Let me start with a question.
Your car has been working without any sign of trouble for a year. Do you expect it to keep running smoothly…or do you worry about a breakdown?
Most people probably wouldn’t give it a second thought. Chances are the car will keep working for a lot longer. Something could go amiss tomorrow. But odds are it won’t.
Many things in life are the same. There’s a natural tendency for events to follow a steady course.
Sure, the cycle will change — life has its ups and downs. But a change in fortune can take a while.
The stock market is no different. It can remain bullish or bearish for lengthy periods. So too can individual stocks. A company’s share price can rise for years.
Think about this. Suppose a stock has been on the rise. It’s just hit a three year high. What’s more, the share price is up at least 300%. Would you consider buying this stock?
People typically view this in one of two ways. Some will look at the past and project it forward. Others will think the shock has run too far and believe it’s about to fall.
Which do you thinking is the better option for making money?
I’ll answer this in a moment. But first have a read of this. It’s an email I received last week.
‘I have been reading the Quant Trader for two weeks now. To be honest, it is not what I thought. So far each of the buy signals I have received have been at a record high on the day of the signal.
‘From reading the lead up to purchasing, I was of the opinion the Quant Trading computer was picking up trading type stocks at a low, not at a record high.
‘I have paid a lot of money for what I feel is high risk buying at record highs. I am more comfortable buying at a more speculative level then this risk level.’
Let me start by saying this. Quant Trader identifies stocks at various stages of a trend. Some will be at all-time highs while others will be just beginning the recovery process.
Quant Trader is also a medium term strategy. It’s not aiming for gains over one or two days. The aim is to capture trends that last many months.
That said, this is an excellent question. I think the logic would make sense to many people. It seems prudent to avoid stocks after a big run.
But there’s a problem. Doing this filters out many of the best performers.
Here’s the thing. A stock trading at a multi-year high is clearly a strong stock. But strength isn’t a good indicator of approaching weakness.
Sure, all bull markets end. A well performing stock could break down tomorrow — but it probably won’t. The path of least resistance is up.
Let’s go back to my earlier question. Who’s more suited to making money? The person that can project forward, or the one who thinks the market has run too far?
Well, it’s the former. This type of mindset makes it easier to ‘jump aboard’.
You see, the odds favour a trend continuing. And some continue for a very long time. In fact, trends often run further than almost anyone thinks possible.
Now let me ask this question again.
Suppose a stock has been on the rise. It’s just hit a three year high. What’s more, the share price is up at least 300%. Would you consider buying this stock?
Think about this for a moment. What’s your natural tendency?
I suspect many people would think they’ve missed it. Some may even be thinking about shorting opportunities.
Rather than guessing what might happen, I’ve done some back-testing. It’s always good to pull a few statistics into a discussion.
What I did was modify Quant Trader’s algorithms. I set two new criteria for a buy signal:
- A stock must be at a three year high (or greater)
- It must be at least 300% above its three year low
So what do you think happens?
It’s actually quite interesting. Have a look at the chart below.
This shows the hypothetical profit from the strategy. The date range is 1 January 2000 to 24 April 2015. It assumes putting $1,000 on every buy signal.
Buying stocks at a multi-year high is a successful strategy. You’ll also notice the strategy’s profits are near an all-time-high — something that can’t be said for the All Ordinaries.
So don’t worry about buying at a multi-year high — the trend is on your side. You’ll find it often pays to be optimistic when others are nervous.
Next week I’ll show you what happens when you only buy stocks trading at a three year low. I think you’ll find the results fascinating.
Editor, Quant Trader
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