 billion, also surpassing expectations of $23.6 billion. Comparable-store sales rose 5.8% from the year-ago quarter.
Management boosted earnings expectations for the full year by $0.10 to $4.52 a share, a 20% increase from the prior year and above estimates of $4.41 a share. It forecasted a 4.8% sales increase for the year, slightly above what the Street was looking for.
In the past two years, shares have gained roughly 65% and are trading near their all-time high above $92.
This advance has been punctuated by a long period of consolidation. After rocketing from around $55 to $80 in just nine months, HD became locked in a tight trading range with resistance near $80 and support a little above $70.
Earlier this month, shares bullishly broke out of an ascending triangle, which was contained within a larger rectangle. The peak of the previous resistance zone, just above $82, should now act as support.
Immediately after penetrating resistance, the stock soared 9% in one week following its better-than-expected second-quarter results. A large white candle formed on above-average trading volume, and it looks like we could be in the early stages of a bullish flag formation.
A flag is marked by a large bullish candle (the pole) and, typically, a downward sloping pennant. In this case, the pole is the rapid upward movement of the Aug. 18 trading week. If the pattern resolves as anticipated, I expect two to three weeks of slightly downward sloping consolidation, which will form the pennant and make for a good entry point. Once the pattern resolves, HD should move higher.
Analysts following the company project the stock could go as high as $104. At current levels, this represents 12% potential returns.
For the upcoming third quarter, scheduled to be reported on Nov. 18, analysts expect revenue to increase 5% to $20.5 billion. Earnings are estimated to rise 18% to $1.12 per share from $0.95 in the year-earlier period.
The company has announced it will repurchase $3.5 billion shares in the second half of the year, in addition to the $3.5 billion it purchased in the first six months of 2014.
Finally, shareholders are rewarded with an attractive $1.88 per share annual dividend, for a forward yield of 2%. The company has paid a dividend for 110 consecutive quarters, and it should help put a floor under the share price.
Recommended Trade Setup:
-- Buy HD at the market price
-- Set stop-loss at $82.23, just below key support
-- Set initial price target at $103.99 for a potential 12% gain by late 2014
P.S.-- Strong growth and promising technicals make Home Depot a smart investment. My colleague Amber Hestla has been making equally smart investments and it's not "dumb luck" that every one of her closed trades is a winner -- 52 trades, 52 winners in the past 12 months. Amber's strategy works. You won't want to miss her next recommendation.
This article originally appeared on ProfitableTrader.com: The No. 1 Home Improvement Retailer to Buy Based on the Charts