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The Trouble with Trend Reversal Indicators, Part 2

Having been working with the Trade Radar trend reversal indicator for over a year, it is time to talk about insights I have gained. This article is a continuation of the original post titled "The Trouble with Trend Reversal Indicators".

This post is concerned with "follow-through" or the ability for a new trend to fully establish and maintain itself. In other words, did the stock throw a head-fake or did it truly do an about face?

Trend reversals tend to be driven initially by internal factors affecting a stock: earnings or buy-out rumors, for example.

There are also external factors that affect a stock. In the first post we talked about "event risk" or things that come out of the blue that would not have been predictable after having read an 8-K.

One of the more formidable external factors for an individual stock is the market itself.

In my observations, I have seen a number of stocks generate great looking BUY signals. Many of these stocks did see some good follow-through for a time and initially did provide share price gains. Fundamentals for many of these stocks were decent. Then the stocks took a tumble. Why?

Market risk --

It is difficult for a stock's price to avoid being affected by gyrations in the broader market. You may have heard of the term "beta". Beta is a measure of a stock's volatility in relation to the rest of the market. Cash would have a beta of zero. A stock that is exactly as volatile as the market would have a beta of one. A stock that bounces all over the place would have a high beta.

"Correlation" is another term that investors use to describe how closely a stock mirrors the behavior of a particular index or other investment. Correlation ranges from 1 (highly correlated) to -1 (the two investments tend to move in opposite directions).

When you combine beta and correlation you begin to see how the market can impact an individual stock. A plunging market can stop a rallying stock in its tracks. On the other hand, a rallying market can pull up a stock that perhaps doesn't deserve it.

In tracking the performance of our various stock alerts we have seen both of situations play out. If the market turns downward, it often takes many stocks down with it. The opposite situation is captured in the old saying: "a rising tide lifts all boats."

As an added variation on the theme, keep in mind that a sector is really just a subset of the overall market. When a particular sector heads for bear territory, it can easily take down both the good stocks and the bad stocks that make up that sector.

Internal risk --

Stocks making a reversal to the upside are, almost by definition, formerly weak stocks that ran into problems severe enough to cause prolonged down-trends. At the point where a reversal appears to occur, enough investors have bid up the stock to create a bump up in the stock price. If the down-trend is steep enough and the up-turn is steep enough and high enough, we get a TradeRadar BUY signal. If investors become convinced that it's now safe to buy the shares, the reversal is confirmed and the price increases.

What this means is that stocks that have recently begun a trend reversal are vulnerable. They are vulnerable to a withdrawal of confidence on the part of investors. They are vulnerable to declines in sectors and markets. They are not perceived to be as solid as another stock that has proven itself over time. Essentially, there is a lack of trust. When markets turn down, it becomes easy to cut loose the riskiest stocks, those with a poor track record. Our trend-reversal candidates often fall into that category. And sometimes the perceptions are accurate, especially in those cases where the financial good fortune only lasts for one quarter.

Another aspect of being a reversal-candidate is that gains often come quickly after the stock bottoms out. At least that is the kind of chart formation that TradeRadar often identifies. In a down market, these initial spikes upward can lead to a quick retracement as early investors take profits while they can. For low priced stocks, the initial spike up can result in 50% to 100% gains from bottom to peak. It's hard to keep the upward momentum after those kinds of gains, especially if the overall market is working against you.

Conclusion --

Our first post on trend reversal indicators discussed how the lag built into some reversal indicators cause the signal to be generated late.

This post points out that good reversals to the upside can sometimes collapse. The reasons can be related to overall market or sector weakness as well as a lack of confidence on the part of investors.

In these kinds of situations an investor has to make a decision: hold on to the stock or sell it. From a discussion of technical factors, we are now brought full circle to a focus on the fundamentals. If the reversal was based on a jump in earnings, for example, an investor must decide if it was a one-time event or if the company is on a sustained path to increased profitability. In other words, the decision to hold should be based on the financial prospects for the company.

As always, an investor can't live by technical analysis alone. Ultimately, the fundamentals must be acknowledged. And as we pointed out above, general market forces will always have their say.

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