If a Stock Keeps Moving Higher, Should You Buy It or Sell It?

In chapter 3 of "How Market Really Work" Larry Connors asked, "Is it better to be a buyer after the market has been strong and had made multiple days of higher highs? And, is it better to be a seller after the market has shown signs of weakness and has made multiple days of lower lows?" The answer to both questions turned out to be a resounding "No". This answer was based on quantitative research conducted over a 15-year period (1989-2003), and the results went against what was generally accepted at the time. We recently updated the research through June 2006, not just looking at the indices, but also individual stocks.

In this article, I'm going to ask the same question of individual stocks. In other words, "Is it better to be a buyer of stocks that have been strong and have made multiple days of higher highs? And, is it better to be a seller of stocks that have been weak and have made multiple days of lower lows?" Once again, the answer will be based on quantitative research; before we get to that, let's define exactly what we mean by multiple days of higher highs and multiple days of lower lows.

Multiple days of "higher highs" simply means today's intraday high (not close) is higher than yesterday's intraday high (see figure 1).

Figure 1

Multiple days of "lower lows" simply means today's intraday low (not close) is lower than yesterday's intraday low (see figure 2).

Figure 2

Multiple days of higher highs are often accompanied by "bullish news;" after all, the stock is displaying strength -- yesterday's high was above the previous day's high, and today's high is even higher. Trend followers are jumping on-board and many investors fear being left behind and are willing to pay almost any price to get into this "hot stock" before it runs away!

Conversely, multiple days of lower lows are often accompanied by "bearish news," and the stock is displaying weakness -- yesterday's low was below the previous day's low and today's low is even lower. Short sellers are enthusiastically jumping on-board, while many investors are dumping their holdings, fearful their stocks will never recover.

At TradingMarkets, we try not to be swayed by emotions, but rather rely on our own quantitative research into the behavior of stocks. We feel that before we trade, it's important to know how the pattern, or setup, we are looking at has performed in the past. That way, we can objectively assess whether the trade offers a good risk/reward opportunity and what might happen in the future. In doing so, we are able to determine a number of important variables:

• Number of Trades
• Avg. % Profit/Loss
• Avg. % of Winners
• Winners Avg. % Profit
• Avg. % of Losers
• Losers Avg. % Loss

We looked at over seven million trades from 1/1/95 to 6/30/06^*. The table below shows the average percentage gain/loss for all stocks during our test period over a 1-day, 2-day, and 1-week (5-days) period. These numbers represent the benchmark which we use for comparisons.

Using the information above we decided to research what really happens to stocks that make multiple days of higher highs and multiple days of lower lows.

Higher Highs

We looked at stocks that made at least three consecutive days of higher highs, all the way to stocks that made at least seven consecutive days of higher highs. The results revealed a number of interesting findings, some of which are highlighted here:

• In all but one case, the average returns of stocks that made "multiple days of higher highs"
  underperformed the benchmark.
  

• In most cases, the average returns of stocks that made "multiple days of higher highs"
  were negative 1-day, 2-days, and 1-week later.
  

• The results, on average, showed even greater weakness when we looked at stocks
  that made at least five consecutive days of higher highs.

In other words, on average, stocks that make "multiple days of higher highs" should not be bought.

Lower Lows

We looked at stocks that made at least three consecutive days of lower lows, all the way to stocks that made at least seven consecutive days of lower lows. Here's what we found:

• The average returns of stocks that made "multiple days of lower lows"
  were positive 1-day, 2-days, and 1-week later.
  
• In every single case, the average returns of stocks that made "multiple days of lower lows"
  outperformed the benchmark.
  
• The results were even stronger when we looked at stocks
  that made at least five consecutive days of lower lows.

That means traders should look to build strategies around stocks that make at least five consecutive days of lower lows.

Graph 1

As you can see, on average, stocks that make at least five consecutive days of higher highs show a negative return over the next week (-0.20%). By comparison, stocks that make at least five consecutive days of lower lows show a positive return (+0.76%).

Once again, our research shows that both news and emotions lead investors to do the opposite of what they should be doing. They are buying when stocks make multiple higher highs and selling when they make multiple lower lows. In both cases, on average, this is will lead to negative returns. Much like my previous article on Gaps and Laps, we found even greater opportunities by adding simple conditions, like stocks trading above or below the 200-day moving average, or combining multiple higher highs/lower lows with PowerRatings, etc.

Our research showed time and again, across almost every possible parameter, that the notion multiple higher highs are bullish, and multiple lower lows are bearish is incorrect. The statistics clearly show that, on average, it has been better to be a buyer of multiple lower lows, rather than multiple higher highs.

So, rephrasing the question asked at the beginning of this article, "Is it better to be a seller of stocks that have been strong and have made multiple days of higher highs? And, is it better to be a buyer of stocks that have been weak and have made multiple days of lower lows?" The answer (to both) is a resounding "yes".

Please send me any questions or comments you may have regarding this article.

Ashton Dorkins is Editor-in-Chief of TradingMarkets.com.
editor@tradingmarkets.com

Larry Connors is CEO and Founder of TradingMarkets.com, and Connors Research.

^* Our research looked at 7,050,517 trades since Jan 1, 1995. We applied a price and liquidity filter that required all stocks be priced above $5 and have a 100-day moving average of volume greater than 250,000 shares.