Everyone loves a bargain. It’s a great feeling to lock in a big discount.
We naturally link lower prices with opportunity. That’s how we’re wired. And in many situations this works.
The Boxing Day sales are a classic. Long lines snake around street corners. The prospect of getting a deal is irresistible. People want to buy as soon as the price drops.
But should we approach stocks the same way?
Possibly the most famous stock market maxim is ‘buy low, sell high’. The saying is about as old as the market itself.
This is largely a statement of the obvious. That’s how you make a profit — buying low and selling higher. There’s nothing profound in that.
But here’s the catch. How do you define buying low?
The mistake in buying low
You see, many people believe buying low means buying when prices are falling. This strategy typically works well for consumer goods. But how does it fair in the stock market?
Well I’ve done some back-testing to find out. I’ll tell you about this in a minute. But first I want to recap last week’s report. If you missed it, you can find it here.
You’ll remember the discussion was about buying strong stocks. This was in response to a member’s concern that Quant Trader signals some stocks at record highs. His thinking was that buying after a big move is extremely risky.
As you know, I ran a back-test to get some data on this. The test had two new rules for buy signals:
- A stock must be at a three year high (or greater)
- It must be at least 300% above its three year low
Here’s the chart you saw last week.
It turns out this was a successful strategy. You could do rather well just buying stocks at three year highs.
This isn’t any great surprise. Buying stocks at multi-year highs is trading with the trend. And the odds favour a trend will keep going.
Last week, I said I’d show you some examples. Let’s do that now.
Stocks that double, and keep going…
These three stocks are from the back-test that produced the above graph. This is why it’s a mistake to avoid stocks simply because they are strong.
The first stock is Aurora Oil & Gas [ASX:AUT]. It ceased trading last year following a takeover.
The system’s buy signal was at $0.95 on 9 August 2010. The shares were 850% off their 2009 low. AUT had also just hit an eight year high.
Just think for a moment. Would you consider buying?
Let’s see what happens next.
Strength led to more strength. The system captured a 169% gain over the following 12 months.
The next example is a financial services company — Credit Corp [ASX:CCP].
Here’s the chart.
CCP was at an all-time high when this buy signal was identified in late 2004. The shares were also 720% above their 2000 low.
Buying at this stage runs counter to the better judgment of many. But the data suggests this shouldn’t be the case.
Let’s check out what happened.
This stock had a lot further to go. The position made a hypothetical 245% in less than three years.
Last but not least is Greencross Vets [ASX:GXL].
This is the chart.
The buy signal was at $2.43 in August 2012. The shares were just hitting an all-time high. This was also 305% above the stock’s low two years earlier.
The result tells a familiar story. Here’s the final chart in the series.
This trade ran for just under two years. The end result was a 220% gain. Not bad for buying at a record high.
There is no doubt about it — buying into strength can lead to big gains. You’re more likely to double your money when trading with the trend. The path of least resistance is up.
It’s important to note that this won’t always happen. There’ll be other times when the stock turns lower the next day. That’s why we have a stop loss. It limits our risk.
Okay, so this brings us back to my opening question.
Should we buy stocks that are falling in value?
I found an interesting article while researching for this update. It was published by a popular local investment advisory last November. The crux of the story was that stocks trading near a one year low are potential bargains.
Yes, they could be. The wreckage of the past can lead to excellent opportunities. But I’d want to see signs of an uptrend before buying. That’s the Quant Trader way.
The author didn’t seem too fussed by this detail. He identified three falling stars as potential buys: Crown Resorts [ASX:CWN], Woolworths [ASX:WOW], and The Reject Shop [ASX:TRS].
Guess what. All three are lower today — despite the All Ordinaries trading higher.
Buying at a one year low seems more of a trap than a bargain. But this is just a small sample. We’re going to need a bigger test.
So let’s reverse the strategy you saw earlier. This time I’m going to set the algorithms to only buy stocks at a three year low (or lower).
Here’s what happens.
This shows the hypothetical profit from the strategy. The date range is 1 January 2000 to 24 April 2015. It assumes putting $1,000 on every buy signal.
The outcome is clear. This strategy is a total failure…it’s got nothing to show after 15 years.
Buying as prices tumble below three year lows is no bargain. Back-testing indicates it’s much better to jump on board an established trend.
As they say, the trend is your friend!
Until next week,
Editor, Quant Trader
Editor’s note: It’s now eight months since Quant Trader began giving live signals. And I can say this — the strategy of buying into strength is working BIG time. There are now 12 trades showing a profit of more than 70%. The largest gain is 164%. Find out how YOU can trade this way here.