Trade Like a Stock Market Wizard: How to Achieve Super Performance in Stocks in Any Market: How to Achieve Superperformance in Stocks in Any Market

by Mark Minervini

Remember, the market is a discounting mechanism that trades on the future, not the past. Just as you can’t drive a car by looking only in the rearview mirror, you shouldn’t run a stock portfolio on backward-referencing valuation metrics. I would rather own a stock that’s reporting strong earnings trading at a relatively high P/E ratio than a stock showing signs of trouble trading at a very low P/E.

The same could be said about an overbought/oversold technical indicator such as the stochastic oscillator. On the surface, both of these popular metrics appear to have a degree of accuracy at turning points because the eye is drawn to peaks and troughs. However, this 20/20 vision is usually a gift of hindsight. In real time, the eye is not very good at filtering out all the noise and static between the upturns and downturns. In addition, what is mostly ignored or misunderstood is the varying time frames spent in the direction of the countertrend reading.

Trying to buy oversold conditions and sell overbought conditions as a trading strategy is risky business. Trading with disregard for a strong directional trend will ultimately lead to buying into a precipitous decline. Similarly, buying stocks simply because the P/E is relatively low and selling because the P/E seems too high produces poor results time and time again. Although overbought and oversold conditions as well as high and low P/Es can exist at turning points, stocks can also have extreme high and low readings in a directional fashion just before major advances and declines. Major market declines always plunge to deeply oversold readings, and roaring bull markets storm through early overbought conditions while advancing much farther.

A common affliction among many investors, including some professionals, is what I call the broken leader syndrome. Here’s how it works. Investors who refused to buy a dynamic new leader when it was emerging—before it skyrocketed—become interested after that stock has topped and broken down in price. Usually this occurs during a stage 4 decline. These people buy stocks that were previously expensive, thinking they will go back up.

With all their rationalizing, they ignore the supreme fundamental: the market’s judgment. They stayed away when the stock was a market leader (probably because it looked expensive), and now they fail to recognize a broken leader. When a leader tops, more often than not the stock price is discounting a future slowdown in growth, which makes it no bargain at all.

By themselves, P/E ratios aren’t very helpful in determining the potential direction of a stock’s price. The P/E ratio tells you what the market is willing to pay for a company’s earnings at the current time. Think of the P/E as a barometer that measures the level of expectation. This is why many growth stocks experience P/E expansion during the growth phase; expectations keep getting higher as the company’s performance expands.

I use the P/E ratio as a sentiment gauge that gives me some perspective about investor expectation. Generally speaking, a high P/E means there are high expectations and a low P/E means there are lower expectations.

Seek out companies with the greatest potential for earnings growth. Companies growing revenues at a rapid pace are your best choice. Look for new emerging trends that can translate into mass expansion: trends that are scalable. Concentrate on entrepreneurially managed companies with exciting things going on (a catalyst), and you’ll eventually latch on to some big winners. The current P/E ratio at which a company trades is only a minor consideration compared with the potential for earnings growth. Growth stocks are driven by growth.

Historical study of superperformance stocks shows that the average P/E increased between 100 and 200 percent on average (or two to three times) from the beginning until the end of major price moves. This information can be used in two ways. First, you can get an idea of a stock’s potential. You can estimate what it might sell for as an average best-case scenario within a year or two down the road from your initial purchase price, that is, if you’re buying a dynamic leader in a bull market. You could estimate future earnings and apply the expanded P/E number to get a rough idea of the stock’s theoretical potential. Second, you can gain some perspective on how much of the company’s good fortune has already been discounted by gauging how much P/E expansion has taken place already. Let’s say you buy a stock with a P/E of 20 at its initial breakout from a sound base. Multiply 20 by 2 to 3 to see what the ratio could rise to. That gives you 40 to 60. You hope that the stock continues to rally. Though it’s always prudent to look for sell signals, pay extra attention once the P/E nears 2x and especially around 2.5x to 3x or greater. It could top soon afterward. If this occurs, look for signs of decelerating growth and signs of weakness in the stock price as your signal to reduce your position or sell it out.

