There is a little-known method that could soon become very controversial in the investing community, but if used correctly, could make huge profits for investors.
This secret method has been proven in numerous tests and the real market to provide a real, short-term entry edge for investors.
I came across this method while working at investment research firm Connors Research, which studies how the stock market really works by using a data-driven approach based on extensive statistical tests and a massive database of past trades.
The stock market is designed to lure the maximum amount of new investors into a stock at the wrong time. The technical setups that look obvious are often traps to quickly relieve investors of their hard-earned money. In other words, the professional market players are selling while the majority are buying, and vice-versa.
And what I discovered surprised me...
What I learned from practical experience as well as extensive tests on data containing millions of stock trades since 1995, is that buying stocks after a series of down days or lower lows creates a greater short-term edge than buying after a series of up days or higher highs. In other words, buying weakness, within certain parameters, trumps buying strength.
Here are the three rules that provide a short-term edge to investors:
1. The stock price must be above the 200-day simple moving average.
This means the long-term uptrend is still intact. Buying only stocks above their 200-day moving average on the daily close helps prevent buying a falling knife or stock that just keeps on moving lower.
2. The stock must have fallen lower sharply or for at least three consecutive days.
This drop in price creates the value that attracts professional investors to the stock.
3. The relative strength index (RSI) of the stock needs to be less than 30.
I use the RSI, but not in the traditional sense. In fact, it was discovered that the commonly used 14-period RSI provided zero statistical edge for short-term investors. Therefore, it was decided to test relative strength using different time periods. The testing was done by building a benchmark of the average percentage gain/loss of all stocks, trading above their 200-day simple moving average, during a one-day, two-day and one-week timeframe.
The amazing discovery is when the RSI periods are reduced to two, a profitable edge is created. What was statistically proven is that the lower the two-period RSI, the better the performance against the benchmark. In addition, the opposite was also true. The higher RSI, the higher the underperformance against the benchmark.
Here are two stocks I've been following recently and how these three rules prove that there's a profitable entry point for each of them.
1. Altria Group (NYSE: MO)
This "sin" stock y fits all three of the buying weakness rules:
- The price has fallen for three or more consecutive days.
- The RSI is well below 30.
- It is still trading above its 200-day moving average on the daily close.
The fundamental picture for the company is strong. Because it's diversifying away from its tobacco core business with other products, revenue is projected to increase 5% in 2013 and major hedge funds are ramping up their positions. In addition, the company has increased it's roughly 5.5% dividend year after year.
2. The Limited Group (NYSE: LTD)
The mall-based retailer of woman's clothing went ex-dividend on Dec. 18, plunging shares more than 6% into the value "buy" zone. This was a special $3 a share dividend following another dividend payout in August. Many companies are declaring special dividends ahead of the potential tax increase in 2013. Looking at the company's short-term technical picture, the RSI is less than 30 and the price remains well above its 200-day simple moving average, creating a compelling technical buying opportunity.
Future prospects are promising. Comparable store sales are increasing month-over-month with a 5% rise in November. Not to mention, the company has an aggressive international expansion plan that should help lift the bottom line in the long term.
Risks to Consider: It's critical to note that just because a particular investing method has been proven to tilt the odds of success in your favor, does not mean it will work every time. The tests are done on large amounts of data and indicate an edge over multiple trades, but not every single trade will be a winner. Always use stops and position size according to your account size and risk tolerance when investing.
Action to Take --> Both of these stocks are great buys right now based on the short-term technical screen. In addition, the fundamental picture is compelling for Altria. A close below the 200-day simple moving average on both stocks can serve as the stop out level from today's entry level.