New Research On Why You Shouldn't Buy Breakouts, Part I

Today I'm stunned. No, that's an understatement. I'm beyond stunned. Why? It looks like we've all been sold a bill of goods. Let's take a short quiz and you'll soon see why...

Today's Test Questions:

Question #1

Let's assume that it's January 1, 1993, and the S&P 500 is at 435.38. Nearly 11 years later (today) it has risen over 145%, rising to 1061.50. How would you have done if you had been a breakout trader and bought every new 10-period high (as all the breakout traders were piling in, most of the money managers were likely adding to positions and the press was jumping up and down about how great things were), and used a trailing stop of exiting when prices closed under their 10-period average?

a. You made a ton of money and are now a member of the Forbes 400, because if the market more than doubled during that period, you as a breakout trader, made a fortune.

b. You made good money. You paid for your kids' college, have lots of money to retire on and have a second home adjacent to the Bush compound on the shores of Kennebunkport.

c. You outperformed buy and hold.

d. You lost money...lots of money.

Question #2

Same assumption as above, but you did the exact opposite of what we have all been taught. You SOLD the market as it made new highs. You put your face in front of a speeding train and shorted the market when the "smart" money was buying. How would you have done?

Question #3

Final question. Let's go a step further. You didn't buy any breakouts. You're a complete nut. You only bought the breakdowns! You only bought when the market made new 10-day lows. When everyone was yelling "SELL, SELL, SELL" -- just like Randolph Duke was yelling in the movie "Trading Places" -- you were just buying away (including during the bear market of 2000-2003), and exiting when the market closed above its 10-period moving average. How did you do?

The Answers

Let's first discuss this and get into the guts of what is exactly happening when the market is making a new 10-period high. This will let us better understand the correct answers.

By the time the stock market makes a new short-term high, there is likely an abundance of good news that has occurred over the past week. Solid economic reports, good earnings reports, upgrades on stocks, and more, have likely occurred. The world is looking very good during those times. Right? Right! So what should stock prices do from there? "Logically," they should go higher, isn't that so? So then "logically," the answer to Question #1 is a, b, or c. Well, the logic is wrong.

In spite of the fact that the market rose substantially during that time, had you bought the 10-day breakouts and exited when prices crossed below the 10-day MA, you would have lost money! In the S&P 500 index, you lost over 312 S&P points. Incredible, isn't it? We've all been taught and told to "buy strength." Great. Super advice. Except in this case, you were right a whopping 39% of the time. We've all been told to be mesmerized by lists that focus on today's new highs. Yet, it reality, it appears to be wrong...very wrong.

So the answer to Question #1 is that you did not beat buy and hold, you are unfortunately not a neighbor of the Bush family in Kennebunkport and you are also not a member of the Forbes 400. Buying new highs loses money...lots of money.

Now, let's move to Question #2. You sold the new highs. While everyone was buying because of the good news, you were "the dummy" who was shorting into this buying. So, how did you do? The results are the opposite of the breakout buyers (you exited when the market crossed under its 10-period MA). Selling new highs in a rising market made 312 points and was correct 61% of the time, whereas buying the new highs lost money. Who would have thought?

We'll now move to Question #3. What happened if you bought a market that made 10-day lows? Again, let's first get into the guts of the marketplace and understand what is happening. When the markets make 10-day lows, it almost always occurs while bad news is permeating the environment. Bad economic news, missed earnings from major companies, scandals and more are being discussed by the press, money managers and nearly everyone else. Again, "logically," no reasonable person would be buying here, But again, the logical ones are very wrong. Since 1993, had you bought every 10-period low and exited when the market crossed above its 10-period moving average, you would have made 830 S&P points (equity traders would use the SPDRs (SPY | Quote | Chart | News | PowerRating)). That's right, the S&Ps have risen a bit over 600 points during that period of time and you would have made over 800 points. Plus, 75.8% of your trades would have been profitable. Nice...very nice.

So How Do You Use this Information?

Many ways. But first let's remember that these are just statistical results that don't take into account trading costs, slippage, etc. And there is no way of knowing whether these results will do better or worse in the future. With that said, here is what the past 11 years' data tells us:

1. You don't blindly buy breakouts in the stock market. Yes, the world looks great, yes the news is wonderful, yes all the excitement is out there. But unless you have some superior exit strategy, you will likely have a very tough time making money buying the highs over the long run. If you didn't make money buying highs in the move since 1993, it's going to be awful tough to do it in the future.

2. As the markets are making these highs, the odds are increasing that a short-term reversal is near. You should be looking to lock in your trading gains as markets make new highs, not add new positions.

3. Buying markets which pull back (is this case, to 10-day lows) is a superior strategy. I strongly believe that. And the statistics prove this out.

4. Don't get caught up in the hype when markets make highs. The press and the investment community is jumping up and down telling us just how great things are during these times. They're right... EXCEPT THAT PRICES ALREADY REFLECT THIS! That's why prices are at new highs. And on the opposite end, there is nothing but negative near the lows. A few days of incidental negative news is not a formula for the market crashing. The "world-is-coming-to-an-end, doom-and-gloom crowd" use these few days to tell you why the market is going to zero and the end of mankind is near. Don't get caught up in this! They're always wrong.

5. And the most important thing to take from this week's column is the same as the theme from one of Apple's commercials ...think differently. Because at the end of the day, when everyone is thinking the same way, they're usually wrong. And, as you can see from this week's BattlePlan, this is especially true when it comes to the financial markets.
   
   Have a great week trading (and feel free to email me at lconnors@tradingmarkets.com if you need any help on the above)!

Larry Connors