A Checklist For Entering a Trade

I just came back from a two-week trip to Italy. During my time there I went over to Piedmont because I am a big fan of the wines that come from that region. We stayed on a vineyard and since I am becoming a bit of a wine nerd, I quickly started talking to the son of the winemaker at the cascina where we were staying. While many people want to get right to the good stuff, what’s in the bottle, I was intrigued by the process. I talked our host into giving us a tour of the vineyard and the facility where the wine is made. I asked a lot of questions, and what I ultimately learned is that the winemaker is essentially a “portfolio manager.” He or she has a large selection of grapes which they can choose to plant but they are selective, only choosing what is best for their environment. 

When harvest time comes around, the winemakers don’t simply take all of the grapes and crush them to make any old wine. They are selective with the grapes that they choose based on the environment of the region and the type of growing season that they had. They carefully select only the best bunches of grapes to crush and ultimately turn into their finished product.

Obviously, there are many other steps that I am missing but let’s just say that I quickly tied the winemaking process into a lesson on investing, at least in my mind.  

In my last post about stock ideas, we discussed a simple process for finding leading stocks in leading industry groups. Different market environments will favor different areas of the market at different times just as the region, soil, temperature and irrigation (if any) favor certain types of grapes for the winemaker. When looking at potential stocks to buy, we want to select the one that are best for the current market environment. 

Once we have identified stocks which are candidates for long ideas, how do you know if the time is right to actually buy them? When we speak with investors, one of the most common issues that they face in the market is timing. Dan, this stock looks good to me, is now the right time to buy it? The simple answer is, there is no way to know with 100% certainty if “now” is the “right time.” But we can use tools to put the odds of success in our favor by taking the weight of the evidence approach to entering trade.

We assess two main aspects to determine if now is the right time to buy a stock. The first is Strength. Is this the type of stock you want to consider owning? The way that we assess strength is to look at three attributes of the stock:

  1. Power Gauge Rating: we want to focus on stocks that have a Very Bullish or Bullish Rating in our 20-factor model.
  2. Relative Strength vs SPY: we want to own the stocks that are outperforming the overall equity market. The majority of professional investors are measured on a relative basis. It is not enough to own stocks that appreciate in value, they have to own the stocks that appreciate more than the overall stock market. These are the stocks that we want to find. 
  3. Industry Strength: our odds of finding a winning stock increase if that stock is part of an industry group which is strong and attracting investors. Think Insurance currently. 

The second aspect to making an investment is Timing. Once we know that the stock has “Strength” we need to know if now is the time to actually commit our hard earned capital to the idea. Here too, there are three attributes that can help us answer the timing question.

  1. Overbought / Oversold: this is a proprietary indicator which was designed to let us know if a stock is currently overbought or oversold within the context of the prevailing trend. For long ideas we want the stock to be oversold in an uptrend. The term “buy the dip” gets used a lot but what constitutes a dip? This indicator helps to answer that question. Ideally, we want the indicator to be in oversold territory and rising (though this is not a deal breaker if the remaining items on the list are flashing green).
  2. Long-Term Trend: we have heard the phrase “the trend is your friend.” In our post on moving averages, we walked through how we use the long-term trend line (or Chaikin Trend) to determine if a stock is in an uptrend or a downtrend. We want to focus on stocks that are in uptrends.
  3. Money Flow Persistency:  Chaikin Money Flow is a way to measure what the big institutions are doing. Essentially, we want to own the stocks that the institutions are accumulating to increase our odds of finding a winner to ride.

When we talk about having a repeatable process for entering a trade or an investment, this is what we mean. And now, we have added a “checklist” so that investors can easily see if the above criteria are being met. 

It starts with a screen of potential long ideas. Everyday, I screen the market for bullish ideas based on the following criteria:

  • Power Gauge Rating is Bullish
  • Stock is Oversold with Strong Money Flow and Strong Relative Strength

This morning, that screen returned 30 names to consider. 

Next, I run through all of the charts utilizing our checklist to find the names that look compelling for an investment or a trade. Barrett Business Services appears to check all of the boxes on our list.

Is this a guaranteed winner? Of course not. But our odds of success are higher now that we have isolated a strong stock in a strong industry group at an opportune time just as our winemaker picks the best grapes at the right time based on the environment in their region. 

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