Once you have created your dynamic stocklist using one or multiple expert stock screens, the next most critical question is when should you buy those stocks? Most people can’t resist a good bargain and rush out to buy supposedly attractive stocks only to experience their new holdings decreasing in value. Often, a common mistake is a failure to look at the general trend of each stock before investing.
One of the most important investment rules is: “Always go with the trend” or, as they say, “the trend is your friend”. The option of not going with the trend is comparable to swimming against the stream. It’s generally a bad idea.
In financial jargon, an “uptrend” is called “positive momentum” and a “downtrend” is therefore “negative momentum”. Imagine sitting on your bike at the top of a hill and starting to roll down. Momentum is the increasing speed you experience during your exciting downhill journey. There is little muscle power for you to invest, if any, to make it conveniently to the bottom of the hill. That’s the invisible energy or tailwind you want to see when investing into a stock.
Price momentum is the “premier anomaly” in the investment world that you can use to your advantage as long as you know how to use it in the right way. Recent research has shown that momentum, as an investment phenomenon, has worked for the U.K. equity market right back to the Victorian Age and for the U.S. stock market even further back to the year 1801! Two researchers Narasimhan Jegadeesh and Sheridan Titman published in their now famous academic paper ‘Buying Winners and Selling Losers: Implications for Stock Market Efficiency Academic’ that strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods. Buying a falling stock can therefore have the same effect as trying to catch a falling knife – it is likely that you will get hurt!
An awareness of what momentum means and its effect is clearly helpful but we also want to make sure that you don’t make the costly mistake of buying stocks on a downtrend, but rather buy stocks when price momentum works in your favour. As longer-term investors, we don’t look for short-term profits (daily to weekly) like traders who often trade against the intraday trend to make a few dollars. We are invested for the bigger swings but taking a position against the trend is an expensive venture you don’t want to follow. To make your life easier in the use of our platform, we have introduced the traffic light system (Red/Green) next to each stock on your dynamic stocklist. Green means the momentum is positive (prices in the recent past have gone up), whilst Red means the momentum is negative (prices in the recent past have gone down). You should only buy stocks when they are trending upwards, which is indicated with a Green light.
Speaking in mathematical terms a Green signal is generated when both of the following conditions are met:
1. The closing stock price of last week is above the 40-week (200-day) moving average (MA) price lines
2. The 40-week (200-day) moving average (MA) line is trending up.
If a stock price meets both criteria then it qualifies to be on the buy list (Green) as the odds for a positive performance are much higher than if it was Red.
Here is a contemporary chart with a real example of Swiss private markets asset management company Partners Group (PGHN SW). The arrows show when the stock price’s 40-week moving average has changed direction (up or down). It should be clear that when this MA-line is in an uptrend and the stock price trades above this MA-line, it is generally in a healthy (up-trending) state.
Below, there is a chart with a real example of a US technology company General Electric Company (GE US). The arrows again show whenever the 40-week MA turned down and the stock price traded below this line it was time to sell your stock and re-invest that money into another stock that qualifies.
Finally, let’s see what some of the worlds’ best money managers have to say about this topic:
Hedge fund legend, Paul Tudor Jones in the book ‘Money: Master The Game’ commented:
“My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.”
Super Performance Trader, Mark Minvervini in the book ‘Momentum Masters’ noted:
“I never go long a stock that is trading below its declining 200-day moving average. No matter how attractive the fundamentals look.”
When investment authorities talk, we should listen and make it one of our cardinal rules for investing:
Don’t fight the trend and stay away from anything that is in a declining price trend – it doesn’t pay.
When looking at the price chart of any stock you want to invest in always make sure that the price of each stock is trading on the left-hand side of a raising 40-week (200 day) moving average.
And if the trend reverses (becoming Red), get out as fast as you can!
Our traffic light system (Red/Green) assists you in doing exactly this and like all of our thinking, this functionality aims to simplify the investment process and facilitate successful outcomes.