The bigger point is that the P/E ratio doesn’t have much predictive value for finding elite superperformance stocks. There is no magic number when it comes to the P/E. In fact, the P/E is far less important than a company’s potential for earnings growth. Stop worrying about the P/E ratio. If you have a company delivering the goods as Apollo Group did, earning 40 percent per annum for four or five consecutive years, whatever the initial P/E was is irrelevant; the P/E takes care of itself. Leave the overintellectualizing and complex theories to the professors and academicians and the valuation tactics to the Wall Street analysts.

Valuing a company on intrinsic value is not trading stocks; it’s buying assets. Your goal is to make money consistently, not accumulate a lockbox of assets that you really don’t own—just pieces of paper that were made for trade.

MY SUCCESS AS A STOCK TRADER relies on a combination of science and art. Mechanical signals backed by scientific research and intuitive feel are both important tools.

When I am screening for superperformance stocks, my initial filter is rooted in strict qualifying criteria that are based purely on a stock’s technical action and is designed to align my purchase with the prevailing primary trend. Once this initial criterion is met, I run “overlay screens” and look at the company’s fundamentals to narrow the remaining universe of candidates. Simply put, no matter how good a company looks fundamentally, certain technical standards must be met for it to qualify as a buy candidate.

No matter how attractive the earnings per share, revenue growth, cash flow, or return on equity may be, I won’t consider buying a stock that is in a long-term downtrend. Why? I want to see some interest in the stock, preferably from big institutional investors. I’m not interested in being the first one to the party, but I do want to make sure there’s a party going on. The goal is to eliminate stocks that are not worth my time so that I can focus on contenders that have the best chance of being the next superperformers. Buying stocks in long-term downtrends will significantly lower your odds of owning a big winner. However, if you want to increase the odds, you should focus on stocks that are in a confirmed uptrend.

Stan’s approach was based on a timeless principle of the four stages that stocks go through, placing importance on knowing what stage a stock is in at any specific time. The ideal scenario, as Stan saw it, was to buy stocks when they are coming out of the first stage and beginning to make a run higher, which is the second stage. Then the objective is to sell them as they approach the peak of the cycle, which is the beginning of the third stage. The fourth stage, as you might guess, is a full-fledged decline that you want to avoid or during which you go short.

What I found through my study of the biggest price performers was that virtually every superperformance stock made its big gain while in stage 2 of its price cycle.

From a fundamental perspective, the cause almost always was linked to earnings: from lackluster performance to upside surprise and accelerating growth, eventually followed by decelerating growth and then disappointment. These underlying fundamental changes drove big institutional players into and out of stocks, phases that could readily be identified by the huge volume spikes that occurred during both the advancing stage and the subsequent decline.

1. Stage 1—Neglect phase: consolidation 2. Stage 2—Advancing phase: accumulation 3. Stage 3—Topping phase: distribution 4. Stage 4—Declining phase: capitulation

Stage 1 is when nothing noteworthy is happening. The stock is in a period of neglect; few big players are paying attention to the stock, or at the very least, the market has not yet paid up for the company’s shares. During stage 1, a company’s earnings, sales, and margins may be lackluster or erratic along with its share price. There may also be an uncertain outlook for the company or its industry. Nothing electrifying is happening to push the stock out of its doldrums and attract the needed institutional volume support to move it decisively into a stage 2 uptrend.

You should avoid buying during stage 1 no matter how tempting it may be; even if the company’s fundamentals look appealing, wait and buy only in stage 2.

To compound capital at a rapid rate and achieve superperformance, it is vital that you avoid stage 1 and learn to spot where momentum is strong during stage 2.

