Why Strong Stocks are Often the Worst Buy Candidates

If a stock gains 5% or more in one week, would you view this action as bullish? What if General Electric (GE | Quote | Chart | News | PowerRating) rose 5% next week? That would equate to an estimated $19 Bln. rise in GE's market cap (at current prices). The media would generally consider such a rise in the valuation of GE as positive. No doubt CNBC, the Wall Street Journal, Investors Business Daily, and others, would all be featuring the stock prominently. Most likely, the price rise would also be accompanied by bullish news.

The 5% gain and ensuing media coverage would lead many investors to expect prices to continue higher, right? Wrong! Unfortunately, most retail investors make assumptions about future price action that are incorrect. Meanwhile, professional investors, market makers, and hedge funds, armed with quantitative research, know what is likely to happen. They understand that, on average, it is better to be a seller of short-term strength and a buyer of short-term weakness.

At TradingMarkets we are committed to sharing institutional quality research with you, based on our own statistical studies of short-term market behavior. Our research allows us to trade with confidence, knowing that when we enter and exit the market, the odds are firmly in our favor.

How to Measure Short-term Strength and Short-term Weakness

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.

We then looked at stocks that have gained 2.5% or more in the past five days, all the way to stocks that have gained 25% or more in the past five days. This type of action would generally be considered to represent short-term strength. We also looked at stocks that have lost 2.5% or more in the past five days, all the way to stocks that have lost 25% or more in the past five days. This type of action would generally be considered to represent short-term weakness.

This research will help determine whether it's better to be a buyer of short-term strength and a seller of short-term weakness, or vice versa.

Stocks Up 5% or More

• Stocks that gained 5% or more over the past five days, on average,
  underperformed the benchmark 1-week later (+0.01%).

Stocks Up 10% or More

• Stocks that gained 10% or more over the past five days, on average,
  were negative 1-week later (-0.12%).

Stocks Down 5% or More

• Stocks that lost 5% or more over the past five days, on average,
  outperformed the benchmark 1-week later (+0.47%).

Stocks Down 10% or More

• Stocks that lost 10% or more over the past five days, on average,
  significantly outperformed the benchmark 1-week later (+0.77%).

This research is yet another study that shows buying short-term market weakness is superior to buying short-term market strength. It also shows that selling into short-term market strength is superior to selling into short-term market weakness.

Recent Example:

On 12/13/06 GE closed at $35.50; over the next five days GE gained 7.46% to close at $38.15 on 12/20/06. GE then lost 1.76% over the following five days.

Just like the other articles in this series (view archives), these returns can be improved even further by adding simple conditions, like filtering stocks based on whether they are trading above or below the 200-day moving average, days of the month, and/or combining them with PowerRatings, etc.

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 from Jan 1, 1995 to June 30, 2006. 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.

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