Rob Hanna from Quantifiable Edges performed an excellent research on the short-term effects following downside acceleration. He tested a system than buys SPX at the close after 4 straight down days and the decline during the last (fourth) day is twice bigger than the preceding three. The system sells after x days, where x varies from 1 to 8. The positive expectancy of the system is excellent. Not only the reliability of the trade (% of time being right) is above 70% for all tested cases, but the average profit is more than twice bigger than the average loss. The nature of the trade is strictly short-term.
How come big acceleration in downside momentum often leads such reflex bounces? When the price of an equity reaches certain level of depreciation, it:
1. Attracts value investors.
2. The traders, who shorted it are afraid to give up their nice sized profit and are covering part of their positions.
3. Short-term traders are trying to trigger short-squeeze.
- Do not turn completely bullish or bearish on the whole market. Look at which sectors are bullish or bearish;
- When you see a move happening in a sector, act upon it immediately, irrespective of the overall market direction. But do not act the same way on other sectors;
- Confine your trading to prominent stocks in prominent sectors. If you cannot make money out of the leading sectors and stocks, you are not going to make money out of the stock market as a whole;
- At any time there are only 3-4 groups leading the market.
One of the most important observation of mine about the market is that even the worst stock in top sector will rally more than the best stock in lagging sector. Sector effect is as powerful as blowout earnings or relative strength.
I have always asked myself what could drive a stock to rise substantially in a short time frame. What makes a stock to appreciate 30, 40%+ in a month. The catalysts are different. Some are fundamental (earnings), other are psychological (technical). I found out that the majority of these fast riders belong to one of the following seven groups:
1. Stocks of companies that received an acquisition proposal at hefty premium. Unless you are an insider or possess extensive knowledge about the trends in a particular industry, your chance of catching such a move is close to zero.
2. Beaten down stocks to levels, where they become an appetite bite for value investors. Such stocks have very high short interest on their float. I believe that bottom fishing is for investors with huge capital base and very long-term investing horizon. For everyone else the probability of catching a bottom is minimal.
3. Recent IPO’s of companies with solid earnings and sales growth, belonging to a currently hot sector. Companies that have key role in core industries.
4. Stocks of companies that have recently received FDA approval for a promising drug.
5. Stocks of companies that have recently received huge order for their products.
6. Stocks of companies that beat the analysts’ consensus estimate (if there is one) by a wide margin. Such companies report triple digit quarterly EPS growth and significant rise in sales. They come and blow out all expectations for the future. Market tends to respond enthusiastically to such news, sending the price of a stock in the sky on monstrous volume. A triple digit earnings’ growth is not sustainable and rarely lasts for more than several quarters. All I care about is, that during this period the stock doubles, triples and quadruples. The initial reaction to earnings’ surprise is indicative for the potential for future price appreciation of a stock.
7. Stocks, belonging to currently hot sectors. What makes a sector hot? It all starts when a company from that sector comes and reports substantial earnings’ growth than is unexpected. The company says that is very satisfied with its current quarter result and it mentions that due to positive changes in its industry environment, it expects to post even better profit in the following quarters. What happens after that? It is very likely that Wall Street will bid up stocks of other members of the same sector, even when the fundamentals of those other members are far from impressing. Investors’ expectation for future earnings is a key here.
I have noticed that 70% of all stocks that experience big moves in congested time frames belong to the last two groups. This is where I focus.