Using real market examples, Tom Aspray discusses how to identify high-relative-strength stocks to buy and manage risk by booking hard-earned profits and limiting losses.
Over the past several months, I have received a fair number of questions about the portfolio of stocks that I have recommended. While speaking at a World MoneyShow workshop in February, I encountered many attendees who were successfully invested, but had questions about the methodology that I employ during the stock-selection process.
I hope this article will answer many of those questions, but I envision this as more of an ongoing project, as I have no doubt new questions will arise.
First of all, there are too many variables that go into the determination of what percentage of one’s portfolio should be invested in stocks. I do assume the money anyone invests is not needed for at least the next year. That said, I am a firm believer that stocks should play a major role in most portfolios, no matter what your age.
One important factor in constructing a portfolio is determining how much is invested at any particular time. There are some money mangers who immediately invest a new client’s money in the same stocks their other clients are invested in. I feel this is a huge mistake and is totally contrary to my investment philosophy.
Once I have found a stock or ETF that looks attractive, the potential risk is the determining factor in deciding whether or not I will recommend it. The potential reward plays a role, but I have found that concentrating on the risk and minimizing it as much as possible will give the best long-term results.
Therefore, I would never want a new reader to take all of the positions that I have previously recommended since the risk is now much different than when those stocks were originally recommended. As a result, I suggest that a portfolio be started with only my current recommendations (see the current portfolio here).
This portfolio is based on $500,000, but it could be easily downsized to $250,000 or lower. The total is important, as I try to equalize the dollar value of each position. For each stock or ETF that is listed, the number of shares was adjusted so that the value would be approximately $10,000.
For example, if I recommend a $25 stock, then I would buy 400 shares. If it were instead a $70 stock, then I would purchase 150 shares. The maximum number of shares is 1000, which reduces the exposure on stocks that are priced under $10.
As I will explain in more detail later, I often recommend buying 50% of a stock position at one level and 50% at another level, so in those instances, I would be purchasing $5000 worth at the first price level and $5000 at the second.
To determine my level of buying or selling, I use my analysis of the Advance/Decline (A/D) line as my primary guide. Also it is determined by the number of favorable risk/reward opportunities that I find as well as the technical readings of the individual issues.
The chart above shows the Spyder Trust (SPY) with the NYSE A/D line and its 34-period weighted moving average (WMA). On the bottom I have added another measure of the A/D line called the NYSE A/D Oscillator, which is the spread between the A/D line and its 34-period WMA.
I am most aggressive in recommending new positions when the A/D line has just completed a bottom formation, such as what occurred in the summer of 2010. The A/D line started acting stronger than prices on July 22, 2010 (line 1) when it moved above resistance at line a.
In early September, the A/D line surged to a new high, indicating that prices would follow. By the latter part of October 2010, as indicated by the rectangle labeled “b,” there were reasons to be a less-aggressive buyer. First, SPY had been above its rising 20-day exponential moving average (EMA) since late August and had bounced off of it three times.
Secondly, the NYSE A/D line had been above its weighted moving average for almost two months, and the spread had formed lower highs (line c). The market did correct after the mid-term election, and it took until early December before the A/D line resumed its uptrend.
By the latter part of February 2011 (labeled d) the A/D line had been above its weighted moving average for almost three months and the Oscillator had again formed a negative divergence, line e.
Of course, I use the long-term analysis of the A/D line to determine the major trend, and while it made new highs in both May and July, the action was quite choppy until the A/D line broke down in July. By mid-May, four of the major sectors and the Dow Transports had turned negative, which limited the buying opportunities.
In September 2011, the A/D line was acting stronger than prices, and it did not make a new low with prices, line g, on October 4. Such bullish divergences in the A/D line are formed over several months are generally quite significant.
The A/D line broke through resistance, line f, on October 12, confirming the positive divergence. This indicated that the stock market had bottomed (see “Be Bold, Be Fearless, Buy the Dip”).
I recommended many stocks over the next few weeks, but many did not reach my buy levels, as they took off to the upside. The most recent good buying opportunity occurred on December 27 when the A/D line moved through resistance at line h and started a new uptrend.
Since early February, I have been suggesting a more cautious stance, as SPY has not even come close to its rising 20-day EMA for almost 50 trading days. The gap between the A/D line and its weighted moving average was also quite wide, and recently, the NYSE A/D oscillator has started to diverge, line h.
In selecting stocks or ETFs, the three most valuable tools are the chart formation; relative performance, or RS analysis; and the volume, specifically, the on-balance volume (OBV). Because I try to find a sector or industry group that is outperforming the S&P 500, this is where the RS analysis is crucial.
