Q: Scott, I have just read your article on when to buy using trendlines as a guide. You showed examples of 6 months and 3 years, but all of this is in retrospect as to WHEN TO BUY. How does one know that this upswing is not just a "suckers rally"? This is a question that has bothered me for some time.

A: You never know if a reversal in a trend is a "sucker's rally" until after the fact. However, the difference between a fund and a stock is that while a stock could be subject to maniplulation by institutions, traders, market makers, bad news or earnings, executive departures, etc.; that would be impossible to happen to the entire basket of stocks a fund holds. Granted, sector-, region- and industry-specific funds could all have a false rally, but that would mean that one had just looked at the trendline and not at the underlying strength of the primary stocks held by the fund.

While a trendline is important, it should not be the only thing you look at. But if it is, then the question of a stop loss should come into play. If you enter a fund that seems to be in reversal, and it turns around and falls back again, there is nothing that says you can't get out. Just as with a stock, there is nothing worse than holding on to a bad investment. If you see some a reversal and the fund continues down, get out after an 8-10% loss at most. It's better to bail and re-enter after it's done falling than to keep on believing it will go back up soon, only to find it doesn't.

Here is an example: Fidelity Growth Company Large Growth (FDGRX).

It dropped from a high of 116.85 to 94.86 (as of 12 April 2000), with several false reversals along the way over the last few months. however, if it dropped 8%, to 107.5, and you exited, you could then wait for a similar 8% rebound to reenter. From the 12 April price, that would mean a recovery to 102.5. That would mean that you could have saved 5 per share even using a trailing stop of 8% - and that is a very generous reversal amount. (A trailing stop is a price that lags the latest high or low.) So if you are in a fund, and the price goes to 100, a trailing stop would be 8% less at 92. Similarly, if the NAV is falling to say 50, a trailing 8% reversal signal to reenter would be at 54 (as that is $4 more, or 8% above $50).

Look at some of your charts to see if this would have helped call entry and exits.

Scott McCormick

Q: What is the most important aspect of stock selection?

A: I believe that sector is the most important aspect of stock selection. There is a lot of rotation in the stock market and being in the right sector is often more important than being in the right stock. I would rank stock selection priorities as follows:

1. Sector/group
2. Broader market
3. Individual Stocks

Some groups are more highly correlated than others. Recently, the biotech advance and correction provides an excellent example of a highly correlated group. Other groups that are highly correlated include: airlines, banks, chemicals, gold, internet (B2B, Portals, etailers, brokers), oil service, paper, pharmaceuticals and semi-conductors. Some groups with less correlation may include computer hardware, software, data storage, gaming and insurance. Even if the correlation is not that high, a stock's group or sector exerts much influence and should not be ignored.

Arthur Hill

Q: Once a stock is selected, what is important for a generating a buy or sell signal?

A: It is tough to set this in stone and no two setups are exactly alike. However, I would rank the order of importance as follows:

1. Price action - support, resistance, chart pattern, candlesticks and volume.
2. Indicators - momentum
3. Reward-to-risk ratio
4. Indicators - money flows

I am certain that the price action should be first and foremost. The other three are a distant second and I believe that momentum ranks just above the other two. I like to make sure that momentum is moving in the same direction as my trade before initiating a position. Reward-torisk ratio is very important to trading, but can sometimes conflict with technical analysis. Money flow, while important, can lag a bit.

Just as important to buy and sell considerations are each individual's trading style, goals and risk tolerance. There are many trading and investing styles, but I think of them as three basic categories: early birds, turn confirmers and trend followers.

Early birds pick bottoms and tops before there is evidence of a reversal. Support, resistance and target levels are looked upon as buying or selling opportunities. Those who concentrate on tight money management might buy at support and sell at resistance. There may be little evidence of a reversal, but support levels usually offer a good reward-to-risk ratio with a tight stop-loss just below support. Tom DeMark uses exhaustion techniques to pick bottoms and tops for buying and selling. Some may see it as a free fall or parabolic advance, but DeMark looks for signs of exhaustion to trade the reversal. This is a very gutsy approach, but DeMark has great credentials.

Turn confirmers look for evidence of a base, a reversal and then some sort of breakout to confirm. I would place myself in this category. I am usually not going to pick the exact bottom or top and will be whipsawed sometimes. However, I feel more comfortable waiting for the confirmation. In addition, my reward-to-risk ratio sometimes suffers by waiting for confirmation.

Trend followers are usually the late comers and wait for solid evidence of a change in trend before initiating a position. The pitfalls of this approach are late entry and exit, poor reward-to-risk ratios and large whipsaws.

These three different styles highlight the ongoing battle in technical analysis and trading. Traders want the best reward-to-risk ratio, but technical analysts want to see evidence of a reversal before turning bullish. The early birds are at one extreme and the trend followers at the other. The earlier you buy, the closer the stop-loss and the better the reward-to-risk ratio. However, early entry usually means there is less evidence of a reversal. It is a tough call and traders need to find the approach that best suits their particular style. I am trying to position myself in the middle by balancing reversal confirmation with a good reward-to-risk ratio.

Cheers, Arthur Hill