From Busting Myths to Building a Trading System

In this issue:

» The silliness that goes on during IPO season

» A roundup of all the week's stock market action

» ...and more!

Most people believe technical analysis is only for day traders. But they're wrong. The fact is that technical analysis was developed long before computers, and it was initially used for medium to long-term investments. But with the advent of fast computers, it can be used across time frames.

Most people are unaware that technical analysis can be used to trade from a medium to long-term perspective.

Even the broking industry has largely neglected longer-term technical analysis in the quest for quicker and bigger commissions. It was never in their interest to tell their clients about medium or long-term trends as brokers earn more commissions when people trade frequently.

I knew there was scope to make higher returns by identifying long-term trends. So I set out to build a trading system that could benefit from these long-term trends.

Now, the best time to get into a long-term trend is just when it is reversing...from down to up. Getting into stocks that have fallen sharply...and are ready to move up...has two main benefits: One, the downside is limited with beaten-down stocks. And two, you can maximise profit potential by staying in them as long as the uptrend lasts. With this approach, we can limit risks while not compromising on rewards.

I have built my system after studying hundreds of stocks experiencing cyclical up and down trends. In our backtests, this system has generated 50%, 61%, 109% and even higher returns in a matter of just weeks to a few months.

I call it the SCOREFAST^TM system. The name is an acronym for the nine indicators I use to identify stocks on the cusp of a long-term reversal. These indicators help us identify trading opportunities that could generate big returns in a few weeks to a few months...

Here's an example of how the SCOREFAST^TM system works...

The stock we are looking at is Punjab National Bank. The SCOREFAST^TM indicators gave an entry signal on 25 May 2016 at 74. Let's look at PNB through the lens of each indicator.

1. Stretch Indicator: The stretch indicator tells us how far (in percentage terms) a stock is from its 200-day moving average (DMA). Stocks that deviate from their mean tend to revert to the mean.
   
   I've plotted the stretch indicator in the lowermost panel. The indicator hit an all-time low of -45% in February 2016, which means stock was trading 45% below its 200 DMA. The indicator recovered marginally by May, but it was still near the lows, which means the probability of the stock bouncing back towards it long-term average was high.
2. Crash or %Drop: The crash indicator tells us how much (in percentage terms) a stock has crashed from its highs. Stocks that have crashed more than 30% are more inclined to move up again.
   
   PNB topped out at 231 in December 2014 and crashed to a low of 69 by February 2016. This was a drop of 70%, more than double our minimum requirement of 30%.
3. Oscillators: Oscillator indicators like Relative Strength Index (RSI), Moving Average Convergence and Divergence (MACD), and Rate of Change (ROC) help identify a shift in momentum from down to up.
   
   Each of these momentum indicators were in a deep oversold zone between February and May. The 14 day RSI had already hit an all-time low of 11.32 in January 2016. But it didn't follow suit in May. It formed a higher low of 28 in May 2016. This was a clear sign of bullish divergence and an early indication of change in momentum from down to up.
4. Reversal Patterns: A break out from reversal patterns such as an inverse head and shoulder, double bottom, rounding bottom, and rectangle patterns often confirms a reversal of trend from down to up.
   
   PNB touched a low of 69 in February 2016. It retested this low in May after a pullback. The possibility of a double bottom or 'W' pattern formation was strong.
5. Entry/Exit: We recommend a stock only after it has witnessed a sharp fall and has limited downside. And we exit a stock only when the up move has exhausted.
   
   The stock was trading near its 52-week lows and its lowest level since March 2009.
6. Fibonacci Retracement: Retracement levels are specific intervals or percentages such as 38.2%, 50%, 61.8%, and 78.6% of the previous move, around which the stocks tend to find support or resistance. We look at price action around these levels to identify an opportunity.
   
   PNB was trading above the crucial Fibonacci retracement level of 78.6%. This level is considered an extreme point from which bulls could snap back in action.
7. Stock Cycle (Accumulation): The price of every stock moves in a repeating four-phase cycle: Downtrend-Accumulation-Uptrend-Distribution. We look for stocks that are in the accumulation phase and are ready to move into the uptrend phase.
   
   PNB was moving rhythmically from one phase to another. I marked all the phases on the chart since August 2013. The downtrend phase started in December 2014. The stock moved into the accumulation phase in February 2016.
8. Support and Resistance: Previous highs and lows act as supports for stocks. We look for stocks trading near multi-month support levels.
   
