Last week we wrote about using Stochastics with moving averages to help on the selection of stocks either as new sell or buy ideas. Lately, we are looking at potentially new buy ideas as most stocks are reaching oversold territory instead of overbought. Many in fact are just getting more oversold.
In terms of using Stochastics and moving averages to pick shorts, that is a whole other discussion, and we will pen on that after the next up cycle completes its run. Understand that most clients we advise are traditional long managers who may use an occasional hedge to protect on the downside.
For now, this has become an ugly market since SPY has failed at the 415 level the week after Memorial Day Weekend and stocks are failing below the 380 level on SPY which we thought had the potential to hold. Longer term we still think that SPY can bottom by late June or early July but it may be at a lower level which validates the discussion below and its theme. No one is a perfect timer.
As you may recall, when Stochastics get oversold (move under 20) and then move back above, the two moving averages we look at, the 5 day and the 20 day, are still in a downtrend with the 5 day yet to turn up. Shortly after the Stochastic moves back above 20 we would expect the 5 day to cross back above the 20 day if the signal is going to work.
Sometimes however the Stochastic can stay oversold for an extended period of time, a month or two. If this happens, then the trend is down and prices will continue to fall until we get a stochastic buy signal where the moving averages cross. We are using another strategy in this environment. This strategy involves “dollar cost averaging”.
The idea is pretty simple. If you are going to buy a position in a stock, then average in with say four buys over a week, month or quarter - a selected timeframe. How do you decide the timeframe? This is based on longer term technical indicators and is outside the scope of this discussion. We give an example below.
Let’s say at the end of Week 1 you bought your first position at $100. Week 2 you bought the second position you paid $95. Your average cost would be $97.50.
Week 3 you paid $90 a share. Suddenly your average cost would be $95. Your last purchase was in Week 4 and you paid $88 for the final position to get you to a 4% overall position (1% each week). The final average price would be $93.25.
A month later the stock has recovered to $100 and as a result of the average you have a gain of $6.75 or 7.24%. If you had bought the entire position week one, then your gain would be 0%. Even experts like myself have a tough time predicting the exact bottom. With a fast-moving market like we have now, it is easy to mistime your position by 5% or even 10% over just a two or three day period.
Averaging your position on down days is one sure way to lower your and your clients stress level. We have been advocating this to our Advisor Teams in the current market and have followed this approach since our days at Robinson Humphrey in the 1990s, Merrill in the 2000s and here at The Fred Report in the last decade.
Our current stance is as follows. We recommended to start to dollar cost average early May, with the idea that positions are completed at the end of September. Our forecast has been for a down second quarter, and so far, this seems to be on point. It is important to remember that not all stocks bottom at the same time! Some lead the market, and some lag it. This gives us time until September and an opportunity to see what stocks in our models are showing relative strength, and which stocks are weaker. Focus on stocks highly rated by your firms that are showing relative strength. That is likely to be the new leadership.
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