These Two Myths Hinder Investors' Returns By Michael Salvatore, Editor, TradeSmith Daily In This Digest: - The two wrongheaded impulses of the casual investor…
- A cautionary tale against buying “cheap” stocks…
- Breaking news: you want to buy stocks that go up (even when they’ve doubled)…
- Mind the bounce in the U.S. dollar…
- Why money flows are powerful for short-term trading …
A friend of mine (probably) made a mistake… I was recently talking to a friend of mine about a big stock purchase he made. Understand, this guy is not a big finance nerd like you or me. And what I’ve noticed is folks who invest casually and aren’t in the thick of it every single day tend to make two key errors that don’t seem like errors intuitively. - They buy individual stocks when they make big, headline-worthy down moves, thinking them suddenly “cheap.”
- They ignore stocks that go up very quickly, thinking them “expensive.”
I get why people think this way. It’s an attempt to invest like Warren Buffett that, unfortunately, does not have the desired result. Oftentimes all this frame of mind does is help you miss out on returns. Anyway, my friend made error #1. He tells me he bought a bunch of stock in Intel (INTC) after its dismal earnings report back on Aug. 1, which sent the stock cratering 26% in a single day. Mind you, this was a few days before the massive rout that erupted in the wake of the Bank of Japan-induced deleveraging event. I get why some investors think this way when they hear of this happening to a company like Intel. It’s been around longer than many investors have been alive. It makes central processing units (CPUs) that are standard in a ton of different computers the world over, including the laptop I’m typing this on and probably a whole lot of systems in the plane I’m flying on as I write this. My friend, like me, is also a traditional nerd who likes to tinker around with computers and rightfully turns to Intel’s CPUs when he’s building one. Suffice to say, looking at INTC intuitively, that drop looked like a fire sale. And if INTC had bounced in the four weeks to follow, I would eat humble pie. But one look at the chart and, well, I’m still hungry: 
Not only did INTC not bounce off that massive drop, it sank lower… and ended the month down 28.3%. That’s even after a merciful 9.5% surge on the final trading day of the year. You know what did bounce after the early August smackdown? Well, lots of stuff. But you could’ve kept it simple and used it as a buying opportunity in the SPDR S&P 500 ETF (SPY), which rose 3.8% over the same span. The moral of the story here is that stocks usually sell off for a reason. Intel may make great products, but its business leaves a lot to be desired. Just look at our own assessment here at TradeSmith: 
INTC has been in the Red Zone – our proprietary measure of poor momentum – for four months. It has a Business Quality Score of 11 (out of 100!) – a lousy score, dragged chiefly by low profit margins and five-year growth rates. And all this for a stock that still trades at more than 96 times earnings – so we can throw “cheap” out the window. Sometimes it can be good to invest in products you like. It sure worked for Apple (AAPL) and Amazon (AMZN) investors. But it’s no hard and fast rule. And you have to do a bit more digging to see if the business matches the product quality. To check the Business Quality Score on any of your stocks, TradeStops Pro is one of our subscriptions that includes BQS; click here to learn more and try it out. My base take is stay away from Intel here. It’s a long road to a turnaround. Not to mention the stock hasn’t made a new high since the dot-com bubble top. There are better options out there… In fact, why not try some stocks that have gone up? Hard to believe, I know... but stocks that go up are generally better buys than stocks that go down. Even stocks that go up a lot really, really fast. I noticed recently that Nvidia (NVDA) has gone up 150% in the last year. That means it nearly tripled. If you tell most people that, they’d say “Well, sounds like I missed that one.” Turns out, that couldn’t be further from the truth. To really put this theory to the test, I screened the Nasdaq 100 for stocks that have gone up 100% or more in the span of six months. Keep in mind these are Nasdaq 100 stocks – not little biotechs that soar on FDA approvals or other small-cap anomalies. Big companies, big market caps. Then, I looked what happened if you bought and held those 100% rippers for three months. Your layman would probably just assume you’re due for some pain. The hot stock’s too hot and needs to cool off. Not so. Over the past 10 years, I found 154 separate instances of Nasdaq 100 stocks rising 100% in six months. - Three months after that happens, the stock was positive more than 61% of the time.
- Taking wins and losses (even including delisted stocks that fell a max of 99.4%), the average gain was 11.7%. That’s a massive win for an average return on such a broad dataset over three months.
- And get this – the average winning gain was 29.4%... but the average losing trade was just 16.9%.
Let’s say you want to hold for six months. Should tamp those returns down some, right? Wrong. - With a six-month hold time, the win rate jumped to 69%.
- The average trade jumped to 23.8%.
- The average winner was 46.1%, but the average loser was 26%.
So, everything amps up across the board. In other words, you don’t only want to not avoid red-hot stocks… you want to buy them and ride the rollercoaster. Myth #2 squashed. It’s September now, and the macro is lining up with the seasonals… You might be aware that September is the worst month of the year for market returns. It was, in fact, the only month with a negative average return going back to 1928 for the S&P 500, which lost -1.1% in Septembers on average. Well, one chart is helping manifest another ugly September for stocks, and it’s the almighty greenback. The Relative Strength Index on the daily chart of the U.S. Dollar Index (DXY) has turned higher from oversold conditions. It’s crossed above its moving average. And it’s doing that after a strong positive divergence – as DXY went lower, its RSI went higher. That’s three strong signs that the momentum has shifted bullish for the time being. Now, look at the chart itself. We can see that the DXY, which measures dollar’s performance against a basket of foreign currencies, has been in a downtrend since July: 
The dollar index has been bouncing off a similar support level all that time and retreating from a similar falling resistance level. Last week’s price action, though, got it above support. Now, is a strong dollar necessarily bearish for stocks? No. But it is something of a headwind. A stronger dollar means one thing for sure – it eats into corporate profits earned in foreign currency, which a lot of the S&P 500 companies earn. That could weigh on company earnings in future quarters, resulting in some misses come earnings season. More generally, a bullish dollar can indicate that investors are de-risking and hiding out in greenbacks, which still earn a decades-high real yield, ahead of traditional September volatility. Our take is: It may be prudent to follow them. Some profit-taking ahead of the worst month of the year, during a seasonal period of high volatility, may indeed be the right move. Another good move is to shorten your time horizon… As we’ve pointed out many times before in these pages, periods of high volatility are great for focusing on short-term trades. The benefit is twofold: - You don’t have to worry about where stocks will be in months or years – that’s hard to anticipate even in the best of times. You can just focus on the next week, or day, or hour… and trade that way.
- Plus, you get the added benefit of higher premiums across the board in the options market. Whether you’re a seller of options and benefiting from high volatility after the fact, or a buyer of options benefiting from volatility surges, there’s a lot working in your favor.
But to really get that edge, I recommend following money flows in the options market. And if you don’t know how to do that, you need to talk to my friend Jonathan Rose. Jonathan’s a former pit trader at the Chicago Board Options Exchange (CBOE) and a master of options flow. His whole trading style is watching for unusually high volume in the options market. The kind of volume that makes you go, “Wow, okay, someone knows something…” and then look deeper. This technique has been absolutely killer for Jonathan. His followers would have the chance to close at least 10 triple-digit winners in just 12 months from the model portfolio Jonathan shares in his Advanced Notice trading room. Jonathan is particularly excited about the trade he’s preparing to share Friday in the trading room. He thinks that one could be a 1,000% winner. Learn more about Jonathan’s unique trading approach right here, right now – which may prove the perfect time to do so, if history is any guide. To your health and wealth,  Michael Salvatore
Editor, TradeSmith | 
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