April 21st, 2010

Selecting Stocks for A Watchlist

A subscriber to the Instant Alerts asked some interesting questions yesterday. He asked,

“Is it possible for you to send us a list of stocks you are watching so that we can get familiar with the stocks you are about to trade?

How do you manage to watch stocks of interest if you have ten or twenty to watch? Do you set some sort of alert when a stock hits certain price?”

As part of a longer response, I answered as follows:

“Have you ever noticed that when the market is headed higher, there always seems to be more great stocks to buy than money with which to buy them and when the market is headed lower, nothing you own seems to be working and nothing looks good enough to buy? Consequently, my philosophy is to focus first on cash management by answering whether to have more or less money at risk invested in stocks. If I feel the market is headed higher and decide, therefore, to put more money to work in the market then finding stocks to buy is no problem either by adding to existing positions or adding more stock of companies in Industry Groups that are working.”

What I omitted was that once having made the decision to put money at risk in the market (i.e., timing the market), the process for finding and selecting specific stocks to buy depends on which stage of its life cycle the market is actually in.

Fundamental analysts use the same techniques regardless of which phase of the economic or stock market cycle they find themselves in. Fundamentalists attempt to project out sales and earnings growth rates, interest rates among other fundamental factors and compare their subjective assessment of fair value against the stock’s current price. A decision to buy is dictated when “fair value” exceeds current market price (i.e., the market has incorrectly valued the stock).

Technicians look at a totally different set of valuation factors. We’re interested in assessing the current supply and demand situation is in the market or specific stocks. Furthermore, we aim to determine in the direction the supply or demand balance is moving over several time horizons (i.e. momentum).

This following chart is from a recent posting (see April 15) depicting different phases in the stock market’s life cycle (the numbers were reference in that post’s text):

Different approaches should be used for identifying momentum depending on the phase of the market’s life cycle. Recall posts with titles like the following when the market was bottoming early in late-2008 and early-2009?:

Those were much simpler days for stock picking. As the market matures and moves into the Mark-up phase, since there’s more and more optimism and excitement I look for greatest opportunity with the least amount of downside risk. Rather than trying to be the first to find a hidden gem, I look for stocks with proven momentum and join the herd stampeding towards them.

After each trading day, I run several scans of about 5000 stocks. The two I like the best are: 1) stocks making all-time new highs (more correctly 5-year new highs) and 2) “Stocks on the Move” which looks at such parameters as: greatest % price change during the day, good earnings growth, volume surge during the day, and strong RSI (relative strength indicator). Another source is a weekly review of IBD’s Industry Group rankings looking for Groups that have moved up the most in ranking over the previous 4 months.

Interestingly, while many names on these lists return day after day, new ones are continually added and some drop off. Finally, I scroll through the charts of stocks comprising these lists and, based on a subjective assessment, pick those that appear to have the best set-ups or are on the verge breaking out.

This phase is the longest in the market’s life cycle. Let’s get together again in the future when we begin to see excitement, thrill and euphoria indicating the beginning of the distribution phase. Rather than selection, we’ll be talking about which stocks to sell.

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