In this series, we’ve asked Covestor managers: “What is the single most important lesson you’ve learned about being a successful investor, and how do you try to apply that today?”
Author: Michael Arold
Covestor model: Technical Swing
The elements of the markets, its sectors and stocks, do not move in unison. While an index such as the S&P 500 might be up on a given day, individual performance of its components can vary quite significantly. Some stocks usually lead the index higher, while others lag. Analyzing this dynamic and following the leaders is the most important investment lesson I’ve learned in recent years.
Following the leaders is not only important when implementing momentum-based trading strategies to benefit from price appreciation of strong stocks, but also to gauge overall market health. Leading stocks are often the first to reverse trend before the entire market does. In turn, strength of these market leaders during general sell-offs can create compelling short-term trading opportunities.
The concept can work in both directions – up and down. It was relatively clear during the financial crisis. While just about every company came under pressure in 2008/9, banking stocks were leading indices lower. On the other end of the crisis, banking stocks were leading the markets higher in March 2009, a suggestion that the bear market was coming to an end.
Often, a bigger fundamental picture drives returns of a market leader. I believe that as an investor, it is important to base one’s strategy on market anomalies in the effort to outperform major indices.
It is important to identify market leaders early, and it’s equally important to recognize when they lose strength. One way to do that is to analyze price action in relation to a general index, such as the S&P 500. I use a scan engine, which scans the entire market for strong stocks and ETFs. I usually get a list of hundreds of stocks each week, then reduce that to the most interesting companies with a manual process. The resulting list is the base for daily trading decisions. In general, I am waiting for short-term weakness in these leading stocks before entering a position. I follow the same process on the short side, especially in bear markets.
Quite often, the scan results contain companies from the same industry, which helps to identify underlying fundamental themes. On the other hand, to manage risk, one has to be careful to not construct a highly concentrated portfolio.
One of the major challenges is the high degree of “noise” in the markets, which sometimes leads to false identification of market leaders. Also, well known leaders are usually followed by a lot of investors. So when underlying fundamentals change, these stocks can decline quite rapidly.
Therefore, it is essential to apply strong risk management and monitor positions on a daily basis. An open mind is needed in order to be sensitive when new leaders emerge. It seems like in recent years, markets have become more dynamic with more frequent change in leadership, so the importance of active position management has grown.
