When declines happen, it's not all bad. Sure, it's difficult, and if we aren't prepared, it can be disappointing and discouraging. Emotions run high as fear and panic grip the market.
However, turbulent times can bring some benefits. Periods of market stress allow the identification of relative strength sectors and stocks. This is an excellent way of identifying future leadership and the areas of true strength.
The decline itself uncovers stocks with strong relative strength and identifies the places investors can hide during the selloff. Market weakness separates the wheat from the chaff and staying with those positions that don't flounder has proven to be a good strategy.
So where do we start? Typically in a decline, the stocks that have run up the most and the quickest ahead of the selloff are the stocks most vulnerable to profit-taking when the volatility surfaces. If the pullbacks have not created any technical damage, they can provide an excellent opportunity to re-enter these leadership names.
We look for the declines to have three characteristics: selling on lighter volume, no distribution prior to the decline and the stock needs to have held support. A good example of this is
a farm machinery manufacturer.
Prior to the recent corrective action, this stock held an established uptrend in a strong sector. The selling resulted in only a minor pullback on light volume and found support at the intermediate-term trend line. This is a good entry point into the stock.
Another way to identify opportunities is to find those stocks that did not join in the selling malaise. There are still a number of stocks that did not succumb to the selling.
The typically more resilient issues are those that joined the rally late or had only recently emerged on the upside. These stocks have less to lose, have less downside risk and are under most participants' radar when the selling starts.
They can quickly emerge as leadership in the ensuing rally. The technology sector is one area that comes to mind and had only recently began to participate. Many names in this sector are not as susceptible to profit-taking and are lower-risk buys in a corrective decline.
We can offer a well-known name that is displaying excellent relative strength,
. While the indices and the majority of stocks were selling off, Cisco simply traded sideways, holding on to the gains made the previous three weeks.
This is a positive configuration that recently completed a major basing process. The stock is not extended or at risk of a deep pullback, making it a high-reward/low-risk trade at current levels.
When things get ugly, stick with what holds up the best. It will provide not only a place to hide, but the possibility of even more when the recovery emerges.
At the time of publication, John Hughes and Scott Maragioglio were long Cisco. Hughes and Maragioglio co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.