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Watch the Traders, Not the Pundits

By    |   Thursday, 12 Mar 2009 01:11 PM

Economic news is bad and getting worse daily. The stock market has been in a freefall, and there is no end in sight according to television and newspaper commentators.

Yet, looking deeper than the headlines, it appears there is an opportunity to earn decent returns in the coming months.

At least traders they think so.

Consider this: Some stocks are actually going up in this bear market. Others are losing less compared to the overall market.

Market analysts call this phenomenon “relative strength,” that is, comparing the performance of an individual stock to the overall market.

Interestingly, academic researchers have found that the best-performing stocks over the previous six months continue to perform well over the next few months.

In a bear market, it’s good defense. If the bear turns bull, relative strength can tip you to where to invest next for the maximum gain.

Traditional relative strength analysis consists of comparing the performance of single stocks to the overall market returns as measured by an index. The strategy boils down to buying the strongest stocks and avoiding the weakest ones.

Academics and many professional traders are convinced that this approach works very well over time. Yet individual investors tend to avoid this style of trading since it requires them to “buy high and sell higher.” It is much more comfortable to buy stocks when they are at low levels, sticking to the well know advice of “buy low, sell high.”

Unfortunately, stocks that are low can go lower. Prices can even go to zero. And, there is no guarantee that stocks that are bought at low prices will ever go back up.

No matter how bad this bear market is, it will eventually end. Historically, new bull markets tend to show very strong gains in the first few months. Owning the stocks with the greatest relative strength, then, should provide the greatest gains, when that time comes.

Right now, for instance, large cap growth stocks are showing a lot of strength in a declining market. At this point, they appear likely to deliver the greatest gains after the bottom is in place.

Similarly, over the past three months, emerging markets stocks have experienced a small price increase. This is a very healthy development, one that shows that investors have not lost their appetite for risk and are, in fact, searching the world for winners.

The fact that growth stocks and emerging market ETFs are doing well shows that speculation is now the dominant theme among traders in the U.S. markets. This is supported by data. StockCharts.com, for instance, provides a “bullish percent index” for several indexes and sectors, an indicator that shows the percentage of stocks showing a buy signal.

These charts show only price changes, ignoring time, allowing traders to focus solely on the trend. Buy and sell signals are very easy to spot using this technique.

The leading sectors right now are telecom and information technology. The Nasdaq 100 is the most bullish index by this measure, thus they the most speculative sectors in the market. The Dow Jones Industrial Average and industrial stocks, comparatively, are the weakest areas if the market at this time.

By looking at the traditional price chart of the technology sector, it’s clear that this sector has not reached a new low, as have the major indexes and most ordinary stocks.

Remember, in a bear market, strong performance usually means losing less than the overall market. That is the case for most tech stocks. But, in a new bull market, the stocks which declined the least in the bear market are often among the early winners.

The market now is at historically oversold extremes. Technical analysts point out the fact that investors seem to bidding aggressive growth stocks higher, a sign that trader sentiment is more optimistic than is media and public sentiment about stock prices in the future.

Many of the commentators we see on the news are simply expressing their opinions, which is fine.

But traders bet with real money, and they are acting as if they have hope for an end to this bear market. Smart investors should go against the crowd and buy, not wait for the news media to tell them the worst is behind us.

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MichaelCarr
Economic news is bad and getting worse daily. The stock market has been in a freefall, and there is no end in sight according to television and newspaper commentators. Yet, looking deeper than the headlines, it appears there is an opportunity to earn decent returns in the...
stock,market
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2009-11-12
Thursday, 12 Mar 2009 01:11 PM
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