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Key Factor In A Bull Market

09/22/10 08:39:17 AM
by Billy Williams

Studies show there is one key factor in stocks leading the next bull market as well earning the highest returns.

Security:   PCLN, LZ
Position:   Accumulate

One of the key factors in identifying the strongest stocks that are likely to lead the stock market higher in a bull market are whether they are trading at an all-time high. Studies have shown that stocks that are trading near or at least close to their five-year high are going to not only yield the highest overall return but also take the general market higher.

One of the reasons for this anomaly is that unlike stocks that have fallen far below their previous all-time highs, stocks that are leading the market higher don't have any overhead resistance. This term was coined by William O'Neil, founder of Investor's Business Daily and author of the trading classic, How To Make Money In Stocks, and applies to the significant highs previously made in a stock's price action that a fallen stock must trade up through again. See Figure 1.

FIGURE 1: PCLN. Priceline trades higher at an all-time high just after trading upward on a extreme price gap. This shows there is a lot of demand for the stock.
Graphic provided by:
These significant highs in price action serve as resistance because the investors or traders who bought the stock at these levels often hold onto positions even after the stock has fallen in price because of fear. Fear is the result of not having a sound approach in the market, and O'Neil observed that when buyers see their investments fall, instead of choosing to sell and take a quick loss, they become immobilized by fear. They reason that they will just hold onto their positions and wait for the tradable to "come back a little" or until they break even.

This flaw in the investors' thinking is, again, the result of a lack of a plan or sound methodology.

However, when the stock's price action begins to trade upward, the investors who have been hanging on for the stock to come back, in some cases for years, finally begin to sell off their investments.

FIGURE 2: LZ. Lubrizol is not only trading at an all-time high but formed a cup & handle pattern recently, revealing a low-risk entry as the stock heads higher.
Graphic provided by:
When this happens, a chain reaction occurs. Massive sell orders can affect the trajectory of the stock's trend, resulting in violent whipsaws that can appear erratic and confuse inexperienced traders. In turn, many aspiring traders or investors who don't have experience with this phenomenon will exit their positions early. See Figure 2.

Stocks that trade at their all-time high tend to have a smoother trend, and while they may experience the natural ebb and flow of buying and selling in their price action, they avoid the turbulence of waves of sellers along its path since it has no significant price points where herds of anxious sellers may be lurking. This helps the stock make more progress in a shorter time; it avoids having to make up for lost ground, as its trend is taken down by this type of selling action and moves upward. This steady increase in value helps you make more money in less time, taking advantage of the compounding effect of both stock value and time.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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