December 18th, 2005

Bounce Off Support or Break Through Resistance?

The two charts (MWD and SLE) in the previous post may look similar but, to the untrained eye, they is a subtle but important difference.

  • In Morgan Stanley’s case, the stock appears ready to either break through the upper resistance trend line or, if unsuccessful, fall off the trend line and head down towards again testing the lower trend line.
  • In Sara Lee’s case, the stock appears ready to bounce off the bottom support trend line and climb to the upper trend line (where MWD is now) or it will reverse itself after briefly rising to be followed by either additional testing of the support or breaking down only to continue moving down to new lows.

Which of these two situations is a more reliable precursor for continued upward movement and therefore a more favorable environment for making new commitments to the stock ?

It’s all about trade-offs — to the extent possible, trading off a higher return for lower risk. As mentioned here earlier, with the market contributing 50% of a stock’s move, the industry 30% and the specific stock only the remaining 20%, our challenge is more to avoid stocks that might be losers than it is finding stocks that will go up (merely by investing in the S&P 500 index fund will produce, over the long run, a 9-10% return).

According to Investors Business Daily, breakthroughs of the top resistance line (along the lines of MWD) are more likely to consistently produce positive returns than bounces off the bottom of a consolidation pattern. Obviously, a stock bought when it turns off the bottom of a consolidation pattern and moves to and through the top resistance level produces a higher return than if one waits and buys the stock after it breaks through the upper trend lines in this consolidation. But there are too many instances when a move through the consolidation pattern fails with the follow through move being down through the lower boundary.

Being essentially a “momentum” investor, I find that the best returns (and fewest disappointments) are on the legs that carry a stock from one consolidation to another (either consolidation or reversal). That’s why I focus on breakthroughs from consolidations. At the present, I’ve identified in a watchlist over 250 stocks that are at various stages of potentially breaking through the top of consolidation patterns.

I haven’t found any hard rules on the subject; if there were, investing would be easy, it wouldn’t be an art and everyone would be rich. But having too many stocks to chose from (those that are about to breakout) as the market moves higher is the sort of problem I can live with!

(My wife and I continually debate this very topic. She claims I buy “at the top” and she likes buying “at the bottom”. Please help restore marital bliss. I’d like to hear your opinion, so please write.)

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