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TIPS ON HOW TO TRADE AN EMERGING RALLY
March 21, 2016
Before jumping in with both feet, one of the confirmations that the market is indeed bottoming is for more stocks to set up behind the first wave of emerging leaders. During the first few months of a new bull market you should see multiple waves of stocks emerging into new high ground, while general market pullbacks will normally be contained to 3% to 5%. Many inexperienced investors will be looking to buy a pullback, which rarely materializes during the initial leg of a new powerful bull market, which from the onset will appear to be overbought.
Typically, the early phase of a move off an important bottom has the characteristics of a “lockout rally.” During this lockout period, investors wait for an opportunity to enter the market on a pullback, but that pullback never comes. Instead, demand is so strong that the market moves steadily higher, ignoring overbought readings. As a result, investors are essentially locked out of the market. If the major market indexes ignore an overbought condition after a bear market decline and your list of leaders expands, it should be viewed as a sign of strength. In order to determine if the rally is real, up days should be accompanied by increased volume while down days or pullbacks have lower overall market volume. More importantly, the price action of leading stocks should be studied to determine if there are stocks emerging from sound, buyable bases.
Additional confirmation is when the list of stocks making new 52-week new highs outpaces the 52-week new low list and starts to expand significantly. At this point, you should raise your exposure in accordance with your trading criteria on a stock-by-stock basis. As the adage goes, Its a market of stocks, not a stock market.
In the early stages of a market-bottom rally its absolutely critical to focus on leading stocks if your goal is to latch onto big winners. Sometimes you will be early. Stick with a stop-loss discipline, and if the rally is for real, the majority of the leading stocks will hold up well and you will only have to make a few adjustments. However, if you get stopped out repeatedly, you may be too early. If you get stopped out of a particular name doesn’t mean that you should walk away from the stock forever.
Often, a stock will create a “shake-out,” and then consolidate or “tighten-up” and then re-emerge. This is a phenomenon I refer to as a “Failure Reset.” The failure reset scenario sometimes happens when a stock establishes a base and makes a new high just as the overall market is beginning to correct. The stock usually falls back into its base while the market corrects. Now that stock will likely consolidate as the correction or bear market unfolds. Some stocks will consolidate in an even tighter fashion, which increases the probabilities of success. When the downtrend bottoms and the weight the market comes off the stock, it can fly right out again to new highs.
As you see a growing number of stocks emerging on the heels of the market’s leaders, you will start to observe what sectors are leading the market’s advance. Leading industry groups can emerge even while other stocks continue to make new lows during the initial upswing.
LEARN TO BUY STRENGTH NOT WEAKNESS
As a general rule, I buy strength not weakness. True market leaders will always show superior relative strength, in particular during a market correction. You should update your watch list on a frequent basis, weeding out issues that give up too much price, while adding through forced displacement new potential buy candidates that show divergence and resilience. In addition to keeping your lineup of candidate buys current, this practice will sharpen your feel for the overall health and quality of the market and keep you focused on the very best companies. Things begin to get exciting as the broader market indexes start to bottom and begin the first leg up in a new bull market.
At this point, you should concentrate on the new 52-week highs list. Many of the market’s biggest winners will be on the list in the early stages of a new bull market. You should also keep an eye on those stocks that held up well during the market’s decline and are within striking distance (5% to 15%) of a new 52-week high. Conversely, every day there is a list of stocks to avoid printed in the financial newspapers: the 52-week low list. I suggest you stay away from this list and all of its components.
If the market is indeed bottoming, a growing number of stocks will display improving relative price performance (relative strength) while they go through a comparatively tight price corrective process. Generally the correction for an individual stock from peak to low will be contained within 25% to 35%, and during severe bear market declines could be as much as 50%—but the less the better. A correction of more than 50% is generally too much, and a stock could fail as it reaches or slightly surpasses a new high. This is due to excessive overhead supply created by the steep price decline.
