A question we’re getting a lot these days is when the market ultimately does bottom, do we want to be buying the stocks that have been hit the most or the ones that have held up the best during the market’s fall?
As with most things in markets and in life, the answer is it depends. In this post, we’ll explain why.
Let’s start with what people are usually asking when they pose this question: What stocks are going to appreciate the most, and the fastest?
At its core, the question is flawed because it focuses on how much money can be made, as opposed to how much potential risk must be assumed to achieve that potential reward?
The 200-day moving average is a simple way to track the underlying trend of the market and the 21-day average true range measures how much volatility there is on a daily basis over the last month.
What we see from the chart is that when prices are BELOW their 200-day moving average, we tend to experience higher volatility and lower returns.
Click on chart to enlarge view.
Running the stats on the Nifty 500 since 1995, we see that when prices are above the 200-day moving average we see an average daily return of 0.14% and a 21-day ATR value of 1.43%.
When prices are below their 200-day moving average we see an average daily return of -0.10% and a 21-day ATR value of 2.00%.
In other words, stocks below their 200-day moving average experience higher volatility and lower returns than stocks above it.
It’s why we use the percentage of stocks above their 200-day moving average to help identify when we should get involved in the market again after a major decline. We’re not concerned with catching the exact bottom (or top), we’re concerned with the meat in the middle of the move where stocks are trending and volatility is lower than average.
This brings us back to our original question, do we buy the weakest or the strongest stocks once the market bottoms?
The weakest areas will likely have the largest percentage moves but experience significantly more volatility than the average stock, whereas stronger areas of the market may appreciate less in percentage terms but experience significantly less volatility than the average stock.
Neither choice is inherently better, but the message is clear: The opportunity for alpha lies in the extremes. If you’re looking to generate alpha, you can’t own average stocks that behave like the index. You have to be involved in either the weakest or strongest names.
Which extreme you play in depends on what you’re timeframe is, and more importantly, how much risk you’re willing to accept.
For people taking a longer-term portfolio approach owning the strongest stocks that are already in uptrends will likely give them a trade that lasts longer (in terms of time in the position) and require less active management since it will likely experience lower volatility. But if you’re looking for large percentage returns in a shorter timeframe and can withstand the volatility, the weakest names often see a sharp snapback.
These are the factors to consider now so that when the weight of the evidence begins to suggest a sustainable bottom has formed, you know what opportunities are relevant to you and how to take advantage of them.
Thanks for reading and let us know if you have any questions.