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Knowing When It’s Time to Sell

by Michael Kahn

Listen to Michael Kahn's presentation at the AAII Investor Conference!

Most investment sites, courses and gurus offer all sorts of ways to find stocks to buy. Whether they are fundamental, technical or dart throwing, there is no shortage of experts telling you where to put your money.

The problem is that buying is only half the job. Unless you plan to leave your portfolio to your children, at some point it will be time to sell some stocks and turn paper profits into actual cash.

Aside from analyzing high valuations and dwindling business prospects, the market itself can be very forthcoming with clues on when to ring the register. By spotting changes in the price trend or even just changes from market-leading to market-lagging performance, individual investors can do just as well as the pros when it comes time to sell.

All that is needed is a chart with one or more of the readily available tools found on most free financial websites. The goal is to spot stocks that have stopped going up or are about to stop going up. To paraphrase humorist Will Rogers, “Buy stocks that go up; if they don’t go up, don’t buy them.” Our goal is to determine when the stocks we already own have moved into the latter half of that dictum.

What Signals Are We Looking For?

There are two reasons stocks stop going up. The first is that they are tired and need to rest. Perhaps price action got too far ahead of the fundamentals. The second is that the bull trend is about to end and a new bear trend is about to begin.

This article is not concerned with the first reason, as the focus is not to trade around any short-term wiggles. Any stock that is just resting before its next push higher is clearly good to own and can be separated from stocks that are resting before turning lower with the methods outlined here.

Rather, I am talking about stocks and not companies. Companies produce value, but stocks are supposed to reflect that value. As we know, value and stock price are rarely the same on any given day, and there is a whole industry built around finding stocks that are undervalued based on the fundamentals. But stock prices swing from theoretically undervalued to overvalued and back again. A good company with a good product may not have a good stock because the market has already priced the stock well above where the stock “should” be.

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Typically, overvaluation comes from too much excitement over the “next big thing.” Stocks such as rare earth minerals miner Molycorp Inc. (MCP) in 2011 and Tesla Motors Inc. (TSLA) earlier this year come to mind. Apple Inc. (AAPL) also generated far too much enthusiasm given its sales and innovation pipeline just before it peaked in 2012, and countless investors wished they had some sort of method for spotting the pending bear market before it really got under way.

Watch the Trend

Charts do not tell us if a stock is fundamentally overvalued or undervalued. However, charts reflect the actions of all market participants, who each have their own view on valuation. It is the sum of their actions—buying, selling or doing nothing—that we use to make our determinations.

Remember, charts are tools used to gauge what market participants are doing with their money. They do not predict the future any more than reading tea leaves or chicken entrails do. Charts do show when investors are behaving in a way similar to what they have done before, however. History shows what tends to happen next.

The simplest way to spot a stock that is tired and ready to pull back, if not reverse course altogether, is to measure the trend. Even without any gadgets or computer drawing ability, a trend can be eyeballed as the stock price moves from a low in the past to a high in the present. We want to know when the series of higher highs and higher lows—the natural ebb and flow of a stock—changes to a series of lower highs and lower lows. Netflix Inc. (NFLX) provided a great example in 2011, as Figure 1 shows.

If a straight line connecting the lows that looks like it follows the trend is drawn and prices move below that line, then we have our first indication that something has changed. When a stock moves below its most recent low, confirmation is given. All else being equal, the change in trend signals time to sell.

How do you know the difference between a correction and a true end of the road for a stock? There are no guarantees, but when the trend changes from up to down and prices make a lower low, the odds that it is more than just a bump in the road are rather good.

How do I know that? History is on my side. Even though outside actions in recent years, such as the Federal Reserve’s bond buying program (quantitative easing) made chart analysis more difficult, the principles still worked.

And they even worked ahead of non-market events such as scandals. In 1999, the chart of the now-defunct Enron yielded many clues near the top that something was not quite right. And just before the scandal broke wide open in 2000, the charts offered trend and technical pattern breaks to give investors a chance to save at least some of their holdings.

Spotting the End of an Upward Run

In early 2012, Apple could do no wrong. Every time it looked as if the stock was starting to stumble, it quickly came back to life and soon outrageous upside targets were being published by respected analysts. But in October 2012, the stock made a rather significant move to the downside and a plethora of technical sell signals fired, as Figure 2 shows. Something was different, even from the last time the stock seemingly fell apart just a few months earlier in April 2012.

Figure 3 shows the price action. The first clue that the stock was cooling off occurred in May 2013, when it failed to make a new high. Behind the scenes, the relative performance chart, which is simply the ratio of General Mills to the S&P 500 index, broke down. The stock moved from market leader to market laggard, which, of course, is not a positive development.

Market pundits were quick to exclaim that money was leaving consumer staples and moving into more aggressive areas such as technology. They called it a healthy rotation in leadership.

