Every year, countless newsletters and trading systems promise a steady stream of winning stocks, but few deliver. More often than not, they pick more losers than winners, leaving aspiring traders with less money than when they started. Some of these spurned traders quit. Others begin developing their own means to stock selection.
To new observers, the market seems to offer many opportunities at first, but most of these opportunities are false and almost all are fleeting. Soon, it’s clear that having a trading method alone isn’t enough without a proven way to find the stocks you’ll trade in the first place.
The ability to pick winning stocks relies on a working framework of stock selection that is reliable for the long-haul. The most reliable frameworks are derived from both technical and fundamental analysis.
Technical vs. fundamental
With technical analysis, price and volume are used to determine when to buy or sell stocks. To the market technician, everything is already expressed in the stock’s price action or its direct derivatives. No thought is given to fundamentals.
When Amazon (AMZN) first went public, it had no earnings or profits, but if you had entered its upward trend with just $1,000, your investment would have appreciated to more than $65,000 in just 18 months. In this case, fundamentals would have failed while a technical approach designed to exploit momentum would have done exceptionally well.
However, this is simply a well-chosen example. While a pure technical approach has merit, it fails to acknowledge that no stock can outrun bad fundamentals over the long run. As fast as a stock may rise, it can just as quickly reverse and take all of your gains down with it.
For those who are not afraid of hard work or long hours, you can devote yourself to the arduous process of fundamental analysis. Studying countless annual reports, revenue growth, tracking earnings and spreadsheets will allow you to gain insight into the current state of health for a given company. While this is helpful, the reality is that companies with good fundamentals often fail to translate that into their stock’s performance.
Starting in 1973, operating on extensive fundamental analysis, Warren Buffett began buying shares in the Washington Post, but experienced no return for almost three years before the stock began to show a pulse. That can be a frustrating test of patience for any trader or investor, no matter how experienced.
Both the technical and fundamental approach of stock selection have their strengths and weaknesses. Certainly, there are extraordinarily successful traders and investors who use one or the other method exclusively. The answer to minimizing risk and uncovering reward for most traders, however, exists somewhere in the middle.
The HAEN Model
During the last 150 years or so, stocks that have emerged from apparently nowhere to rack up gains of 50%, 100%, 500% or greater have had four common factors: High relative strength, accelerated earnings, explosive price action and new price highs. These factors are the cornerstones of the HAEN model of stock selection.
High relative strength
Relative strength is a comparative indicator that measures the performance of a given stock against the market. The score can range from 1 to 100; the higher the score, the better the stock is performing compared to the rest of the stock market. This is a readily available indicator in financial media and analytical software (see “It’s relative,” below).
You want to trade on the side of strength, which is where you’ll find stocks that are leading the rest of the market higher. These stocks tend to take the market higher while outperforming the other 80% of the market. Bottom line, look for stocks with a six-month historical relative strength of 85 or greater.
Studying the biggest stock winners in the last century, there was a common thread that they possessed: Accelerated earnings. This performance indicator separated run-of-the-mill stocks from those to emerge as leaders. Consider the following:
- Dell Computer’s (DELL) earnings per share surged 74% and 108% in the two quarters prior to its price increase from November 1996.
- Cisco (CSCO) posted earnings gains of 150% and 155% in the two quarters ending October 1990, prior to its giant run-up over the next three years.
- Google (GOOG) showed earnings gains of 112% and 123% in the two quarters before it made its runaway move after its IPO.
- Going back as far as 1914, Studebaker’s earnings were up 296% before it sped from $45 to $190 in eight months.
- In 1926, du Pont de Nemours showed earnings up 259% before its stock took off from $41 and surged to $230 before the 1929 stock market crash.
Earnings are what allow competitive companies to break free of the stock market’s gravity and ratchet up superior returns. Look for companies that have reported at least two consecutive quarters of earnings growth of 30% or more.
Explosive price action
The school of technical analysis teaches that there are two forms of price action: Contraction and expansion. When price is contracting, it appears to be trading back and forth with no real direction or movement. Neither the bulls nor the bears have control of the stock’s price movement and the stock will remain range-bound. When price enters a period of expansion, it will trade in a specific direction. If bullish, then price will trade upward in a steady series of higher highs and higher lows. For a bearish stock, price will trade downward in a steady series of lower highs and lower lows.
When a stock is experiencing a period of contraction, accelerated earnings often will act as a catalyst to ignite the stock’s contracted price action into expansion (see “Earning potential,” below).
New price highs
Stocks that are racking up big earnings are followed by explosive price moves, which then often lead to new price highs.
New price highs indicate strength and separate the wheat from the chaff by revealing potential stock leaders from average stocks. Those that emerge as leaders will outperform any other class of stocks; including blue-chip, value, dividend yielding, and they take the overall market higher as well. For this reason, stocks that are trading near their all-time price highs are where future stock leaders are likely to emerge (see “Not ready,” below).
Trading at new price highs gives you a strong edge three ways: It avoids overhead resistance, takes advantage of momentum and rides the path of least resistance. Overhead resistance forms when a stock declines and begins to reverse its direction and make up lost ground, but encounters resistance at each significant price point on the way back up. This resistance occurs at these levels because investors who had bought at these price points before the stock declined have been sitting there waiting for the stock to come back rather than sell and take a loss. As price begins trading back up through those price points, then those investors sell at breakeven to get out of the position. When they do this, volatility enters the market and throws off the stock’s price trend that was in motion.
At new price highs, a stock has no overhead resistance to create a drag on the trend, giving it a distinct edge.
Stocks that have strong earnings attract legions of investors, including institutional investors like mutual funds or pensions. Earnings drive the majority of the investment decisions by major institutions that are hungrily looking for new up-and-coming companies to invest in. As a result, their massive buying and selling creates new dynamics in the supply and demand for the stock and increases share price in the process.
Sound speculation is about putting the probabilities on your side and taking measured risks. Trading at new price highs accomplishes this by helping keep you on the right side of the trend. Trend trading is like taking an elevator in the mall versus hiking a dangerous canyon. You still go up but you avoid the jagged edges and treacherous cliffs by taking the path of least resistance.
In trading, there is a strong emphasis on finding the right trading method for your personality to have a chance at being successful. But, if you don’t have a method to spot opportunities that complement that trading system, then you are likely to do more harm than good to your trading account.
George Soros and Warren Buffett are incredibly successful money managers who each has a unique system of finding opportunities to match their individual trading styles. But, if you were to force them to trade each other’s picks, they would likely be much less successful.
So, however or whatever you trade, the first step is having a method of picking the right stock to match your trading style.
The HAEN model provides a framework to find emerging stock leaders with runaway potential. But you have to combine it with a reliable trading system and the discipline to use both effectively.
Billy Williams is a 20-year veteran trader and publisher of StockOptionSystem.com, providing commentary and reports on the fundamental keys for the aspiring trader.