A good example of this was the action in the homebuilders in the middle of October. By October 21, I had already recommended the SPDR S&P Homebuilders ETF (XHB) and followed it up with my analysis of the individual homebuilding stocks (see “Big Volume Is Bullish for Homebuilders”). I recommended four stocks then, but will concentrate on Toll Brothers (TOL) and KB Home (KBH) in today’s lesson.
The volume in the homebuilders had been very heavy on October 18, as the original chart of Toll Brothers (TOL) indicates. The resistance at $16.23 had been overcome, and both the RS analysis and OBV were positive. The weekly analysis also turned positive at the end of the week. The first upside target was at $19.40.
My recommendation at the time was to go long at $16.46. The updated chart shows that on November 1, TOL got as low as $16.77 before accelerating to the upside. The initial target, line b, was hit on November 8 with TOL making a high in February at $24.22.
The updated chart shows that the RS analysis completed its bottom formation by the end of October when it overcame resistance at line c. The RS analysis is currently moving sideways, which is consistent with a correction, not a top. The OBV formed a bullish divergence at the lows, line f, and is holding well above this support.
My recommendation in KB Home (KBH) turned out much better in the long run, but it was not an easy trade. On October 18, I recommended buying at $7.04 with a stop at $6.14. This would have been filled on October 31 with the close at $6.97.
KBH made higher highs in early December but because of the strong weekly RS analysis, I chose not to tighten the stop. That was a good thing, as on December 28, KBH dropped to a low of $6.17 before closing at $6.34.
From the original article, my initial target was at $9.30, which was the 38.2% Fibonacci retracement target. Because of positive market action in early January and the bullish volume in KBH, I held on to the full position.
On January 24, I recommended selling half the position at $9.90, which was filled on January 25. The rest of the position was sold on February 16 at $12.56.
This was one of my best trades over the past few months, as the average exit price was $11.23, so the potential profit was a gain of over 59%.
I often use this when I think that the pattern or technicals are strong enough that I want to be in the stock or ETF but do not want the risk of a full position at one price level. In this instance, my recommendation was to go 50% long at $16.16 and 50% long at $15.56 with a stop at $14.25 (risk of approx. 9.8%). These two levels are identified by blue lines on the chart.
Two days after the recommendation, CRUS opened at $14.53, down $2.48 from the prior day’s close. Both buy orders would have been filled in this area, and soon after, the stop at $14.25 was hit when the low was $13.75.
This is a good example of why I recommend having stops in the market so you are not able to second guess or change your stop. In this example, I was lucky to keep the damage quite low. As it turned out, by early March, CRUS had rallied above $24 per share, as the volume expanded nicely in early 2012.
The stock had rallied sharply for the prior few days, so I was looking for a pullback to support, line d, to buy. I recommended going 50% long at $7.74 and 50% long at $7.46 with a stop at $6.84 (risk of approx. 10%). On December 15 (see arrow), ONTY had a low of $7.43, so both orders should have been filled.
The stock bounced for a few days and made it back above the $8.00 level before turning lower. On January 5 (see red arrow), the stop at $6.84 was hit for a 10% loss. The short-term uptrend in the relative performance (line e) was broken in late December, which was the initial warning.
The RS line did not break to new lows until after the stop was hit, as ONTY had a low of $6.21. In the middle of February, ONTY made it close to my initial upside target at $9.30 before prices collapsed.
Some of my best trades come from well-defined chart patterns, but sometimes the price targets are not hit and you end up with considerably less than you had originally planned. In early January, I wrote about reverse head-and-shoulders bottom formations that I was observing in many markets (see “The Dominant Chart Pattern of 2012.”)
One of the stocks I focused on was Dover Corp. (DOV), which was very close to completing its reverse head-and-shoulders formation. The upside target from the formation was at $75.51.
I recommended that after a close well above $60.60 (which was well above the neckline), one should “look to buy roughly between $59.90 and $60.25 with a stop under $54.67, which was the December 14 low.”
The following week, DOV closed at $60.85 and then dropped back as low as $58.88 the following day, hitting the buying zone. As DOV began to move higher, I determined that the 100% Fibonacci projection target using the rally from the head to the neckline was above $65.00.
Once a position moves in my favor, I generally look for a level to sell half of the position. By doing this, the overall risk on the position and the portfolio are lowered. Secondly, I think it has a positive psychological affect.
On January 30, I recommended selling half the position at $65.16 and raising the stop. Half was sold about five days later. Subsequently, the remaining position was stopped out in early March (red arrow) at $62.32, and the stop had been raised when I turned more cautious on the market.
The average exit price was $63.74, or a 5.8% gain. This was well below the potential 25% gain if the target from the chart formation had been met.
I hope these examples help you further understand the methodology behind building a strong stock portfolio. Of course, other factors also go in my decision-making process, and I hope to expand on these in the future. Having a concrete plan in place and using a set of criteria that you believe in are two of the most important steps in building a strong stock portfolio.