Canslim Pullbacks

8/10/2019 Canslim Pullbacks

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(appeared in October '04 issue of CANSLIM.net News)

Buying Quality Stocks in Today's Market: Pullbacks Versus 21-Day New

Highs and 21-Day New Lows

Ive written here about cycles in the market, i.e., market patterns that appear often enough tobe judged statistically significant. For example, the Automotive, Health Services, andAerospace Industry Groups were shown last month to provide the best performance of the

31groups in the September-to-December time frame over the last four years. Here, I wantto contrast three chart patterns that are routinely used to enter long positions in short-termtrades. I think youll be surprised at the results.

Larry Connors and Conor Sen wrote an important book detailing the importance of chartpatterns, How Markets Really Work: A Quantitative Guide to Stock Market Behavior. Ireceived my copy just before hurricane Ivan arrived and was so fascinated by the subject

that I finished it that evening, storm and all. It presents 15years of historical data (1/1/89through 12/31/03) refuting much of what passes for "common market truisms." Theseauthors looked at several market criteria (new 5 and 10-day highs and lows, the impact ofbeing above or below the 200-day moving average, multiple day pullbacks, and others) to

evaluate how each impacted one day through one week returns for the S&P 500 andNasdaq 100 cash markets. Most of what they found went against our dearly held marketbeliefs.

For example, during this period there were 94710-day highs in the S&P. Buying the close of

a new 10-day high then selling one week later returned 0.0%on average with 53.43%of thetrades being profitable. Not too impressive, since the average 5-day return (irrespective of

whether a new 10-day high had been made or not) was +0.21%. Contrast this behavior with

buying a 10-day low then selling one week later. This strategy returned 0.56%on average

with 333(of 557) profitable trades (almost three times the unrestricted average 5-dayreturn). The message: Buying strength hasn't worked as well as buying weakness! If one

buys the 10-day low but requires the S&P 500 cash index to be above its 200-day movingaverage, the average return increases to +0.66%with a 66.43%win rate (190winners of

286occurrences). The authors put it this way: "...the greater opportunity and edge lies inbeing a buyer as the market makes a new short-term low versus buying when it makes anew high."

http://www.triplescreenmethod.com/MonthlyArticles/MonthlyArticle10...

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Following this theme, I tested three common patterns used for entering long positions inindividual stocks: three or more day pullbacks, new 21-day highs (breakouts), and new21-day lows (bottom fishing). Chart 1 shows examples of each for ARO as they occurredover a two-month period in 2003. To validate this study, I studied these three patterns for agroup of fundamentally sound stocks (9/24/04) with earnings and analysts rankings revision

fuel (Zacks rankings of 1 or 2) and value left in price (two year PEG ratios less than 1.25):36stocks shown in Table I were evaluated over the 294-day period between 7/30/03 and9/28/04 (10,584 test days).

For the pullback, three or more lower highs were followed by a reversal candle. To limitpurchases to stocks in up trends, the 50-day moving average was required to be rising overthe last six days, and the 20-day moving average to be greater than its 50-day. When theseconditions were met, a long position was entered then exited at the close f ive days later.

Similarly, for the 21-day high, a position was entered when todays price exceeded the highof the last 20 days, again, when the 50-day moving average was rising over the last sixdays, and the 20-day moving average had to be greater than its 50. When these conditionswere met, a long position was entered then exited at the close f ive days later.

Finally, for the 21-day low, a new position was taken today when price exceeded the high ofyesterdays new 21-day low, this time with no additional conditions. And again, the positionwas exited at the close five days later.


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Table 1

Table I provides results for each of the 36stocks over the 294-day period. AMED, for

example, had 16pullbacks meeting the required conditions and an average resultant

five-day gain of +3.0%(10with positive gains and 6with losses); AMED had 33instances of

making new 21-day highs and an average f ive-day gain of +3.89%. AMED also had 6instances of new 21-day lows and an average gain of +5.58%. Contrast these returns with

the average 5-day gain (+2.29%) earned from the control condition, i.e., from buying eachoccurrence where todays price exceeded yesterdays high and holding for five days.

For these stocks, the average 5-day gain for the control condition was +1.27%, as thesewere quality stocks performing in both bullish and bearish phases of the market. Limiting

buys to pullbacks increased returns to +1.84%(1.45x the control), to new 21-day highs

increased returns to +1.38%(1.09x the control), to new 21-day lows increased returns to

+2.59%(2.04x the control). Clearly, in this market, buying the new 21-day lows for aweek-long trade was a superior strategy to either buying pullbacks or buying breakouts.

These results are consistent with Connors findings for 15 years of S&P data. Whilesignificantly longer holding periods lessens the importance of an entry strategy, the strategyof buying 21-day lows reduces short-term risk and provides better risk/reward limits.


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