STAGE 1 CHARACTERISTICS • During stage 1, the stock price will move in a sideways fashion with a lack of any sustained price movement up or down. • The stock price will oscillate around its 200-day (or 40-week) moving average. During that oscillation, it lacks any real trend, upward or downward. This dead in the water phase can last for months or even years. • Often, this basing stage takes place after the stock price has declined during stage 4 for several months or more.

I can tell you from experience that attempting to bottom fish—trying to buy a stock at or near its bottom—will prove to be a frustrating and fruitless endeavor. Even if you are fortunate enough to pick the exact bottom, making significant headway usually requires sitting without much progress for months and in some cases years, because when you buy a stock near its bottom, it is in stage 4 or stage 1 and therefore by definition lacks upside momentum.

My goal is not to buy at the lowest or cheapest price but at the “right” price, just as the stock is ready to move significantly higher. Trying to pick a bottom is unnecessary and a waste of time; it misses the whole point. To achieve superperformance, you need to maximize the effects of compounding; thus, it’s important to concentrate on stocks that move quickly after you buy them. You want to focus on stocks that are already moving in the direction of your trade. To accomplish this, you should wait for a stage 2 uptrend to develop before you invest.

One thing is certain, however: a proper stage 2 will show significant volume as the stock is in strong demand on big up days and up weeks, and volume will be relatively light during pullbacks. There should always be a previous rally with an escalation in price of at least 25 to 30 percent off the 52-week low before you conclude that a stage 2 advance is under way and consider buying.

For Amgen, by the time stage 2 was clearly under way, the stock price had already advanced more than 80 percent from its 52-week low. This would be the point at which I would start to consider a new purchase; any earlier lacks confirmation and is premature, meaning you run the risk of being stuck in dead money. Most amateurs would think the stock is too high and wish they had bought it when it was lower, using hindsight as a guide. That’s why most amateurs don’t make big money in stocks.

TRANSITION CRITERIA 1. The stock price is above both the 150-day and the 200-day moving average. 2. The 150-day moving average is above the 200-day. 3. The 200-day moving average has turned up. 4. A series of higher highs and higher lows has occurred. 5. Large up weeks on volume spikes are contrasted by low-volume pullbacks. 6. There are more up weeks on volume than down weeks on volume.

With a buildup in earnings momentum (or in some instances earnings expectations), the stock price starts to escalate because of a surge in demand for shares as big institutions buy the stock in size. A daily and weekly price and volume chart will show big up bars representing abnormally large volume on rallies, contrasted with lower volume on price pullbacks. These signs of accumulation should appear during every stage 2 advance. By the time stage 2 is under way, the stock has been moving upward in a stair-step pattern of higher highs and higher lows. The share price may have doubled or even tripled at this point; however, this may be only the beginning. The stock could still move substantially higher. If the company continues to deliver strong earnings, the growth rate will soon attract widespread attention and subsequent buying, especially if the company has reported several quarters of impressive earnings gains.

STAGE 2 CHARACTERISTICS • The stock price is above its 200-day (40-week) moving average. • The 200-day moving average itself is in an uptrend. • The 150-day (30-week) moving average is above the 200-day (40-week) moving average. • The stock price is in a clear uptrend, defined by higher highs and higher lows in a staircase pattern. • Short-term moving averages are above long-term moving averages (e.g., the 50-day moving average is above the 150-day moving average). • Volume spikes on big up days and big up weeks are contrasted by volume contractions during normal price pullbacks. • There are more up days and up weeks on above-average volume than down days and down weeks on above-average volume.

During stage 3, the stock is no longer under extreme accumulation; instead, it is changing hands from strong buyers to weaker ones. Smart money that bought early when the stock emerged onto the scene is now taking profits, selling into final signs of price strength. As that occurs, buyers on the other side of the transaction are weaker players who know about the stock because it has made such a dramatic run and captured headlines. In other words, the long trade in the stock has become crowded and too obvious. This distribution phase exhibits a topping pattern. Volatility increases markedly, and the stock becomes visibly more erratic relative to its previous stage 2 trading pattern.

