If you ask most investors, you’ll find that they love to buy on weakness. They want to buy a “good company” after the stock has fallen 10%, 20% or more. A few investors, on the other hand, like to buy strength–they want to buy a stock as soon as it breaks out of a range, often into new-high ground.
(The phrase “buying strength” always reminds me of Carlton Lutts, who founded our company decades ago and successfully ran Cabot Market Letter until just a few years ago. He told me that, back in the 1960s, when Chrysler was a market leader of a brand new bull market, he bought some and told his broker to buy a little more every couple of points on the way up. He was working in France at the time, getting his trade confirmation slips in the mail … and he ended up getting 22 of them as the stock powered ahead! Needless to say, Chrysler was one of his biggest winners.)
Back to buying strength versus buying weakness, neither way is right or wrong. In Cabot Top Ten Report, I do like to buy the market’s strongest stocks during periodic pullbacks of 5% or 10%. But, truth be told, I prefer to buy neither strength nor weakness … instead, I like to buy tightness. It’s a topic I covered in one of my recent online seminars, and I want to write about it here.
Tight trading refers to a stock that really isn’t doing much of anything. For a big-cap like Johnson & Johnson or Coca-Cola, tight trading isn’t unusual and isn’t meaningful. But when you see it in a volatile growth stock after a big run-up, it’s almost always a bullish sign.
Why? Because tight trading following strong price action signifies two things. First, there isn’t much selling coming into the stock despite the advance; shareholders are content to hold their positions. Second, it usually tells you that big institutional investors are accumulating stock in a certain price zone–they’re telling their traders to buy, say, 200,000 shares in the next couple of weeks, as long as the stock is between 80 and 83. When a few institutions are doing this, the stock basically gravitates between those two levels.
The theory behind it is all well and good, but the reason I love to spot tightness is that it can highlight low-risk entry points into some of the market’s most dynamic stocks. The best way to spot them is by using charts, and here are some guidelines to work with:
First, I prefer to spot tightness on daily charts (as opposed to weekly charts). Tight weekly closes are a good sign, too, but I find it easier to hone in on true tightness on the dailies.
Second, you want the stock to be in a major uptrend–tight action after a big downtrend doesn’t mean anything. Demand that the stock is above its 200-day moving average, and hopefully its 50-day line, too.
Third, you want to see at least six or seven days, and preferably 10 or more, of tight action. Two days of quiet after a big run-up doesn’t do it. During those days, you want volume to dry up (which helps tell you that there’s no more selling coming into the stock), with a day or two marking the lowest volume in many weeks. And, remember, you’re looking for a consolidation, not a deep correction, so the stock shouldn’t retreat more than 10% to 15% or so.
If you see this, and the market is healthy, you can usually buy the stock right away, and put in a pretty tight stop-loss, making for a great risk-reward investment (lots of upside, little risk). That’s a good thing!
Flash Player 9 or higher is required to view the chart Click here to download Flash Player nowOne example today is Prudential Financial (PRU), which is not a stock that attracts me fundamentally. However, the stock zoomed from 30 to 46 over three days in early May on gigantic volume after earnings. Since then, the stock pulled back to 37 or so, but volume has begun to dry up and the stock’s movements are getting tighter. Chartwise, PRU likely won’t fall below 35 or so, if it even gets that low.
A growth stock example: Visa (V), which had an earnings-induced rally from 58 to 68 earlier this month, and has now gone quiet during the past two-plus weeks. Support should be strong in the low 60s, and a decisive move above 69 would be highly bullish.
If you’re game, I think you can nibble at both of these right here and add to your position should they break out above their respective resistance levels (46 for PRU, 69 for V).