I know I have said it before, but I think it bears repeating—I believe fundamental indicators tell us what to buy, while technical indicators tell us when to buy. With all of the carnage we have seen in the last four or five weeks in the overall market, my beliefs continue to be proven.
The S&P peaked back on February 19. When I ran nightly scans on February 18, I got a bearish reading on the overall market. I have been running these nightly scans since the beginning of 2009. On February 18, I got a list of 104 bearish signals and only four bullish signals. That ratio is somewhat of an extreme, but not a discrepancy that is only seen every few years or anything like that.
What that those signals suggested to me was that the probabilities showed that an overall market downturn was getting ready to start. Did I know that we would see the S&P drop nearly 30% in the next month? Of course not. My scans aren’t a crystal ball, but they do tend to let me know when the odds are better for a move higher or a move lower. Those scans are based on technical factors—overbought/oversold indicators, volume, stochastic readings, RSI readings, etc.
I went back and looked at the 104 signals that were generated after the market closed on February 18. You have to keep in mind there are stocks and Exchange Traded Funds that appear in the scans. ETFs don’t have the usual fundamental readings that I like to look at for individual stocks. Investor’s Business Daily doesn’t calculate and provide EPS ratings and SMR ratings for ETFs.
After weeding out the ETFs and any stock that might not have an EPS rating or an SMR rating, there were 60 bullish signals left for me to look at, individual companies where I could look at the earnings growth and other factors.
Of the 60 companies that were on that bearish list on February 18, there were 16 companies that received an A rating in the SMR category from IBD. There were 23 stocks that received B ratings, 13 that received C ratings, and eight that received D ratings.
With the market tanking since February 18, all 60 stocks that appeared on the bearish scan that night were down through the close on Friday, March 13. That is an anomaly, but worth noting never the less. The S&P was down 19.56% during this period. To give you an idea of how well quality stocks hold up when the market is falling, I ran the average returns based on each of the SMR ratings. The results were as follows:
- SMR rating of an A, average return= -18.72%
- SMR rating of a B, average return= -26.95%
- SMR rating of a C, average return= -35.23%
- SMR rating of a D, average return= -33.06%
There is a reason I use the ratings from IBD to come up with my trade ideas and there is a reason I combine them with the technical scans that I created. I have run correlation studies and there is definitely a high correlation between my bullish and bearish scans and the SMR rating from IBD. We see that the higher the stock was rated, the better it fared in the market selloff.
Just to cover it again, the SMR rating looks at sales growth, profit margin, and return on equity. The A rated stocks are the top companies in these categories and the C rated companies are average. The E rated companies are the worst, but there weren’t any stocks with E ratings that appeared on my scans on February 18.
I know I have spent a lot of time talking about my own investment methodology since the stock meltdown started. Trust me, I’m not trying to get everyone to invest just like I do. It would hurt my results if too many people started investing the same way. What I am trying to impress upon readers is to have a plan and try to invest in quality stocks.
Don’t just buy a stock because your neighbor’s son works for this company or that company and he says, “This thing’s going to the moon.” Do some research on the company. Don’t just buy a stock because it has fallen by X% and it’s bound to bounce back. And develop an exit plan before you even enter the trade. It could be a set percentage decline that you are willing to accept or it could be a support level that you see on the chart. But have a stop-loss point set up.
Remember, if a stock drops by 20%, it now has to rally by 25% for you to be back at breakeven. If it drops by 50%, it has to rally by 100% for you to be at breakeven.