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The health care sector has led the market decline over the past few days, but that's nothing new. It's been the worst performer so far in 2016, and it looks like it will continue to move still lower in the coming weeks.
The weakness in the sector is pervasive, hitting all subgroups, but drug stocks seem to be technically poised for a serious decline.
I've noticed a pattern in some of the biggest drug stocks, specifically Pfizer (NYSE: PFE) and Merck (NYSE: MRK), where they trade near their 52-week highs in a tight range or rectangle pattern, break out on news and then fail badly. Pfizer did this in July and has been falling ever since. Merck, on the other hand, broke out and failed just this week, so the jury is still out on that one.
A lesser-known drug stock is currently exhibiting the same pattern as Pfizer and Merck, which could result in a nice profit for short sellers.
Zoetis (NYSE: ZTS), which focuses on drugs and vaccines for pets and livestock, was actually spun off from Pfizer in 2013, so there's not a lot of history for chartists to ponder. But the short-term pattern of range, breakout and failure is quite clear, as is the break below the rising trendline drawn from March of this year.
Specific news events preceded Pfizer and Merck's reversals. But while Zoetis does not have a major news event, it has something its larger peers did not: falling cumulative volume ahead of its peak.
Cumulative or on-balance volume is a measure of volume changing hands on up days versus down days. Theoretically, it tells us whether bulls or bears are more aggressive, and, most of the time, it mirrors price action. When the two diverge, we get a good signal that the trend is about to change.
With Zoetis, cumulative volume has been falling while shares have been rising. This tells us the bears are selling, distributing their shares to supposedly weaker hands. Supply goes up, demand goes down, and that typically leads to a decline in price.
With Tuesday's big decline, Zoetis has already broken down below its 50-day moving average, ahead of its larger cousins during their patterns. However, ZTS bounced off the bottom of its two-month range, so traders should be aware that there is support at the $50 level. There was unusual options activity at the $50 strike as well.
Given the stock's failure to hold its breakout and the weak overall condition of the health care sector, it seems the writing is on the wall here.
Conservative traders may want to wait for a break below $50 support to sell given Tuesday's large drop. However, more aggressive traders can sell shares short now and add to their positions on a break below the $50 level.
The next important support is around $45.50, which is near the June lows, and that seems to be a compelling downside target.
Recommended Trade Setup:
-- Sell ZTS short at the market price
-- Set stop-loss at $52.75
-- Set initial price target at $45.50 for a potential 11% gain in eight weeks
-- Amplify those gains by 5-10 times with this "backdoor" method
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