Let’s start with a question:
Your car has been working perfectly for a year. Do you expect it to continue running smoothly…or do you start worrying about a potential breakdown?
I’m guessing you don’t give this a second thought. Chances are your car will keep working for a lot longer. Something could go amiss tomorrow. But odds are it won’t.
Many things in life are the same. There’s a natural tendency for events to follow a steady course. Sure, the cycle will turn — but a change in fortune can take a while to happen.
The stock market is no different. It can remain bullish or bearish for lengthy periods. So too can individual stocks. A company’s share price can rise for years.
Think about this. Suppose a stock has been on the rise. It’s just hit a one-year high, and the share price is double what it was last year. Would you consider buying?
People typically view this in one of two ways. Some will look at the past and project it forward. Others will think the stock has run too far, and believe it’s about to fall.
I can understand why people worry about buying at the highs. It can be hard to imagine a big move getting even bigger. This can make avoiding these stocks seem prudent.
But there’s a problem with this reasoning.
A stock trading at a 52-week high has clearly been doing well. If you exclude these companies, you’ll be overlooking many of the best performers.
Sure, all bull markets end — a strong stock could break down tomorrow. But chances are it has further to go. The path of least resistance is up.
You see, the odds favour that a trend will continue. And some do so for a very long time. In fact, trends often run further than almost anyone thinks possible.
On a 12-month high
Now let me ask this question again.
Suppose a stock has been on the rise. It’s just hit a 52-week high, and the share price is up at least 100% on last year. Would you consider buying?
Think about this for a moment. What’s your natural tendency?
Many people will think it’s too late to buy. Some may even consider shorting the stock.
Rather than guessing what might happen, I’ve done some back-testing. It’s always good to pull a few statistics into a discussion.
Here’s what I did.
I put together a simple strategy for buying shares. There are two key rules:
- A stock must be at a one-year high;
- It has to be at least double its value from a year ago.
I also set a minimum entry price of 20 cents. This removes a lot of ‘penny dreadfuls’. These stocks can double or halve overnight, and they often increase a portfolio’s volatility.
Finally, the system uses Quant Trader’s exit strategy. This allows it to run profits, while cutting stocks when the trend turns lower.
So what do you think happens?
It’s actually quite interesting. Have a look at the chart below.
Source: Quant Trader
[Click to enlarge]
This shows the hypothetical profit from the strategy (excluding costs and dividends). The date range is 1 October 2000 to 6 October 2016. It assumes putting $1,000 on every buy signal.
Now remember, these results are not for Quant Trader. The graph plots the performance of a very simple strategy. It’s not a method I would trade myself.
But the message is clear. You can make money buying at a one-year high. This should dispel the myth that buying after a big run is asking for trouble.
For comparison, here’s a chart of the All Ordinaries for the same 16-year period:
[Click to enlarge]
The All Ordinaries is still well below its 2007 peak. Now take another look at the ‘buy at a 12-month high’ strategy. You’ll see it’s hitting record levels.
Counter to popular thinking, buying after a strong move is often profitable. This is because you’re trading with the trend, and the odds are in favour of it going further.
So don’t avoid a stock just because it’s doing well. Chances are that — just like your car — it will still be running smoothly tomorrow.
A final word
Remember, this is a basic entry strategy. It’s by no means a complete system.
Quant Trader takes this concept a lot further. The system doesn’t simply buy into strength. It uses a variety of strategies that can boost returns and lower volatility.
The system also calculates a unique exit level for each stock. This helps you manage one of the hardest parts of trade — selling.
Until next week,
For The Daily Reckoning
Editor’s note: Are you falling short of your goals? Do you find it a struggle to consistently make good profits? Don’t worry, you’re not alone. The stock market can be a tough place to navigate on your own.
Here’s something you should do — check out Jason McIntosh’s Quant Trader advisory service. It’s a fully algorithmic trading system for ASX stocks. Quant Trader scans practically every company. It then tells you when to buy and sell. I can just about guarantee you’ve never heard of some of the stocks it identifies.
Try it. See if it makes sense to you. It could change the way you trade forever.