10. Selling Rules
In this, our last lesson of the course, we wish to explain our methods for selling growth stocks based on momentum. As most everyone reading this knows, we measure a stock's momentum by its RP line, which graphically depicts how a stock has performed relative to a market index. In our quest for profits, of course, we search for stocks that have up-sloping RP line, meaning they're outperforming the market on balance.
Because trends tend to stay in effect, stocks with positive RP lines usually continue higher, and vice versa. That's why we use RP lines not just to identify potential purchases, but to identify potential sales as well! If a stock's momentum turns from positive to negative, the odds are that the newly established downtrend is likely to persist. And that means it's time for you to move on.
Thus, in this lesson we'll explain many of our selling rules based on momentum, helping you sell your profitable stocks after giving them every chance to keep on advancing. While following the RP line will never get you out of a stock right at the top, it will keep you in strong stocks as long as they're strong, while getting you out once the chances of a sustained advance are small.
Now we'll discuss the rules we use to determine whether or not to sell a stock. Every week, Cabot editors meet and check the RP lines of the stocks we follow in our growth publications—Cabot Market Letter, Cabot Top Ten Report, Cabot China & Emerging Market Report and Cabot Green Investor—checking whether or not they've broken any rules. If so, out the stocks go! By carefully reading and understanding the following set of rules, you'll be looking for the exact same things as we do, and thus be in sync with our advice.
Momentum turning down for eight weeks
If things are truly on track with your company and it's stock, and perception hasn't been sharply damaged, then a stock's RP line should rarely pull back for more than eight weeks. Thus, if a stock's RP line correction lengthens to 10, 12, or 15 weeks, it's probably telling you that the fundamentals of the company may be changing for the worse…poor sales or earnings, deceleration of growth, etc. So when you see an eight-week correction, you should be throwing up safety nets, making sure your stock doesn't fall much further.
And here's how you should do it. First, remember that an RP line correction is counted from the recent peak to a new correction low. So if the RP line bottomed four weeks after it peaked, then proceeded to move sideways for three weeks, this is not an eight-week correction. Only if the RP line hits a new correction-low eight weeks after its peak do you have the required length of time.
Once the RP line breaks down, you should look at the price chart and set a mental stop slightly below its current price, hopefully at an area of support. If the stock closes any day below this mental stop, you should then sell. Mental stops let you hang on to a stock with a lagging RP line as long as the price (i.e., your money) is still appreciating, or at least not depreciating.
30-degree rule
This unique rule was developed simply through years of watching, drawing and analyzing RP lines. We noticed that after a stock had a meaningful correction (usually at least four weeks in length) and rebounded strongly for two weeks, it entered a critical juncture.
Specifically, it's at this time, after a correction and short rally, that a stock's positive momentum started to come into question. Many stocks would continue advancing strongly, breaking through their old RP highs. Others, of course, saw their rallies falter, and they lost their positive momentum.
What does all this have to do with 30-degree lines? Following the initial two-week rally, if a stock's RP line can stay above a 30-degree up-sloping trendline drawn from its RP low, then holding on is your wisest course. Conversely, if the stock's RP line breaks down below this trend line, the positive momentum has faded.
Studies of our portfolio actions have shown that selling based on the breakdown of a 30-degree line is our best sell rule. We believe this is because the best time to sell a faltering growth stock is when a rally following a correction falters. And that's exactly what the 30-degree rule allows you to do!
Let's look at two examples. The first is Amazon.com, which appreciated almost ten-fold from its lows of September 1998 to its high in April 1999. Notice that after the RP line peaked in April, Amazon sank for 16 weeks, with its price being chopped down by 63%. But investors soon turned back to Internet stocks, and Amazon's price rebounded all the way back to its old price high in December.
However, the RP line was telling a different story. It looked good at the time, but it wasn't quite as strong as the price. Thus, when Amazon pulled back in the coming weeks, the RP line broke down through its 30-degree line. After setting a mental stop, you probably would have sold AMZN in the upper 60s.
A similar pattern was recorded with Qualcomm. This stock had a stunning advance in 1999, moving ahead by more than 2000%. But by the time the new decade began, Qualcomm had seen its best days. The RP line corrected sharply for nine weeks, then bounced for three.
By that time, though, the market was running into trouble and Qualcomm was following suit. The RP line broke below its 30-degree line in April, which would have led you to sell somewhere near the 100 level.
Two RP tools that can help you sell right
Combined with the 10%-20% loss rule that The Cabot Market Letter employs, the eight-week momentum breakdown and 30-degree line penetration (using mental stops with each) make up our three official rules for selling. But there are a couple of tools we use, tools that often help us identify trouble before it occurs. And those are what we'd like to explain here.
First, we're always on the lookout for double or triple RP tops. Just as it can be a tip off of weakness when a stock itself has a tough time getting through a given price level, so it goes with RP levels. Often times, when a stock's RP line attempts to get above a certain height two or three times and fails, its run is over and lower prices can be expected.
This is doubly true when a divergence occurs between the price and RP line, which is the second tool referred to above. This is a sign that the sponsorship behind the stock is waning…the buying power that previously made the stock outperform the general market has since subsided, creating just an average market performer. More often than not, this subtle decrease in sponsorship continues until it's not so subtle! That means lower prices ahead.
Here's a good example. It's Gemstar, an extremely profitable company that investors were scooping up for the better part of a year. In early November, note the RP line peak, with the price in the mid-70s. Then in December, the RP line tried to break out to new highs but failed. The price was around 80.
A normal correction ensued in January and February, taking the RP line back down for a few weeks. When the stock began a new advance in March, however, you had reason to worry.
Why? Well, Gemstar actually closed out three consecutive weeks above 90, well above its previous weekly closing high of 80. But the RP line just barely recorded a new peak, forming a triple top. This non-confirmation of the RP line was reason to worry, and the sharp downturn in the price and RP line in the following weeks told the investor that the game was probably over for a while.
Conclusion
Those are our RP line selling rules. When combined with mental stops, we've found that these selling rules allow you to hold on to your strong stocks, tolerating corrections in an ongoing advance. But when these rules are broken, they should be taken seriously—it means sponsorship is fading, and that usually leads to a big break in prices.
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