Such rotation does not mean General Mills was about to fall. The stock could have continued higher, but at a slower pace. The outlook changed when shares of General Mills moved to a new one-month low and broke its 50-day average to the downside. Within three weeks, the stock gave back nearly half of its gains to date and left investors scratching their heads. After all, the S&P 500 was still about 4% below all-time highs. Clearly, General Mills’ generous dividend yield and relatively stable business (consumer staples) was not enough to protect investors from losses.

Relative Performance and Fading Momentum

Relative performance and relative strength charts are very simple tools that can tell investors when a stock or sector is moving into and out of favor. I wrote about this in more detail in the June 2011 AAII Journal (“Picking the Right Stocks Using Charts”).

Spotting these shorter-term tops allows more active investors to outperform the market, but for most investors spotting “the big one” is far more important. How can you determine if the market is about to form a major top such as the one seen in 2007?

The principles are the same: Look for fading momentum, more urgent sell-offs and failed attempts to recover. Let’s look at Figure 4, which shows the performance of the S&P 500, and this will become clear.

In 2006 and early 2007, the market seemed to be firing on all cylinders. Housing was leading the way and all sectors were fully engaged in the rally. But over the course of 14 months, the market stopped going up and eventually rolled over. Wall Street wisdom points out that bottoms, such as the end of the bear market in 2009, are usually “events,” while tops are usually “processes.” Evidence that a bull market is ending builds gradually as more stocks and sectors start to change for the worse.

The first blow for the bulls was the initial news of the sub-prime mortgage crisis in August 2007. The stock market plunged and, although it recovered quickly, broke the string of higher highs and higher lows that mark a bull trend. Something had changed, although at the time the fundamentals, aside from the mortgage market, were still good.

The market moved back to new high ground but it did not last. Prices once again dipped back to the previous low—now called support—to signify more aggressive behavior by the bears. The balance of power, and supply and demand, shifted.

When the index sliced through its previous lows one more time, the technical sell signal was given. As I’ve come to expect, signals are never this clean and easy. After a 10% drop from support and a similar-sized recovery, the index touched that former support level one more time. It was the same kiss goodbye that occurred with Apple above but on a large, market-wide scale. The bear market raged for months thereafter.

An important point to remember is that the kiss goodbye occurred at the same price level for the S&P 500 that was seen in late 2006. The same price but with a different trend. One place was a buy signal, the other was a sell signal and it paid, quite literally, to know the difference.

Combine Charts and Fundamentals

Many investors use charts exclusively to make sell decisions, but most are likely more comfortable letting changing fundamentals tell them when it is time.

However, using charts in conjunction with other analyses can provide early warning for market changes so you can take profits and move either to other stocks or into cash to sit out market turmoil that may be on the way.

Michael Kahn CMT, writes the twice-weekly Getting Technical column for Barron’s Online (www.barrons.com) and the daily Quick Takes Pro newsletter (www.quicktakespro.com). Kahn will be speaking at the AAII Investor Conference this fall; go to www.aaii.com/conference for more details.


Discussion

Paul Hervey from IA posted about 1 year ago:

could you do the charts for caseys please


William Hutchinson from AZ posted about 1 year ago:

It's hard to tell a dip from a trend until the trend has taken away much of the gain.


Toan Nguyen from CA posted about 1 year ago:

It's always easy to look back and see that certain analysis make sense.


Werner Emmerich from PA posted about 1 year ago:

The RSI in conjunction with the 50 day moving average is actually quite a good tool for defining a trend, if you learn how to use it, especially for the entire market, where there are not so many other comparisons available. Some professionals are so good that they can infer a trend just from looking at a performance chart. I am not one of them.


Harish Jethwa from MD posted about 1 year ago:

I use 10/20/50 day averages, bollinger bands
and MACD, also RSI at Yahoo finance, to buy or
sell. I think they give good signals.
what do you think?


Norton Waterman from KY posted about 1 year ago:

I agree with the two previous views.


James Grant from OH posted about 1 year ago:

First, I have to say that I am very happy to read another article in the AAII Journal that offers advice on how to "use" technical analysis indicators to make trading decisions, rather than "how they are calculated". --- However, I was disappointed that Mr. Kahn copped out in the last couple sentences of his article, implying that investors should take fundamentals analysis into account, too.

I read the article pretty closely twice. While there are section titles, the rules to sell are largely buried in the text. Here's a list of the ones I was able to identify.

1. Sell when a series of higher highs and higher lows changes over to lower highs and lower lows.
2. Sell when the momentum indicator (RSI 14) rises above the upper threshold and then starts to fall.
3. Sell when the price falls below the 50-Day Moving Average (MA).
4. Sell when the Relative Strength line heads down.
5. Sell when a new low occurs after a new high is not reached.

