There are many different ways to make money in the stock market. What they have in common is that each has its own sweet spot – an environment when it works best and delivers the biggest return on capital.
I constantly innovate and try different setups. I started my career with just one setup – the so-called post-earnings announcement drift, which buys tight consolidations in stocks that gap up on earnings. It has delivered consistent profits and I continue to use it today. Over time, I gradually added more ideas to my portfolio of setups until I reached a point where I have a good setup for each type of market environment – uptrend, distribution (topping process), downtrend, accumulation (bottoming process).
Here’s an interesting setup I’ve been experimenting with. A false breakdown – it happens when a stock breaks down to new 52-week lows, but its RSI reading doesn’t confirm it. This is often referred to as a positive momentum divergence. The goal is to enter when a stock goes back above its breakdown level and to sell near a declining 20 or 50-day moving average. In a strong bull market and near major market bottoms, such type of setups could deliver quick 20-30% in 1-2 weeks. My stop is usually the low of the breakdown day.
Keep in mind that not every positive momentum divergence leads to a reversal or profit. In some cases, stocks might continue lower for several days before they reverse. This setup doesn’t work during market downtrends.
Typically such setups work best near major market bottoms. Stocks tend to top individually, but most of them bottom as a group. I talked about this development here.
VRX is down another 40% this morning, extending its drawdown to 85% from its 52-week high reached last summer. I am not familiar with VRX’s fundamentals and I am not going to argue about them. My point is strictly about technicals and sentiment.
Over the past few weeks, many have been pointing out to a positive momentum divergence in VRX – its price made new price lows in early March while its RSI didn’t. For some this is enough to put it on their watch list and wait for some signs of strength before entering on the long side. While it is true that momentum often leads price, price is the only thing that actually pays us. The delay between a positive momentum divergence in individual stocks and price reversal could be substantial or longer than most people could remain solvent and sane. Plus, this signal doesn’t always work. No indicator does.
My friend Frank Zorrilla made a really interesting observation this morning:
$VRX is the reason why you don’t bottom fish, $NFLX back in 2012 is why you do…that settles it…
— Frank Zorrilla (@ZorTrades) Mar. 15 at 07:35 AM
NFLX also lost 80% of its market cap in 2011/2012. The difference is that then it spent multiple weeks in a tight, low-volume range, which is the ultimate sign of neglect. Then, it made a new 52-week high in early 2013 and it never looked back. It went up more than 400% in the next 3 years. You didn’t have to bottom fish for NFLX. You could have been “late” and wait for a fresh breakout from a consolidation and still achieved a substantial return. The best performing stocks in any given year are usually the ones that surprise the most. This means that they will often come from a place very few expect – they are likely to be widely neglected before and even after their major high-volume breakout to new 52-week highs.
There is a time and place for each market strategy.
Stocks that make new 52-week lows in a bull market are usually there for a good reason. From my perspective, there’s only one market environment where it is relatively safe to try bottom fishing and the potential reward far outweighs the risk taken. It is during market corrections when the general market tests its momentum lows with some form of breadth divergence. In my book CRASH, I describe the five stages that a typical market correction goes through:
- The Guillotine Stage – fast sharp decline that last 1-3 weeks and leads to a 5-10% loss in major indexes and leads to extremely oversold market breadth readings. Volatility spikes through the roof during this stage and it stays there. Indexes close below their 200-day moving average.
- Short-term bounce that gains back 30-50% of the sharp decline in stage one. Such bounces often find resistance and reverse lower at declining 10, 20, 50 or 200-day moving averages.
- Choppy market environment, that gradually whipsaws both bulls and bears as market often changes directions and daily price ranges are extremely wide. During this stage, fear is gradually replaced by apathy and lack of interest in the market.
- A retest of the momentum low achieved in stage 1. There is usually some type of breadth divergence – indexes are piercing below their momentum lows but with improved internals – there’s a smaller percentage of stocks making new 20-day lows than in stage 1. If indexes cannot sustain bounce after this retest, we are probably in the midst of a bear market or a lot longer correction, at least.
- Recovery – correlations are very high at this stage. Indexes quickly reach overbought levels and stay there for a long time. Those who wait for a pullback, miss the boat.
Most stocks tend to top individually, but they bottom together as a group. Fishing for beaten down stocks that are down 80% or even 90% from their 52-week highs only makes sense in stage four of a typical market correction. Here’s a recent example.
Various market breadth readings have been overbought for a week already. In most situations, it means that a short-term pullback is likely. There is one exception. When stocks recover from a deep correction, it is normal for market breadth to quickly reach overbought levels and stay there for quite some time while sector rotations take care of the extremes.
Look at the chart below featuring the New York Stock Exchange Composite (NYA) and the NYSE McClellan Oscillator ($NYMO).
There are two lessons from this chart:
1) In October 2015 and in February 2016, the index made a new price low with a positive breadth divergence. NYA made new lows while NYMO didn’t. This marked a short-term bottom and the beginning of a powerful rally. Study any past correction and you will realize that bottoms are formed when there’s some form of positive breadth divergence and market breadth always bottoms before price.
2) In October 2015, NYA continued to advance even after breadth readings (NYMO) reached extremely overbought territory and started to pull back. Sector rotations and skeptics coming back on the long side kept the rally going until NYA reached its declining 200dma. It is still below its declining 200dma, but this is another discussion to have. Study any past correction and you will realize that market breadth (NYMO) always reaches super-overbought readings when indexes are recovering from a >10% decline. Those overbought readings don’t usually lead to an immediate decline in the indexes. On the contrary, in most cases the indexes continued to slowly climb higher. Those who were afraid to jump back in because of overbought breadth readings were in a way locked out of the rally. The market didn’t give them a chance to get back in. It is the nature of the market to surprise the majority.
I am not saying that overbought and oversold market breadth readings should be ignored. On the contrary, they are very useful indicators most of the time. Everything should be looked in context. There are always exceptions to the rule. Knowing when an indicator can be ignored is just as important as knowing when it could be trusted.
Here is a different perspective of the same relation.