When Is A Stock Considered Broken?

My friend, Phil Pearlman asked a bunch of prominent traders “How do you know when a stock is broken” and since the good doctor shrank my answer for presentation purposes, I decided to post it here in its entirety:

Don’t forget that one investor’s garbage could be another investor’s treasure, so the whole concept of a “broken” stock is very subjective.

With that in mind, a good rule of thumb is:

1) Stocks that are making new 52-week lows during bull markets are usually there for a good reason. Stay away from them. If a bull market cannot lift them up, there is an inherent weakness that is not fixable or discountable overnight. Example – coal and gold miners over the past 2 years. Stocks don’t just switch from a state of being in a downtrend to a recovery mode just like that – there is a long, boring period of accumulation in between; therefore don’t worry that you are going to miss the bottom. You want to miss it. There are always better places to allocate your capital.

2) When a momentum high-flyer breaks its uptrend, it is in a no-man’s territory – a place, where momentum investors are gone or short; also a place, where value investors are not interested yet. There are no motivated buyers and the number of sellers increases with every downtick. When a momentum leader closes below its 50-week moving average, consider it a a big warning sign. $AAPL did that in November 2012, when it was trading at $550. It went below $400 in the following 6 months.

I wrote on the subject last year too: This is How Upside Momentum Often Ends

Think Different

There is a saying that in the stock market, the obvious rarely happens and the unexpected constantly occurs and it is true. The market could be quite counter-intuitive sometimes. The biggest opportunities are often disguised and exist in industries most people are not willing to touch.

In 2012, the conventional wisdom was to stay away from all Chinese stocks. Their economy was slowing down. Their stock market was a mess. Their earnings numbers were questionable. As a result, only two Chinese ADRs made their debut on U.S. exchanges that year: Vipshop Holdings ($VIPS) and YY Inc. ($YY). Both of them formed solid technical bases, broke out to new all-time highs and never looked back.

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Don’t assume that you know everything. The market is frequently a lot wiser than you and discounts events and processes long before they become mainstream. It doesn’t hurt you what you don’t know, but what you think you know when it isn’t so. Don’t let your biases blind you. Pay attention to price action.

The best performing stocks in any given year are the ones that surprise the most, which means that they are very likely to come from industries no one expects. In late 2011, housing related stocks started to clear 52-week highs. No one believed, because of their horrid performance in the previous few years. They ended up being the hottest sector in 2012. In early 2013, solar stocks started breaking out to new 52-week highs. No one believed. In most people’s minds, they were garbage that should not be touched. Many of them tripled in a few short months.

Every trend needs skeptics and doubters. Otherwise there won’t be anyone left to buy. This is why I always smile when I see people making fun of my investment ideas. It tells me that I am on the right path.

It happens over and over again and it will continue to happen, because this is how the market works. Don’t believe me? Take the advice from much more prominent sources:

To make money, you must find something that nobody else knows, or do something that others won’t do because they have rigid mindsets – Peter Lynch

To make money in the stock market you either have to be ahead of the crowd or very sure they are going in the same direction for some time to come. – Gerald Loeb

You can only make big money by being right about something that most people think is wrong. – Paraphrasing Howard Marks