Should You Buy A Very Weak Close? The Answer Usually Is, Yes!

Three
weeks ago, and two
weeks ago, we began the process of looking at how markets really work and
we backed these findings with statistical evidence. We found that buying 10-day
lows in the market over the past 15 years, in both the S&P 500 index and
the Nasdaq, was a far superior strategy than buying 10-period highs. In fact,
had we bought 10-period new highs (breakouts) and exited on the close the day
the market closed under its 10-period ma, we would have lost money, in spite
of a market that has risen significantly. Simply buying the 10-period lows,
essentially at the times when no one else wanted to be buying, was a much better
way to go.

Last
week, we looked at selectively waiting to enter markets instead of “guessing.”
We saw that in spite of the upward bias over the past 15 years, one had about
a 50-50 chance of “guessing” the next day’s market direction. But,
had one simply waited for the market to pull back and drop three days in a row
(again buying when no one else wanted to be buying), one would have correctly
predicted the direction of the market nearly two-thirds of the time, within
a few a days.

Buying ‘Em
When Nobody Wants ‘Em…Part IV

Now, this week let’s look at another
counterintuitive way to enter markets, which goes completely against the way
we’ve all been taught.

We’ve all been told to buy a strong
close. Strong closes carry into the next day, right? The news is great, the
market looks great, the buying momentum is there…it’s when we should be entering
the market. And on the opposite end, get rid of your positions on very bad days.
The days that look like crap are the days that are going to look like worse
crap tomorrow. Get out today in order to avoid tomorrow’s “follow-through.”
All great advice. But none of it is true.

Let’s assume that the trend is up
(the market is trading above its 200-day moving average) and that today was
a wonderful day. And as we headed into the close, the money managers and institutions
were screaming to their brokers…”all in”. They needed to be fully
long by the close. The message was that things looked great and they wanted
to be long, as the rally (in their minds) was going to continue. The SPX
(
SPY |
Quote |
Chart |
News |
PowerRating)
closes in the top 1% of its daily range. This means things couldn’t be stronger.
And, as I mentioned, we’ve all been taught that this means we’ll likely
follow through the next day. “Things
looked strong today” is the most common quote you’ll hear after the close.
And they are right. Things did look strong today. So what has this meant for
tomorrow? It’s meant “NO EDGE.” This
scenario (the market closing in the top 1% of its range for the day, while trading
above its 200-day moving average) has played itself out 395 times since 1989.
Amazingly, the market has risen 198 times the next day and dropped 197 times
the next day. The urge to splurge
and buy into these days is meaningless as it’s basically a flip of the coin
whether we would go up or down the next day.

Now let’s look at the results at
the opposite end of the spectrum with the market also above its 200-day ma.
The market looks horrible today and “things look bleak for tomorrow,”
because the close was weak and the S&Ps ended the day closing in the bottom
1% of the range. When this has happened over the past 15 years, guess how often
the conventional wisdom was correct and the market followed through to the downside
the next day? It followed through a whopping 34.8% of the time! Yes, all that
selling at the close and all that doom-and-gloom “analysis” was correct
a bit over one-third of the time. 65.2% of the time, the market rose the next
day, completely at odds with the conventional wisdom.

We Said It
Three Weeks Ago And We’ll Say It Again This Week…The Key To Market Success
Is To THINK DIFFERENTLY

1. Buy When They’re Selling
and Sell When They’re Buying. We’ve seen this over and over again the
past four weeks.

2. When the urge to sell
is great because the market “looks weak,” it’s often the best time
to be buying. Buying 10-day lows, buying after the market has dropped
three days in a row, buying when the market closes in the bottom of 1% of its
daily range is not something most people do. But, at least over the past 15+
years, it’s been where the money has been made.

3. When everyone is on TV screaming
buy, buy, buy because the economy looks wonderful, the market looks healthy,
Saddam has been captured, etc., etc., etc., the only thought in your mind should
be sell, sell, sell!

4. In no way do I believe this is
the only way to make money in the markets. But, historically, buying
on weakness and selling into strength is a core fundamental truth of the marketplace
that has existed for decades. It can be done with long-term investing
and it can be done with short-term trading. The time frame is irrelevant, it’s
the principle that’s important.

5. Much of the conventional
wisdom (which is logical) is wrong. The key is for you to find the
things that do work. Hopefully the past four columns have given you
ideas on how to go about looking at the market, going forward. As I’ve stated
before, the stock market, most times, goes from overbought to oversold to overbought
to oversold. The edge moves in your favor when you’re buying when it’s oversold
and selling when it’s overbought. Not only does this statistically prove itself
out, but it also makes a heck of a lot of sense.

Have a great week trading (and send
any questions you may have to me at lconnors@tradingmarkets.com)!

Larry
Connors

P.S. You can find
a number of trading lessons and trading research such as we’ve seen over the
past few weeks, in the University Section of TradingMarkets.com