   All the major bottoms were made in the range of 60 to 75. The probability the stock would bottom out around these levels during the ongoing bear market was high.
9. Time: Stock prices tend to stay in a range for a while before they can move further up. Once the stock has spent enough time consolidating gains, we can enter for the big upside.
   
   PNB topped out at 231 on 19 December 2014 and bottomed out at 69 on 24 February 2016. This means the downtrend lasted for 432 days (14 months). Most bear markets last anywhere between nine and fourteen months under normal circumstances. We'd already seen a price correction of 70% from the highs and were at the end of a time correction as well. Thus, from a long-term perspective, the stock was ripe for reversal.

With PNB, all nine SCOREFAST^TM indicators signaled a reversal was around the corner. And it was. The stock zoomed off just days after the system gave us the signal.

Now, it's important to note that a system can easily identify a reversal, but no system in the world can tell you how long the uptrend will last.

So, the best way to benefit after identifying a long-term reversal is by using a trailing stoploss and holding the stock as long as it stays above the trailing stoploss. This is what world-renowned trend followers do: cut their losses short and let their profits run.

It's what we do as well. We applied a 10% trailing stoploss to PNB. It was triggered on 22 July 2016. We marked the exit price at 119.45 (the opening price on the next trading day). This was 61% above the entry price of 74.

That's how the SCOREFAST^TM system can identify stocks on the cusp of a long-term reversal. If you want to benefit from this system, you have two options: One, learn the system yourself and apply it. Or allow me do all the work and send you stock recommendations based on this system.

If you're considering the second option, then I have good news for you. I just launched a new trading service based on the SCOREFAST^TM system.

It's called Peak Profit Alert, and you can know more about it here.

03:05 Chart of the day

Talking of trends, one hot trend in the stock market these days is definitely that of initial public offerings (IPOs). The markets have been doing well, and promoters and investment bankers are of course busy making hay while the sun shines.

But there is another curious phenomenon that comes along with IPO season. Already listed companies belonging to the same industry as that of a high-profile IPO tend to see a surge in their stocks in the months preceding the IPO.

See today's chart of the day for example. Retail stocks had a field day during the two months leading up to the Avenue Supermarts IPO (subscription needed). There are plenty other examples too.

The Avenue Supermarts IPO Effect?

This is very intriguing indeed. Why would the value of an already listed company increase as a response to an IPO of another company? Aren't the markets supposed to be efficient enough so that its stock already reflected its fair value to begin with?

And if it is all hype (generated by the strong marketing machine of the IPO) and no substance, then shouldn't investors become very cautious about such spikes in these stocks' prices?

Yes indeed they should. During IPO season, investors are bound to see a lot of silliness go on. Caution is the name of the game.

Most of the global financial markets ended the week on a flat note. The Brazilian index registered a 3.3% drop over the week, making it the top loser. Most of the global indices ended the week on a flattish note as they awaited cues from the US financial markets amid an impeding rate hike by the US Federal Reserve. European financial markets closed marginally positive as market participants managed to eke out gains late in the week, digesting strong US jobs growth data. Market participants in global markets remained cautious as a probable rate hike by US Federal Reserve was priced in the global indices.

US financial Markets (down 0.5%) snapped their four-week winning streak and ended marginally lower as participants were already looking ahead for the probable interest rate hike in the US Fed meet next week. Trump is looking forward to lower the tax burden on corporates. The Fed is scheduled to meet next week with most market participants expecting the central bank to tighten U.S. monetary policy. According to the CME Group's FedWatch tool, market expectations for a March rate hike stood at 93 percent.

Among developed economies, all European indices closed on a slightly weaker note in contrast to the rally earlier in the week. The UK indices closed the week down by 0.4%, while the German and French indices ended the week on a flattish note with gains of 0.1% and 0.2% respectively.

Back home, the BSE-Sensex ended in green and was up 0.4%. The week started on a positive note with the Indian indices hitting their respective 52-week highs earlier in the week. However, the early momentum was lost amid caution ahead of the assembly election results in five Indian states.

04:56 Investment mantra of the day

"We don't have to be smarter than the rest. We have to be more disciplined than the rest." - Warren Buffett

Editor's note: There will be no issue of The 5 Minute Wrapup on 13^th March 2017 on account of Holi.

This edition of The 5 Minute WrapUp is authored by Apurva Sheth (Research Analyst).