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