STAGE 3 CHARACTERISTICS • Volatility increases, with the stock moving back and forth in wider, looser swings. Although the overall price pattern may look similar to stage 2, with the stock moving higher, the price movement is much more erratic. • There is usually a major price break in the stock on an increase in volume. Often, it’s the largest one-day decline since the beginning of the stage 2 advance. On a weekly chart, the stock may put in the largest weekly decline since the beginning of the move. These price breaks almost always occur on overwhelming volume. • The stock price may undercut its 200-day moving average. Price volatility around the 200-day (40-week) moving average line is common as many stocks in stage 3 bounce below and above the 200-day average several times while topping out. • The 200-day moving average will lose upside momentum, flatten out, and then roll over into a downtrend.

During stage 4, earnings models are generally revised downward, which puts more selling pressure on the stock. The stage 4 selling may continue for an extended period until it’s finally exhausted, and the stock enters another period of neglect. As a stock languishes, it’s back to stage 1. It may take a while for the company to get back on the growth track and return to strong earnings, or the company may remain in stage 1 for many years. In some cases the company may go bankrupt. Stage 4 is essentially the opposite of stage 2 in terms of price and volume characteristics, with higher volume on down days and lower volume on up days. You should definitely avoid buying while a stock is in stage 4.

STAGE 4 CHARACTERISTICS • The vast majority of the price action is below the 200-day (40-week) moving average. • The 200-day moving average, which was flat or turning downward in stage 3, is now in a definite downtrend. • The stock price is near or hitting 52-week new lows • The stock price pattern is characterized as a series of lower lows and lower highs, stair-stepping downward. • Short-term moving averages are below long-term moving averages. • Volume spikes on big down days and big down weeks are contrasted by low-volume rallies. • There are more down days and weeks on above-average volume than up days and up weeks on above-average volume

Now that we have broken down the four stages individually, it’s important to understand that the study of the four stages of a stock’s life cycle is not meant for pinpoint timing purposes, which requires a more precise approach and tactics that I will discuss below. Rather, the four stages are most useful for gaining perspective on where a stock is in its life cycle pricewise and then to compare that with where the company is in its earnings cycle.

Even if the fundamentals are compelling, the stock must be in a long-term uptrend—as defined by the Trend Template—for me to consider it as a candidate. Without identifying a stock’s trend, investors are at risk of going long when a stock is in a dangerous downtrend, going short during an explosive uptrend, or tying up capital in a stock lost in a sideways neglect phase. It’s important to point out that a stock must meet all eight of the Trend Template criteria to be considered in a confirmed stage 2 uptrend.

Trend Template 1. The current stock price is above both the 150-day (30-week) and the 200-day (40-week) moving average price lines. 2. The 150-day moving average is above the 200-day moving average. 3. The 200-day moving average line is trending up for at least 1 month (preferably 4–5 months minimum in most cases). 4. The 50-day (10-week) moving average is above both the 150-day and 200-day moving averages. 5. The current stock price is trading above the 50-day moving average. 6. The current stock price is at least 30 percent above its 52-week low. (Many of the best selections will be 100 percent, 300 percent, or greater above their 52-week low before they emerge from a solid consolidation period and mount a large scale advance.) 7. The current stock price is within at least 25 percent of its 52-week high (the closer to a new high the better). 8. The relative strength ranking (as reported in Investor’s Business Daily) is no less than 70, and preferably in the 80s or 90s, which will generally be the case with the better selections.

Within an overall long-term uptrend (the tide) there will be short- or intermediate-term price action (the waves) that consist of pullbacks and basing. These shorter-term moves may last from four or five weeks up to a year or more in many cases. Most commonly, base patterns forming within a stage 2 uptrend last anywhere from 5 to 26 weeks.

