While finding winning stocks is an essential part of the equation for consistent positive returns, avoiding the losers is just as important. Many analysts would have you to believe those big losers that investors and traders get stuck with can merely be chalked up to unforeseen news events or bad luck. The truth is that any given time roughly 20% of all available stocks to purchase are part of what I would call the "litter group" that should be avoided at all costs. The leaders are where you want to position yourself, the laggards can often be disguised as leaders short-term which we only find out in hindsight, but the litter is typically very easy to pick out in the crowd. To my amazement, some analysts focus their efforts almost solely in this group, and it shows up clearly in their long-term performance. This article will discuss character traits of the litter group, which is typically brutally obvious so that investors and traders can avoid this group. A portfolio made up of 50% leaders, 30% laggards, and 20% litter can manage to break-even or show a negative return for the year as the litter group's losses can easily offset the leader group's gains. One of the easiest reminders I use to stay away from this group is as follows: "If you can't avoid the litter, your portfolio returns will end up in the toilet".
The popular mantra "buy low and sell high" seems to be engrained in the minds of most market participants, but it is imperative that one knows when to buy low and when just to say "no". When it comes to great companies with no deterioration in the fundamentals, buy low can work quite often, when it comes to the litter of the market, what seems low often goes quite a bit lower. Fortunately for investors, there are a few things to watch when deciding whether one should buy low. These three things will help one discern whether they're buying low on a stock that's worthy of that bet or whether they're parking their money in a pig. The following four questions should be answered before one buys low:
- Is the stock below its 200-day moving average?
- Is the stock more than 25% off of its 52-week lows? What is the current 12-month return for the stock?
- Does the stock belong to one of the worst-performing sectors currently?
Let's dig a little deeper into what the answers to these questions should be below:
The 200-Day Moving Average
Paul Tudor Jones was interviewed by Tony Robbins and said something that I believe is extremely underrated that most market participants are not aware of. The following excerpt is from that interview:
(Source: "Trader" Documentary with Paul Tudor Jones)
Tony Robbins: Okay, any specific strategies for protecting your portfolio?
Trader Paul Tudor Jones: I teach an undergrad class at the University of Virginia, and I tell my students, "I'm going to save you from going to business school. Here, you're getting a $100k class, and I'm going to give it to you in two thoughts, okay? You don't need to go to business school; you've only got to remember two things. The first is, you always want to be with whatever the predominant trend is.
Tony Robbins: So my next question is, how do you determine the trend?
Paul Tudor Jones: My metric for everything I look at is the 200-day moving average of closing prices. I've seen too many things go to zero, stocks and commodities. The whole trick in investing is: "How do I keep from losing everything?" If you use the 200-day moving average rule, then you get out. You play defense, and you get out.(Source: Trend Following Trading Systems & Research from Michael Covel)
As Paul Tudor Jones explains above, when an asset class is under the 200-day moving average, the reward to risk ratio has dissipated, and the priority is to conserve one's capital. While it's possible that occasionally you will find deals under the 200-day moving average, it is better to wait for that asset class to reclaim this key moving average first. There will always be exceptions to any rule, but a trader's focus should be on the next 100 trades, not the current trade. One thing I see a lot is individual traders that will point out why a strategy doesn't work because the last time they did the opposite of this strategy, they managed to find a big winner. A good trade is a trade that has a positive edge going into the trade and is carried out with discipline, and a bad trade is one without a positive edge and is made with zero plan or discipline.
Many traders and investors seem to think that a good trade is one that makes money and a bad trade is one that loses money; this is flawed thinking. This is the same idea as a poker player playing low-probability starting hands and winning and then concluding that this is how to make money. Just because a weak starting hand like J-4 (Jack-Four) managed to beat a hand like K-K (Pocket Kings) does not mean this will happen in the long run. This recency bias about a strategy with a negative edge will eventually bankrupt a poker player, the same as it will make it difficult for a trader to be consistently profitable over any 10+ year period. Many traders get bailed out and look great in bull markets, but shopping for deals under the 200-day moving average in a bear market is an excellent way to set oneself up for a 30% plus drawdown in one's equity.
As we can see in the above chart of Barrick Gold (ABX), this stock clearly has exuded one of the key characteristics that litter stocks show. It most recently broke beneath its 200-day moving average (yellow line) in September of last year, and has been a clear avoid using this rule since. While there have been rallies in the stock over the past year, these bounces were against the dominant trend and were difficult to profit from unless one was very nimble. When the trend is down and trading beneath the 200-day moving average, it makes the most sense to stay away. If one is stuck long a stock beneath the 200-day moving average, any bounces are opportunities to lighten up or exit positions. An example of this is H&R Block (HRB), which I mentioned was a sell into earnings in the $27.00+ area in my recent article "H&R Block: Sell The Rally".
One of the easiest ways to spot a stock that belongs to the litter group in the market is by seeing whether it's below its 200-day moving average. If the market is trading well above its 200-day moving average, but a stock is below its 200-day moving average and is having difficulty reclaiming it, in most cases you're either shopping in the laggard or litter group. The next two characteristics can help you to see whether the stock is a laggard which may be temporarily out of favor or part of the litter which must be avoided.
Percent Off Of 52-Week Lows + 12-Month Performance
The second characteristic to determine if a company is in the litter group is what percent the stock is from its 52-week lows and its 12-month performance. Stocks in the litter group typically have a hard time rallying more than 25% off of their 52-week lows, while laggards may temporarily drop beneath their 200-day moving averages but may still be in the upper or mid-range of their 1-year chart.
