When looking to purchase a stock, you should examine both the company's fundamental and the stock's technical health. This lesson will focus on what technical factors you should be looking for when searching for great growth stocks. The following lesson will present the fundamental characteristics we look for.

We'll start this lesson by defining some of the various terms that will be used:

• Price Chart: This is simple enough. We prefer to look at bar charts, which show the high, low and closing prices of a stock for every day (or week or month, depending on what type of chart you're looking at).
  
  
• Volume: Usually included on the price chart is the volume, or the amount of shares traded in a stock, for a day, week or month.
  
  
• Moving Averages: Moving averages smooth the fluctuations in a stock. To get a moving average, you simply add up all the closing prices for a stock over a certain time period (say, 50 days) and then divide by that time period (50). Thus, you can get the average price the stock has closed at over a given time period. Although any time period can be used, we usually keep an eye on the 25-day (short-term) and 50-day (intermediate-term) moving averages.

If you look at a bunch of other indicators you may just confuse yourself. What you really want to be analyzing are longer-term charts, which capture the real picture of the supply and demand relationship for a stock.

Momentum
Our stock selection system is based on momentum analysis. Any new stock we buy must have positive momentum. A stock has positive momentum if its RP line has been advancing for at least 13 weeks, which is the number of weeks in a quarter. We've found that this period of time is usually sufficient to establish a new momentum trend, and once a trend is in place (positive or negative), it tends to stay in place for a relatively long period of time. That's why you want to own stocks that are going up!

Once you've selected a few stocks that have positive momentum, you need to take your search to the next level. Specifically, you should look for stocks that have particularly strong RP lines…ones with corrections of two weeks or less. Brief corrections (timewise) tell you that there are hundreds of buyers in the market willing to snap up the stock on any decline. And this is exactly the situation you want to be invested in! Ideally, you want RP lines with brief and shallow corrections, but of the two, brevity is more important than depth.

If you've selected stocks that do have a positive RP line, you should analyze just how strong they are by asking the following questions: How long have the corrections been over the past 6-9 months? How deep have those corrections been? How steep is the RP line (the steeper the RP line, the more the stock has been outperforming the market)? And, finally, how has the RP line acted during market corrections (a strong RP line during market turmoil means buying pressures are super-strong)?

In sum, you should only be buying stocks that have positive momentum. Ideally, the RP line will have a steep slope and corrections that are brief and shallow. Finding an RP line like this is a big part of the battle of finding a successful investment.

Price
After examining the RP line, we shift our attention to the stock's price chart. Most times, the price chart and the RP line will look similar. But there are times when they differ…usually during market corrections. The strongest stocks hold up the best during market corrections, with a price chart that resists the downward pull of the general market. If this is the case, the price is probably trending sideways, but the RP line will be heading toward the heavens! This is because, relative to the market, the stock is making a lot of progress.

Either way, when examining the price chart, you're looking for the same characteristics you looked for in the RP line, namely brief and shallow pullbacks within a steep uptrend. And steep rebounds after corrections are also a telltale sign of strong sponsorship.

(As a side note, examining the new highs list in your newspaper on a daily basis is one of the best ways we know of to discover new stock ideas.)

Volume
Studying volume is helpful, but there are no set rules when using it. (This is in contrast to, say, 13 weeks of positive RP to establish positive momentum.) In general, you want the volume of a stock to confirm its uptrend by rising to a higher level on the days the stock advances, while falling to a lower level when the stock declines. When you see this type of action, it's telling you that the supply and demand relationship for your stock is truly in your favor (there's lots of buying power but little selling pressures).

If anything, volume tends to confirm your convictions rather than lead you to a great stock idea all by itself. But there are times when a stock will soar or plummet on massive volume, which is what we call a Volume Clue. It's a sign big investors are getting in or out. In particular, look for stocks that rise 10% or more the day after reporting earnings - these stocks often have further to run.

Moving Averages
Moving averages can also be helpful. We look primarily at the 50-day moving average. Why? Well, it tends to be long enough to allow corrections in a stock but short enough so that the trend hasn't turned down by the time a stock touches it. But an even better reason is this: great growth stocks tend to find support (declines stop) when they reach this moving average. It's often fruitful to buy a stock as it's bouncing off this moving average.

Thus, any stock you're considering for purchase should have stayed above its 50-day moving average for most of time over the past few months. And it's also a positive if the stock has tended to bounce strongly off this moving average in the past. If this is the case, a good buying point may be when the stock is just beginning to bounce off its moving average.

The 25-day moving average isn't as vital, but it, too, often lends support to the strongest of market leaders. In a powerful situation, contained drops to the 25-day can offer buy points.

A stock is never too high to buy
Here at Cabot, we always remind each other to have no preconceived notions about the stock market or any individual stocks. We've learned from experience the big winners in the stock market are usually the stocks that have already appreciated many-fold off their lows. And just when people begin thinking that a stock is "too high", it usually begins its next major advance!

Of course, you always want to buy a reasonable short-term pullbacks of 5% to 15% off a stock's high, but don't think a stock can't rise further just because it's had a good few months. Don't let your emotions about a stock's value get in your way. Instead, focus on following our proven system laid out above.

Summary
We've laid out a lot of material for you in this lesson, so don't expect to fully grasp all of it at once. It's going to take practice with your own money before you feel comfortable with (and thus get the most benefit from) our momentum system.

Let's summarize the main points of this lesson.

• When looking for potential purchase candidates, you should examine both the company's fundamentals (which will be addressed in the next lesson) and its stock's technical picture.
• When analyzing the technicals, you should primarily focus on the stock's momentum and price chart, along with its volume pattern and 50-day moving average.
• A stock MUST have positive momentum before being considered for purchase. And your goal should be to find RP lines with steep slopes and corrections that are brief and shallow.
• When looking at prices, be sure to examine a price chart and not simply the daily fluctuations of the stock. You want to find price charts that have steep upward trends, with brief and shallow corrections. In other words, you're looking for similar characteristics on a price chart as you are for an RP line.
• The volume pattern in a stock can confirm your initial thinking of a stock, but is unlikely to lead you to a great stock idea all by itself. You like to see heavy volume on up days (showing accumulation) with lighter volume on down days.
• Finally, the 50-day moving average is a helpful indicator in two ways. First, your potential purchase should have (in most cases) held up above this moving average for the past few months. Second, if there is a pattern of sharp rebounds after touching the moving average, then you can pinpoint your initial or follow-on purchase after the stock begins to bounce off the moving average

Lesson 6. Fundamental Analysis
More on Technical Analysis
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