As the overall market is bottoming, your watch list should multiply over a number of weeks. The better stocks start moving into new high ground as the market rallies off its lows. This is a good sign that the market has either bottomed or is getting close to a bottom. This is a critical juncture. Each emerging bull market tends to send up its unique set of leaders. The leaders of the past bull market rarely lead the next rally, so expect to see some new and unfamiliar names. Less than 25% of market leaders in one cycle will generally lead the next cycle. Its important to recognize the new crop of top-performing companies and industries as early as possible. Remember: listen to what the stocks are telling you, not the pundits. This will be your best early-alert system.
The 95 best-performing stocks of 1996 and 1997 took just five weeks to surge 20%. On average, these stocks gained 421%. Among these 95 stocks, 21 jumped 20% within a mere week. Those went on to surge, on average, 484%. In 1999, many of the best stocks took just one week to run up 20%; some did it in a mere three days. All of them displayed superior relative strength before they advanced significantly.
FUNDAMENTALLY SOUND VERSUS PRICE READY
The fact that a company has met all of your fundamental criteria does not mean that you should necessarily run out and buy it right away. Even if your fundamental analysis of the company is spot on, to make big money, your analysis of investor perception also needs to be accurate and timed correctly.
Often a company will deliver one or two great quarterly earnings reports while the stock is still in a correction or consolidation. The stock price may have already run up in anticipation, and it simply needs time to digest the advance while earnings catch up, or perhaps the overall market is in a correction, holding it back. Be patient.
Keep the stock on your radar and wait for its price and volume characteristics to set up properly. The key to making big money in stocks is to align supporting fundamentals with constructive price action during a healthy overall market environment. You want all the forces behind you: fundamental, technical, and market tone.
A stock can be fundamentally sound but not price-ready, meaning that supply and demand dynamics have not yet established the line of least resistance. A good company is not always a good stock. It’s important that you learn to differentiate between the two. It doesn’t really matter what you think about a stock. What matters is
what big institutions think, because they are the ones that can move a stock’s price dramatically. Therefore, it’s your job to find the companies that institutions perceive as valuable.
After Dick’s Sporting Goods (DKS) issued positive guidance in early 2003, a strong response in its stock price put the stock on my watch list. Once it delivered the strong earnings promised and the stock held up technically, I moved its status up to buy alert. A few weeks later, constructive price action forged the setup I was waiting for, and I purchased the stock as it emerged from a proper consolidation.
SHOULD I STAY OR SHOULD I GO?
Here’s a recent question that came in from someone who read my book and sent me an email today. He asked: “How do you avoid giving back profits on market pullbacks like I am experiencing now?”
My reply: Take profits when you have them. Make a decision that you’re either a short-term trader or a longer-term “investor” – YOU CAN’T HAVE IT BOTH WAYS. You must sacrifice one for the other. When you finally decide to decide once and for all and make the decision as to what type of trader you are, your frustration will lessen and your performance will improve.
Trader or Investor?
The average trader spends the majority of his or her time vacillating between two emotions: indecisiveness and regret. This stems from not clearly defining one’s style.
Should I Buy?
Should I Sell?
Should I Hold?
I Should Have Bought
I Should Have Sold
I Should Have Held
The only way to combat paralyzing emotions is to have a set of rules that you operate from with clearly stated goals. You simply must make a decision: Are you a trader or an investor? Some people have a personality best suited for trading, and some prefer a longer-term investment approach. You will have to decide for yourself which is best for you.
Keep in mind that if you fail to define your trading, you will almost certainly experience inner conflict at key decision-making moments.
If you are a short-term trader, recognize that selling a stock for a quick profit only to watch it go on to double in price is of no real concern to you. You operate in a particular zone of a stock’s price continuum, and someone else may operate in a totally different area of the curve. However, if you’re
a longer-term investor, there will be many times when you make a decent short-term gain only to give it all back in the pursuit of a larger move.
The key is to focus on a particular style, which means sacrificing other styles. Once you define your style and objectives, it becomes much easier to stick to a plan and attain success. In time, you will be rewarded for your sacrifice with your own specialty.
Folks, you can’t have your cake and eat it too. You must make a decision and live with it.
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