Should You Buy A Very Weak Close? The Answer Usually Is, Yes!
Friday December 26, 1:12 pm ET
By Larry Connors
TradingMarkets.com
Thinking Different...Part IV
Three weeks ago (http://biz.yahoo.com/tm/031208/11017_4.html) and two weeks ago (http://biz.yahoo.com/tm/031215/11047_4.html), we began the process of looking at how markets really work and we backed these findings with statistical evidence. We found that buying 10-day lows in the market over the past 15 years, in both the S&P 500 index and the Nasdaq, was a far superior strategy than buying 10-period highs. In fact, had we, bought 10-period new highs (breakouts) and exited on the close the day the market closed under its 10-period ma, we would have lost money, in spite of a market that has risen significantly. Simply buying the 10-period lows, essentially at the times when no one else wanted to be buying, was a much better way to go.
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Last week (http://biz.yahoo.com/tm/031219/11074_4.html), we looked at selectively waiting to enter markets instead of "guessing." We saw that in spite of the upward bias over the past 15 years, one had about a 50-50 chance of "guessing" the next day's market direction. But, had one simply waited for the market to pull back and drop three days in a row (again buying when no one else wanted to be buying), one would have correctly predicted the direction of, the market nearly two-thirds of the time, within a few a days.
Buying 'Em When Nobody Wants 'Em...Part IV
Now, this week let's look at another counterintuitive way to enter markets, which goes completely against the way we've all been taught.
W,e've all been told to buy a strong close. Strong closes carry into the next day, right? The news is great, the market looks great, the buying momentum is there...it's when we should be entering the market. And on the opposite end, get rid of your positions on very bad days. The days that look like crap are the days that are going to look like worse crap tomorrow. Get out today in order to avoid tomorrow's "follow-through." All great advice. But none of it is true.
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Let's assume that the trend is up (the market is trading above its 200-day moving average) and that today was a wonderful day. And as we headed into the close, the money managers and institutions were screaming to their brokers..."all in". They needed to be fully long by the close. The message was that things looked great and they wanted to be long, as the rally (in their minds) was going to continue. The SPX (AMEX:SPY - News) closes in the top 1% of ,its daily range. This means things couldn't be stronger. And, as I mentioned, we've all been taught that this means we'll likely follow through the next day. "Things looked strong today" is the most common quote you'll hear after the close. And they are right. Things did look strong today. So what has this meant for tomorrow? It's meant "NO EDGE." This scenario (the market closing in the top 1% of its range for the day, while trading above its 200-day moving average) has played itself out 395 times since 1989. Am,azingly, the market has risen 198 times the next day and dropped 197 times the next day. The urge to splurge and buy into these days is meaningless as it's basically a flip of the coin whether we would go up or down the next day.
Now let's look at the results at the opposite end of the spectrum with the market also above its 200-day ma. The market looks horrible today and "things look bleak for tomorrow," because the close was weak and the S&Ps ended t,he day closing in the bottom 1% of the range. When this has happened over the past 15 years, guess how often the conventional wisdom was correct and the market followed through to the downside the next day? It followed through a whopping 34.8% of the time! Yes, all that selling at the close and all that doom-and-gloom "analysis" was correct a bit over one-third of the time. 65.2% of the time, the market rose the next day, completely at odds with the conventional wisdom.
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We Said It Three Weeks Ago And We'll Say It Again This Week...The Key To Market Success Is To THINK DIFFERENTLY
1. Buy When They're Selling and Sell When They're Buying. We've seen this over and over again the past four weeks.
2. When the urge to sell is great because the market "looks weak," it's often the best time to be buying. Buying 10-day lo,ws, buying after the market has dropped three days in a row, buying when the market closes in the bottom of 1% of its daily range is not something most people do. But, at least over the past 15+ years, it's been where the money has been made.
3. When everyone is on TV screaming buy, buy, buy because the economy looks wonderful, the market looks healthy, Saddam has been captured, etc., etc., etc., the only t,hought in your mind should be sell, sell, sell!
4. In no way do I believe this is the only way to make money in the markets. But, historically, buying on weakness and selling into strength is a core fundamental truth of the marketplace that has existed for decades. It can be done with long-term investing and it can be done with short-term trading. The time frame is irrelevant, it's the principle that's important.
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5. Much of the conventional wisdom (which is logical) is wrong. The key is for you to find the things that do work. Hopefully the past four columns have given you ideas on how to go about looking at the market, going forward. As I've stated before, the stock market, most times, goes from overbought to oversold to overbought to oversold. The edge moves in your favor when you're buying when it's oversold and selling when it's overbought. Not only does this s,tatistically prove itself out, but it also makes a heck of a lot of sense.
Have a great week trading (and send any questions you may have to me at larryconnors@tradingmarkets.com)!
P.S. You can find a number of trading lessons and trading research such as we've seen over the past few weeks, in the University Section at www.TradingMarkets.com
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