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Pareto's Law And Stock Leadership

03/25/11 01:37:28 PM
by Billy Williams

A relatively unknown report reveals how Pareto's law applies to trading winning stocks and how you can profit from it if you know what edge it offers.

Security:   BIDU
Position:   Buy

In Pareto's law, famously known as the 80/20 principle, roughly 80% of the effects come from 20% of the causes and, in the case of stock leadership, this principle can be quantified to give you a strong edge in the pursuit of outsized gains in the stock market. In their report "The Capitalism Distribution," the Black Star Fund group documented their findings of an exhaustive study conducted to identify the massive differences between successful stocks and failing stocks that make up a given index.

What was revealed was an elegant conclusion that when applied can give you a deciding factor in selecting winning stocks versus underperforming stocks that go nowhere.

To quickly summarize their findings, the following results were documented out of more than 8,000 stocks:

-39% of stocks were unprofitable investments
-18.5% of stocks lost at least 75% of their value
-64% of stocks underperformed the Russell 3000
-25% of stocks were responsible for all of the market's gains.

The final documented finding where 25% of the stocks were responsible for all the market's gains is what warrants a closer observation.

Comparing this to the other findings from this study, the one deciding factor that stood out from other stocks was "both the biggest winners on annualized return and total return basis tended to have one thing in common while they were accumulating market beating gains," according to Black Star. See Figure 1.

BIDU broke out to an all-time higher of just over $46 in January of 2010 and continued higher to almost triple in stock value. Along the way, each significant high offered a great opportunity to enter as BIDU continued to make new all-time highs as a high-peforming stock leader.
Graphic provided by:
In fact, if you had managed through sheer bad luck to invest in every type of stock instead of the top 25% of high-performing stocks trading near their all-time price highs between 1983 and 2007, your total return would have effectively been 0%.

Now, the question remains: How do you use it to trade effectively for higher returns?

First, you want to run a stock scan that identifies stocks that are currently trading near their all-time highs. Then, run a filter on the trade volume where the stock trades more than 300,000 shares a day based on a 20-day moving average (this will keep you out of penny stocks and low-priced stocks that have been in a trading range at the low end of the price range for a while).

As a stock that is consolidating or in the middle of a bull run trades through a prior significant high, you want to place a stop-buy order just over that high to enter right as momentum is carrying the stock higher. If a stock is going to trade from $20 to $300, then it needs to trade up through $30, $40, and higher before getting to $300 a share, giving you plenty of opportunity to ride the stock's momentum to each significant price level.

There are lots of methods of placing stops in order to control risk, but you might want to consider a stock placement strategy based on the average daily price range of the stock itself. Winning stocks have a shelf life of 9.85 years, according to Black Star's report, so you want to give the stock a wide berth when placing a stock to compensate for market selloffs, earnings reports, and so on. Two times the average daily price range should keep you in good standing during downturns and if your stop does get hit, you can reenter if the stock gains support and trades up through its former significant all-time high again in the same fashion you entered. Otherwise, look for a new emerging stock leader that is trading at or up through its all-time high and start the cycle again.

Trading stocks this way with quantifiable edges lets you trade successfully in the long term as well become one of the elite few that successfully make money from the market on a consistent basis.

Billy Williams

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

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