January 12th, 2006

When to sell stocks

I confess, I’m a “market-timing, momentum investor”. For those unfamiliar with the terms, “market-timing” is “attempting to predict future market directions, usually by examining recent price and volume data or economic data, and investing based on those predictions.” While “momentum investing” is the “strategy of buying stocks that have a strong upward price trend.” And over the past few months, market-timing, momentum investors have made some excellent profits.

But have we become so jaded by this market’s action since the October 19 bottom that it’s easy to forget that it can go down as well as up? And if you’ve been buying all those stocks that on your price trigger watchlist that broke through resistance trendlines you must have some very respectable percentage gains. So what should we do with those winners now? Remember, even doing nothing is a decision to not sell.

Most stock newsletters, magazines or talking heads offer advise on buying either individual stocks or the market in general. Picking individual stocks or timing the market for the optimal conditions for buying stocks is relatively easy when compared with figuring out when to sell. My mailbox and email in-box continually overflows with buy recommendations. But have you ever wondered why there’s so little written about when to sell a stock?

One reason may be because no two people ever have the same portfolio. There are millions who might want to own a particular stock. But in a random sample of 25 companies in a variety of industries and sizes, I found an average of only around 23,300 shareholders each. With such a small target, newsletters and magazines would be wasting resources and their audience’s time if they focused on specific sell recommendations.

As this market moves from an up-leg into a consolidation or, worse, in a down-leg phase (which it ultimately will do), I’ll give some specific stock examples and, from them, together we’ll develop some rules-of-thumb for when to sell your investments. So let’s get started:

  • Rule #1: “The market is your friend; never bet against the market”: Again, it’s been said that 50% of a stock’s move is determined by the market, 30% by the industry and only the remaining 20% by the individual stock itself. I believe in the long-term secular growth of the economy and the market and that, over the long-run, a “rising tide lifts all boats”.
  • Rule #2: “Nothing continues forever”: “Trees don’t grow to the sky” and “everything reverts to the mean”. Anyone who’s looked at a few charts can attest that stocks and the market move in waves. The zig-zags of stock charts merely reflect the tug of war continually taking place between the supply and demand for stocks.
  • Rule #3: Resistance and support levels are real: In my December 3, 2005 posting, entitled “Do Trend Lines Work”, I described how trendlines connect inflection points and, by so doing, define resistance and support levels. However, since supply and demand are dynamic forces, be prepared to perhaps redraw move lines as subsequent transactions are completed and new information becomes available.
  • Rule #4: “Cut your losses”: Making mistakes is natural. If we don’t make mistakes, we’re not taking enough risks to increase our portfolio’s performance. Would you buy that stock today thinking it will outperform another stock or are you holding on to it merely to protect your ego (“I believed that was a good stock or I wouldn’t have bought it”). Match, or even out-perform over-all market returns by selling losers quickly and putting “dead money” to better work.

Enough selling rules for the time being (there will be more in future postings), let’s start with the big picture and then zero in to a specific example.

The market made a inverted head-and-shoulder bottom between 2001 and 2004 with a neckline at 1155 that’s clearly visible on the chart below. After breaking through that neckline at the end of 2004 and retesting it (which became a support line) twice in 2005, the market has maked significant strides since the October 19 reversal day. The index appears to be trying to catch up with what I’ve called the Long-term Secular Trendline clearly visible in a chart I included in my August 27, 2005 posting.

We can see that the S&P 500 is bumping into the upper boundary of an upward sloping channel. If you look at the first chart, you might be able to imagine a horizontal trendline at 1287, where the index is now, all the way back to 1998. This level is significant having served as either a resistance level or a support level 4 times. And now let’s zero in on a the S&P since the beginning of 2005:

It wouldn’t be surprising if the index consolidated for a short period here and when it gains sufficient momentum to breakthrough 1300 with conviction, it would continue and move to the next resistance area, 1370-1400.

And what has the recent move meant for individual stocks. As I mentioned in an earlier post, when this up-leg began in mid-October, I had a watchlist of 150 stocks that appeared to be waiting for a supportive market environment and breakthroughs. By the end of December, while some had successfully breaken through, new ones were added to the list which had, by then, grown to nearly 300. It’s been a fantastic run with more stocks breaking through resistance level trendlines than one can possibly take advantage of.

Take, for example, Bell Microproducts (BELM). On July 28, 2005, the stock broke through a resistance level that stretched back to 2002, the upper boundary of a classical upward sloping triangle. (see chart)

However, after several months after failing a test of the support, on October 13, BELM opened with a 2.1, or 22% gap down closing down 2.44 or 24.9% for the day. (see chart)

Some might hold the stock hoping that it would close all or some of the gap and recover some of the loss. However, following Rule # 4, I sold and redeployed the cash in another investment. Lucky I did because, while the indexes were moving into new high territory, BELM gapped down a second time and closed at 6.45. (see chart)

Subscribe below or click here to learn more about help for navigating turbulent markets.