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The last thing that any investor wants to experience is one of their holdings going bankrupt. Yet, it happens–Washington Mutual, Lehman Brothers, Refco, WorldCom, Enron, Kodak, and the list goes on. In fact, during the 20-year period from 1989 to 2008, 21% of of all stocks listed in US stock markets became bankrupt (Phys.org).

But, how can you identify those companies that may be on their way to going under? That was the topic of a recent study by physicists, from Boston University in Boston, Massachusetts, and Fudan University in Shanghai, China. Their study attempted to “develop a statistical-analysis-based early warning system to forecast the time of bankruptcy.” Among their findings:

For all stocks, there is a correlation between volatility and volume. However, the closer a stock is to bankruptcy, the stronger the correlation, since both volatility and volume increase as bankruptcy approaches.

Maybe they’re on to something. However, here’s a more straightforward approach to identifying danger stocks: avoid declining trends!

(click to enlarge)

It’s easy to get hooked on the story of a company…why the market is making a mistake…how it’s becoming a better value…how it’s about ready to turn around (and some certainly do), but I would suggest that the best approach to avoiding stocks that are on their way to bankruptcy is to simply listen to the chart (or, even better, let your model listen to the chart!).

By the way, the chart above is that of Nortel Networks (currently being liquidated in bankruptcy).

HT: Abnormal Returns

Disclosure: A list of all Dorsey Wright holdings for the trailing 12 months is available upon request.

Source: Avoiding The Next Nortel