The Best Of Times, The Worst Of Times
Buy Strong Groups Or Weak?
by Jay Kaeppel
Is it better to buy weak industry groups or strong ones? The best approach might be to utilize both strategies.
Is it better to buy weak stocks or strong ones? The theory behind buying weak stocks is that you have the opportunity to buy low and (some time later) sell high. The theory behind buying strong stocks is one of momentum; the idea is that a stock in motion is most likely to continue in that direction, at least for a while. Most research suggests that when you buy individual stocks, you are better off buying stocks making new highs rather than new lows.
This is also true with industry groups, but not to the same degree. While a given company may go out of business for any number of reasons, it is much more rare for an entire industry group to decline in price and never rebound (although it can happen - the horse and buggy industry has yet to recover from the introduction of the Model T). Thus, it can make sense to buy an industry group that has experienced a recent, sharp decline. The problem with this approach is simply this: How do you know if you are buying low or unwisely trying to catch a plummeting safe?
WEAK INDUSTRY GROUPS
Generally speaking, there is a common pattern for industry group price performance. At some point, the fundamentals for a given industry go south, and eventually so do the stocks in that industry group. This can go on for any period of time, but it usually does not last much longer than about two years. Once the majority of the decline is over, the group may then experience a period of basing action for up to a year (actually, the longer, the better).
Once this long decline and basing period is over, it is not uncommon for a group to then reemerge as a leading performer. Once the industry has been "wrung out" and the fundamentals (which usually change over a long period of time) swing back to the upside, the industry group as a whole is ripe for an advance in price. In a moment, we will look at a simple method that attempts to take advantage of this phenomenon.
...Continued in the September issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the September 2004 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2004, Technical Analysis, Inc.
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