An example of a laggard which had a pretty good year up until now but has recently succumbed to the selling and fallen beneath its 200-day moving average line is Abercrombie & Fitch (ANF). As we can see from the below chart, while the stock is below its 200-day moving average for the past couple weeks, it is more than 80% off of its 52-week low. As it only has one characteristic of the three that would make it a litter stock, it is just a laggard.
Taking a look at Barrick Gold, we can see that the stock is only 7% off of its recent 52-week lows, which means it meets the first two requirements to be placed in the avoid list of litter stocks. I do not care what the fundamentals are for a company that's in the litter pile, the simple fact that a stock is less than 25% off of its 52-week lows and staying below its 200-day moving average tells me just about everything I need to know. This is especially true when the market itself is less than 1% off of its 52-week highs and well above its 200-day moving average. Just because Barrick Gold is stuck beneath its 200-day moving average and trading near 52-week lows does not mean the stock can't stage a rally, but the stock does have higher odds of being sold off into this rally. Therefore, from an investment standpoint, it is not an ideal candidate. The stock is best suited for only experienced traders who can swing stocks in bear markets. The fact is that most retail traders that trade from the long side in bear markets will lose out over the long run whether they're willing to admit it or not.
The problem with the majority of stocks that are not at least 25% off of their 52-week lows is that they are going to be in ranges or downtrends in the majority of cases. If a stock is in a range, then this means it's most likely going sideways and I would consider it dead money, and I might as well be holding cash at the bank earning interest. If a stock is trending down and in a bear market, then cash is definitely the best option from an investment standpoint. While there are some traders that can trade their way around downtrends and stocks in bear markets from the long side, most fail, especially when we exit a bull market. This is because they are used to getting bailed out by the market when they buy weakness. In a bear market, things change drastically. Positions that used to drop 20-30% off their highs during a bull move can start dropping 50-60% during an intermediate bear move.
The final part of this analysis comes down to the 12-month performance (or return) for the stock, and those in the litter group will typically show a negative return of 20% or larger. As we can see, if we head back to the second week of September in 2017 for Barrick Gold, the stock also meets this requirement as it's down 40% over this period - more than double the required threshold to constitute as a litter stock.
In summary, if a stock is trading below its 200-day moving average and cannot reclaim it, is also trading within 25% of its 52-week lows, and is down 20% or more over the past 12 months, there's a very good shot it belongs to the litter group. There are caveats to this rule which will be mentioned at the end of the article.
When it comes to a stock's sector, it's extremely important to know what pond you're fishing in. A little known fact to many traders is that 40% of a stock's move is tied to the sector it is a part of. This means that an investor or trader absolutely needs to know the strength of the sector that they're looking for prospective new buys in. Two of the weakest sectors this year have been Silver Miners (SIL) and Gold Miners (GDX), and it shouldn't be much surprise that new positions added between January of this year and now have likely been terrible investments.
The trouble with buying a stock in a weak sector is that the weight of the sector will often drag on the stock. Except for Kirkland Lake Gold (KL), Corvus Gold (OTCQX:CORVF) and a few other names, more than 85% of the sector is showing a negative year-to-date return. If an investor knows that the sector they are looking for new prospective buys in has the worst year-to-date performance of any sector, they will be aware that they have stacked the odds massively against themselves before they even start that position. This is because 40% of a stock's move is tied to the sector it's trading in. What this essentially means is that if the sector continues to drop, you have a 40% chance that the stock you've selected will follow the sector down.
As we can see from the Barrick Gold example used above, the stock meets all three requirements of a litter stock. It's in one of the worst-performing sectors, it's spent the past year below its 200-day moving average and continues to trade below it, and it's within 25% of its 52-week lows and down 20% or more over the past year. For the reasons laid out here, there is no reason to be long the stock other than very short-term trades. This doesn't mean the stock can't come back in favor, but the odds are stacked against a trader going into any long trade in the stock. A trader or investor should want to select the best starting hands like Pocket Aces or Pocket Kings, not one of the worst starting hands like Jack-Four which Barrick would currently belong.
So what are the caveats?
The big caveat to this rule in discerning between leaders, laggards, and litter is what the overall market is doing. If the S&P 500 is in a full-blown bear market and down 25% for the year, many leader stocks and even laggard stocks are going to exude the same characteristics as the litter group shown above. This is why it's imperative to know what type of market you're in when it comes to applying this rule. A stock that is sitting at 52-week lows and down 20% for the year while below its 200-day moving average would be completely normal if we were currently in January of 2016 or September of 2011 when the S&P 500 was down nearly 10% for the month. The easiest way to identify the litter group of stocks is when the market is strong as they stick out like sore thumbs. This is when it's the least excusable to be invested in these stocks as nearly everything else is performing well and it's a massive opportunity cost to be holding duds. Unfortunately, this doesn't stop many analysts from recommending these stocks on a regular basis.
It is important to remember that great returns do not just come from finding the best winners, but from protecting one's self from the litter. The litter stocks can often end up as penny stocks eventually in a bear market and getting stuck with these is a great way to hinder one's performance. Hopefully this sheds some light on how to better avoid these names in the future.
Disclosure: I am/we are long SPY, CORVF, UPRO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: While I am long Corvus Gold currently, I am only long on the Canadian Market for liquidity reasons. The stock is much more liquid on the Canadian Market under the ticker $KOR.TO. It is my only gold miner I am long currently, and I am long from $2.83 CAD.
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Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.