Three Rules and Three Tools to Spot Oversold Stocks
Use other investors' fear to capitalize on the markets
Three Rules and Three Tools to Spot Oversold Stocks
I'm sure you've heard the Warren Buffett quote that you should "be fearful when others are greedy and be greedy only when others are fearful."
Aside from "buy low, sell high," it's probably among the most-often-repeated pieces of investment wisdom out there.
What is maybe less obvious is how to pinpoint those turning points and what – specifically – to do once you've identified them.
The good folks at Bespoke Investment Group publish an indicator that I like to use as one proof point for identifying whether we're in a greedy or fearful market stage. And, spoiler alert: Today we're sitting squarely in a fearful phase.
In last week's sell-off, we got to the point that less than 30% of S&P 500 stocks were trading above their key 50-day moving average, i.e. in a healthy uptrend. So, 70% of them fell into a downtrend.
But not all stocks and sectors are suffering equally, as you can see in this chart below. Technology has really taken a beating, moving from the market's leading sector to now lagging. But, on the other hand, over 95% of energy-sector stocks are still above the 50-day moving averages and in a healthy uptrend. Plus, interest-rate-sensitive utilities and consumer staples have also held up very well:
That's the hallmark of a fearful stock market: When investors flock to the relative safety of defensive stocks like utilities and staples.
So today, I'm going to show you how to follow the second half of Buffett's mantra. I'll show you how to find potential buying opportunities in the deeply oversold sectors – where investors are exhibiting the most fear.
Three Rules and Three Tools
There are three rules of thumb that I live by when it comes to prospecting for oversold stocks. And you should strongly consider them, too.
Look for an upside catalyst.
Buy at strong support.
Look for relative strength.
But I wouldn't be doing my job if I just told you what to look for without telling you how.
In fact – lucky us – there are three handy tools already within TradeSmith Finance that match up perfectly and can help you when prospecting for oversold stocks. They are:
Our proprietary Trade Cycles Peak and Valley Indicators
The Volume-At-Price Indicator (VAP)
Relative Strength Index (RSI)
Let's take a closer look at these three tools and how to use them.
The very first step is to find a list of healthy, high-quality stocks that have an upside catalyst. If there is a third piece of investing wisdom that I would add to the two I mentioned earlier, it would be this: Don't buy stock in crappy companies.
Once you've got your list of strong companies, then apply rules 2 and 3.
Let's dig in and see how this works in action.
Screening for Fear
As I often do, I'll use our TradeSmith Screener tool to get started. Note that you'll need access to the Screener via Ideas by TradeSmith, Trade360, or a Platinum membership, and our Business Quality Score (BQS) tool via Ratings by TradeSmith, TradeStops Pro or Elite, or TradeSmith Platinum.
Be sure you are logged in to TradeSmith Finance. Click Invest on the top menu, then the Screener tab. Click the + Create New Screener button and set up the following:
1. I want healthy stocks that can trend higher, so I included filters for Health Status Green Zone and Trend Up or Sideways.
2. Since the entire market looks oversold here including most sectors, I filtered Markets by S&P 500 Index (SPX) and Nasdaq 100 Index (NDX).
Next comes our proprietary Trade Cycles timing indicators that can really give you an edge by zeroing in on stocks poised to move higher.
3. Under Cycle Turn Area, I'm looking for stocks in a Valley or an Upcoming Valley, based on the Composite Cycle Period (an average of all our timing cycles), and a Cycle Conviction Level of Medium, High, or Very High.
4. As always, I want to prospect in high-quality stocks to help avoid value traps. I use our proprietary Business Quality Score (BQS) and set it to more than 75, to narrow my list to only the top 25% of stocks by BQS.
Finally, I Display & Sort Results by Health.
This "fear" screener gave me 51 stocks that met all my filters. That's a good field to prospect in with further research. But you can always tighten or loosen some of these filters, or add your own, to either narrow or expand your list.
Now let's also apply rules 2 and 3.
I mentioned two additional tools to help us here:
Volume at Price (VAP): to find stocks that should be trading at solid support levels, and
Relative Strength Index (RSI): to find potentially oversold stocks with upside momentum.
Let's look at how each indicator works, and then I'll illustrate with an example.
VAP shows you the amount of volume for a particular price range. On TradeSmith Finance charts, it's displayed as horizontal bars on the left side of the chart to correspond with these price ranges. By combining volume and prices, this indicator can help you identify high-volume price ranges to mark support or resistance levels for the stock.
Developed by J. Welles Wilder, RSI measures the speed and change of price movements over time (usually a 14-day period). The RSI oscillates up and down between zero and 100. When RSI is above 70, it generally indicates overbought conditions. And when the RSI is below 30, it indicates oversold conditions.
To find possible oversold buying opportunities, I look for a stock with low RSI, generally below 40 or 50. Ideally, RSI was recently below 30 and is already rebounding. And by studying the VAP bars, you can easily see if the stock is trading at a good support level and whether it's poised to move higher, according to our Trade Cycles.
Case Study on a High-Quality Stock with Upside Catalyst
Here's an example using one of the stocks that made the cut on my screener. It's homebuilder Lennar (LEN).
This stock has pulled back in price recently along with the market. Yet it's a solid company with a Strong Bullish rating from TradeSmith and a BQS of 89, in the top 11% of all stocks we rank by quality.
Plus, LEN is in a valley turn area, meaning the stock should turn higher from here. And you can see from the dotted blue line that TradeSmith's smart moving average bears that out – the stock is in a fairly recent uptrend.
In other words: It's a strong company with an upside catalyst, according to our system.
We've checked the first rule off the list for LEN; now let's look at our two additional rules and indicators.
Volume at Price: On the chart above, did you notice that big horizontal bar just below the current price? It shows there is a strong price at the volume level stretching from roughly $150 up to $155. That means significant buying has taken place at this price level previously, so it should provide important support here to LEN's price.
Relative Strength Index: LEN was pretty oversold this month, hitting a low of 36 last week. Since then, the stock has gone mostly sideways while RSI has improved. It's now up to just above 44, and that's a positive divergence indicating LEN is gaining relative price strength.
Mike Burnick's Bottom Line: You can use our powerful TradeSmith screener tools to find a select list of stocks meeting your favorite filters. That's a great starting point for more research. And there's no substitute for taking a closer look at the individual charts of the stocks on your list. Pay close attention to price trends and our Trade Cycles forecasts. Use VAP and RSI to help confirm a stock is a buy candidate. Put them all together and pull gains from the market's fear, just like Buffett.
Good investing,
Mike Burnick Senior Analyst, TradeSmith
P.S. If you have any questions or concerns, please reach out to me at emailmikeburnick@tradesmith.com and include "Inside TradeSmith" in the subject line.
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