When buying a stock, the odds of strong performance are improved when multiple factors are all aligned, including:
- the stock’s fundamentals
- the stock’s technical position
- the industry group
- the sector
- the status of the overall market.
Identifying such situations can make a major contribution to investment performance.
This means that the weekly research process should include a complete review of charts and data, covering the status of the overall market, sectors, industry groups, and individual stocks.
For example, one of my reports contains a case study showing how a well-designed research process reaches the conclusion that we should buy electronic gaming stock Take Two Interactive (TTWO) in April 2017 (note: I have also written a brief summary of this situation in a PDF file: 3 page report ).
The research process should proceed in a top down manner, first assessing the status of the overall market, then sectors and groups, and finally individual stocks.
As seen in Figure 1 below, in late April 2017, the condition of the overall market was bullish, and the S&P 500 had just broken through a downward-sloping trendline, indicating the end of a two-month market pullback.
Figure 1 S&P 500 daily chart — there was a market pullback in March – April 2017
A review of sector charts shows that during this market pullback, the technology sector had good relative strength. This is seen in Figure 2.
Figure 2 Technology sector (XLK) had good relative strength in the market pullback of March – April 2017
Within the technology sector, further analysis showed that the electronic gaming group also had good relative strength, as well as good fundamentals. This led to the identification of Take Two Interactive (TTWO) as an ideal stock to buy in late April 2017.
Figure 3 TTWO formed a “Buy” signal by breaking out to a new high in April 2017
This was a perfect stock to buy at that time, because:
- TTWO had a bullish fundamental rating and had just announced a strong earnings report.
- TTWO had a very good chart pattern — it had just broken out to a new high, after consolidating to its 50-day moving average. This technical “buy” signal would be spotted by the weekly research process.
- Strong industry group — other stocks in the electronic gaming group were also acting well.
- Strong sector — the technology sector had good relative strength.
- Good market conditions — the overall market was in a long-term uptrend and was just emerging from a two-month pullback.
TTWO then went on to outperform the S&P 500 by a wide margin for the rest of 2017, with a gain of 75% vs. 12% for the index.
In order to find such situations, in addition to watching the overall market, we need to consistently monitor the behavior of sectors, industry groups, and individual stocks, as well as fundamental data on stocks.
To facilitate this analysis, I have developed pattern recognition software and data management procedures covering sectors, industry groups, and over 1,100 individual stocks and ETFs.
By using charting software and databases effectively, we can cut through the information overload, and zero in on those stocks with good fundamentals and bullish chart patterns, which are also in strong industry groups and sectors.
My research shows that this approach adds a lot of value beyond using composite scores from equity quant systems that rank stocks on a scale of 1 – 100, or selecting stocks based on the fundamentals only.
At any given time, the vast majority of all stocks in the market are given “Buy” ratings from analysts who follow the companies. Therefore we need another level of analysis to determine which ones are likely to outperform.
Note: in the example above, the electronic gaming stocks were attractive in April 2017 because they had good relative strength. However, this does not mean that we always want to simply buy stocks with good relative strength. It depends on the condition of the overall market.
For example, if the overall market were overbought, stocks with good relative strength would be even more overbought, meaning they would be vulnerable to a sharp selloff if the market goes into a correction. Therefore we need to use some decision making rules that depend on market conditions.
These issues are discussed further in the article entitled “A Rule-Based Approach instead of Statistics.”