These leave me with some questions for Mr. Kahn.

(1) If you believe (and I do) these rules are good enough to base a sell decision on, is there any reason you would not propose using the opposite rules to base buy decisions on?

(2) Are you proposing that an investor sell if any one of the rules is met? All five are met? Two of five?

(3) In the spring of 2012, AAPL's price dropped below its 50-Day MA and its RSI 14 was heading down. Is there any reason you wouldn't have sold then?

(4) If an investor uses your sell rules, are you confident that over the long run, he/she will materially make more money than just investing in a professionally managed fund that invests in the S&P 500?

(5) In regard to #5, when a new low occurs, how many past days, weeks, months should be considered to determine that it is a new low?

(6) What is the difference between #1 and #5?


I also offer these opinions to other readers of these posts:

* 50-Day MA - Using that technical indicator, an investor could take a 20% loss, as happened with AAPL in the spring of 2012. That's too much for me. There are several other technical analysis indicators (not the least of with is the MLR (Moving Linear Regression) line that give earlier sell signals than a simple MA.

* Straight Trend Lines - I've always been troubled about drawing lines on charts. The rules for drawing them seem quite arbitrary. As anyone who remembers high school geometry remembers, any 2 points constitute a straight line. So, how many points are needed? What is the minimum number of days, weeks, or months that should be covered by the chart before straight trend lines can be applied? Every time I hear/read someone offer answers to questions like that, I get a different answer.


Steven Greenfield from NY posted about 1 year ago:

I find it is is easy to look back and suggest when a sell decision was correct. How about picking 5 stocks that meet your criteria today and advising us what action should be taken and then following the movement of the stocks over the next 90 days?
That would be instructive, I believe.


Robert Talambiras from NJ posted about 1 year ago:

I fully agree with Steven Greenfield above. 20-20 hindsight may be instructive, but it is not convincing. Let's see some predictions, and publish the mistakes too!


Raymond Gundersen from CA posted about 1 year ago:

I have found the Ichimoku Cloud indicator most useful for making sell decisions. You can find it on Freestockcharts.com or your broker web site might have it. Research Ichimoku Cloud on Google to learn how to read it. Between 11/21/11 to 9/10/12 I had 7 potential sell signals using moving averages, MACD, and RSI on Ross Stores (ROST). Thanks to the Ichimoku Cloud it advised me not to sell and I held on for an 80% gain.


Ken from CA posted about 1 year ago:

Author Kahn, as useful as his remarks are, neglects to discuss volume action as a prime factor, notwithstanding his reference to "supply and demand."

Contributions from AAII members much appreciated as well.

Thank you.


Anthony Babich from MA posted about 1 year ago:

It's easy to present a working hypothesis from specific archival data, and, as all disclaimers state - this is not a guarantee of future performance. What is missing in all these discussions are statistics on both the archival and follow-up results of using these hypotheses on a continuing basis. When using multiple hypotheses, must they agree, or is one better, or should you use a weighted combination? In the examples, what if you used 50 day averages (arithmetic or exponential?) instead of a trend line, or vice versa? If you are looking for speed, I would submit that both the Fast Stochastic Oscillator and MACD would be better, but you might get dizzy watching them. From an overall perspective on longer term trends I would even suggest considering Point and Figure charts. In the end, however, I think that the final decision is a subjective one. As I said above, we don't have any numbers on how good anything is - are my chances of being right 30%, 80%, or what? Finally, let's not forget that the majority of trading today is algorithmic, which doesn't necessarily follow any of these hypotheses. Experience is the best teacher?


Bob Samson from MD posted about 1 year ago:

I avree with earlie posts basically stating that cherry picking of histotical data dies not carry much weight in this forum. Come up with deterministic rules thst can be back tested. To dste, only the shadow stock portfolio expkicitly fies thus.

It is time for AAII to begin looking at combinations of stock screens on both the buy and sell sides to complete the picture when comparing strategies.


David E. from Washington, Not D.C. - Vancouver, Not B.C. posted 12 months ago:

Some of you seem to have forgotten that market movement is a behavioral science, not a 'hard' science. So perhaps you should quit looking for concrete rules where there aren't any. These 'rules' are generalizations based on looking at past behavior suggesting patterns. Reading these patterns is an art if only b/c none of us can foretell the future.
I have great difficulty trying to determine when to sell. So I find the pattern IDs explained By Mr. Kahn above to be quite helpful. I've already bookmarked this page b/c I know I will be referring to it often as a starting point for my sell decisions.
Thanks, Mr. Kahn, for a great article. Timely, too, in today's market. Well done.


Enock Mwila from WA posted 12 months ago:

The article from Mr. Kahn is a very useful instrument for me. It gives good information on stocks. Thank you Mr. Kahn for your educational article and please publish more of this nature.


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