Bases 1 and 2 generally come off a market correction, which is the best time for jumping on board a new trend. As the stock makes a series of bases along the stage 2 uptrend, base 3 is a little more obvious but usually still tradable. By the time a fourth or fifth base occurs (if it gets that far), the trend is becoming extremely obvious and is definitely in its late stages. By this point, abrupt base failures occur more frequently.

You want to get on board when institutional money is pouring into a stock and lifting it significantly higher. To do that, you need confirmation that this inflow is starting to happen before you invest.

Keep in mind that if the institutional investment community doesn’t see what you see, your stock could sit dormant for an extended period. Why sit and wait when you can put your money in another stock that is already on the move higher and has attracted big institutional volume support?

To compound your capital rapidly, you must be where the action is; you can’t afford to have your money tied up in a stock waiting for what you think is a great fundamental story to get noticed by the rest of the world.

The goal is not to buy at the cheapest price but to sell your stock for significantly more than the price you paid in the shortest period. That’s how superperformance is achieved.

Regardless of your fondness for or attachment to a particular security, it’s important that you learn to detect and, more important, respect a change in trend. Stocks very often top out while earnings still look good. Investors who wait for the earnings picture to dim before hitting the bid in the face of a stage 3 top or stage 4 decline often end up with a huge loss or at the very least give back much if not all of what they made on the upside. When topping signs start to appear after a long, extended price run, it’s time to take your profit and head for the exit.

To be successful, you must respect the trend and the wisdom of the market.

If your stock experiences its largest daily and/or weekly price decline since the beginning of the stage 2 advance, this is a sell signal in most cases even if it comes on the heels of a seemingly great earnings report. Don’t listen to the company or the media; listen to the stock. I have seen companies report earnings that were only a few cents better than expected on in-line revenues and skyrocket, and I have also seen companies report earnings and sales much better than expected but the stocks sold off hard and could not recover.

Many times before a fundamental problem is evident, there will be a hint in the form of a material change in price behavior. That change should always be respected even if you don’t see any reason for the sudden change in sentiment. Earnings may still look good. The story may still be intact. However, in most cases, you’ll be far better off getting out—shooting first and asking questions later—than waiting to learn the reason why. When a stock that had been in a strong stage 2 suddenly goes into a stage 3 topping pattern or transitions quickly into stage 4, don’t sit there and assume that everything is fine. There is a reason for the adverse price move; you just don’t know it yet.

Whatever you do, don’t think that a big break in the stock is now a buying opportunity. Many investors get caught in this trap: A stock they own suddenly declines sharply. Believing that the marketplace must be wrong and that the stock is still a good performer, they decide it’s time to buy more. They don’t realize that the stock price is down because the big players know (or at least suspect) something is wrong and are getting out. When you see that happen in the price action, regardless of what the fundamentals are saying, it’s time to exit.

A proper stage 2 uptrend provides evidence that institutions are indeed stepping up to the plate, just as a stage 4 decline clearly demonstrates the opposite. Having the long-term trend on your side is like sailing with the wind at your back. If there’s no wind, you’re dead in the water (stage 1), and if the wind is against you, you have little chance of moving forward (stage 4). The proverbial wind in your sails is the long-term trend of big money that’s buying in sync with you. You should look to align yourself with this powerful force. Stick with stocks that are in a solid uptrend and you will be much more likely to own a stock that has the potential to skyrocket and become a superperformer.

What I’ve discovered is that they generally tend to fall into one of six categories: 1. Market leaders 2. Top competitors 3. Institutional favorites 4. Turnaround situations 5. Cyclical stocks 6. Past leaders and laggards

Market leaders are easy to spot, but most investors have psychological difficulty deciding to buy them. The share prices of market leaders power up the most percentagewise in the initial stages of a market rally. They move into new high ground first. That unbelievable price strength causes most investors to think these stocks have run up too far; hence, most investors are afraid to buy the very best stocks capable of superperformance.