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A Better Way to Find Beaten-Down Stocks to Buy

One of the dangers during a down market is the temptation to buy just because stocks have declined sharply. We cannot handicap adequately the extent of the coronavirus, nor the speed with which it is spreading. (Fortunately, we warned our clients in our Jan. 9 report that our work generated Sell signals on the Russell 2000 and S&P MidCap 400 indexes.)

Until we can, there is a better way to approach potential stocks for purchase.

Instead of trying to pick a bottom in the market, look for “relative strength” in stocks and industries that are either resisting the decline or are declining significantly less than the market indexes.

To determine and plot relative strength, divide a stock’s price by a market average. Ideally, you want to find a pattern of rising relative strength while the stock market is declining. These are usually the stocks that lead once a bear phase ends.

For example, AT&T’s (ticker: T) chart below shows that it has declined less than the S&P 500 for the past three weeks. Since Feb. 12, AT&T has outperformed the S&P by +10% (pink arrow). Notice also that AT&T’s relative strength climbed from last April through October, when the stock advanced while the market made little progress.

So we have a pattern of outperformance while the market did little and while it declined. It was only when the indexes surged 10% quickly from October through early February that relative strength pulled back. But relative strength retraced just half of its gains—a bullish move.

If AT&T’s relative strength could advance from its 15-month “rounding base,” then it would signal a new bull market, at least versus the S&P. Sporting a rich 5.5% dividend when Treasury bonds are yielding less than 1% might be another reason to consider Ma Bell in the months ahead.

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