Technical Indicators of Superior Growth Stocks
A few days ago, I identified the “Fundamental Traits of Super Growth Stocks.” To summarize, those three metrics are a company’s PEG Ratio, Return on Equity, and Earnings Growth Rate.
Not that long ago, only a handful of stocks would have cleared all three of the minimum thresholds that I set for those metrics. But we are now in a runaway growth market, so we have to apply another set of rules to separate the wheat from the chaff.
Just because a company has superior growth metrics doesn’t necessarily mean it will outperform the overall stock market in the near term. It also needs the support of trading algorithms that make decisions based on recent behavior.
It is estimated that algorithmic trading comprises roughly two-thirds of the total trading volume on the major U.S. stock exchanges. Over time, these algorithms establish a discernible pattern for buying and selling stocks.
The set of rules that drive each algorithm is a closely held secret. However, in aggregate we can identify when most of them are about to buy or sell a stock based on the following three technical indicators.
Relative Strength Index
Although the stock market is quite efficient at price discovery over the long haul, in the near term it tends to exaggerate movements in both directions based on current trends. The Relative Strength Index (RSI) compares the magnitude of a stock’s recent gains and losses to determine how much of its price movement is being driven by momentum.
The RSI is expressed on a scale of 0 to 100. An RSI below 50 implies that a stock has become oversold and is likely to rebound soon, while an RSI above 50 implies that a stock has become overbought and may soon weaken. The further above or below 50 the RSI is for a stock, the more likely it is that it will soon reverse direction.
Directional Movement Indicator
Over time, a stock tends to move along a discernible trend line throughout its daily ups and downs. The Directional Movement Indicator (DMI) measures the difference between a stock’s positive directional movement (+DI) and its negative directional movement (-DI) to determine in which direction it is likely to move in the near term.
To do that, the DMI compares the daily high and low prices for a stock over a recent period of time. When the +DI line crosses above the –DI line, that means that a new uptrend is underway until the +DI line crosses below the -D line.
Since the daily price swings for a stock can be severe, the Stochastics Oscillator (SO) uses closing prices only to determine the directional trend for a stock. To do that, it compares a stock’s current share price to its highest and lowest closing prices over the previous two weeks.
Similar to the RSI, it is expressed on a scale of 0 – 100. An SO score above 80 is considered bearish, while an SO score below 20 suggests that a stock is oversold and likely to rally.
Of course, none of these technical indicators is perfect. Sometimes, the price of a stock will change direction due to events that these mathematical models can’t predict. But when all three of these metrics are in agreement, that’s a good sign that a stock is about to make a strong directional move.
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Jim Pearce is the chief investment strategist of Personal Finance.