But most investors give back more of their profits than they should, and too many give back the whole thing and then some.
In this article, I’ll give you some historically proven sell rules to follow so that you can keep most of your profits in future bull markets.
Sell on the Way Up
The only way I know to nail down a profit is to sell when your stock is still advancing and in good health.
You can do well if you consider selling many of your stocks when they are up 20% to 25% from your purchase price, and cutting all your losses at 7% or 8%. Under this system, you will sooner or later put together two or three 25% gains in a row. Three 25% gains in a row will nearly double your money.
Notice I say sell “many” stocks at a 20% to 25% profit. There’s a key exception to the rule that I always apply:
- If the big picture shows an overall strong bull market,
- If the stock I just bought is clearly one of the market’s best performers (it has the attributes of a great growth stock—great current and three-year earnings and sales growth, a high return on equity, better-quality sponsorship and is a leader in a strong industry group) and
- If the stock bolts 20% on good volume in just one, two or three weeks when it breaks out of a sound and proper base
If all of these “ifs” apply, then I will hold a stock for at least eight weeks from its breakout buy point.
Our historical studies show that stocks with that much initial rocket-like thrust have the potential to be the biggest winners of all. Not only will they stay out of trouble during those eight weeks, they will probably be ahead more than 20% or 25% when the eight weeks are up.
Making It to the Top
Making the crucial exception to the “sell when you’re up 20% to 25%” rule will let you have, in addition to your many singles and doubles, a home run now and then.
If your stock is clearly one of the market’s very best performers, you might try to sit with it until it has a chance to make a climax top.
During a climax top, a stock leader that has risen for many months will suddenly take off and run up much faster than it has in any week since the start of its whole original move. On a weekly chart, the spread from the absolute low to the absolute high of the week in almost all examples will be wider than any price spread in any week so far.
If you don’t use charts, you can tell a climax top by noting day-to-day price changes. Many will run up seven or eight of 10 days in a row, and one of those days will show the biggest point gain since the stock broke out of its original base. For example, say a stock that’s been moving up for several months but never by more than eight points in any one day, shoots up 12 points. When that happens, along with the several other characteristics we’ve mentioned, you know you could be just several days away from the ultimate top.
Some call this pattern a blow-off top, others call it a climax top. Whatever the name, it describes a situation in which seemingly everybody is buying a stock that looks for all the world like it’s going to double again. But it’s just at that point, when the crowd is all excited and drawn into it, that the bubble will break.
A final telltale sign of a climax top is when, after months of advancing, a fast-running stock opens on what is called an exhaustion gap. For example, it might close the night before at $70 and open the next morning at $75, without making all the usual stops in between. That’s a sign you’re at the very end, and you want to be selling. You could be within a day or two of the top.
At such moments, it’s important not to hesitate. You want to sell while the stock is still advancing and looks super-powerful, because once it does top, it can break very sharply. In as little as two days, it can retrace much of its final run-up.
Making the sell decision even tougher at times like this will be that several brokerage firms may be recommending the stock as a buy. You, however, will know better, especially after you’ve experienced a climax top or two. And when everybody’s running around saying how great a stock is, everybody who can buy probably already has—and the only direction for the stock to go at that point is down. When it’s obvious and exciting to everyone, it’s too late. Pulling the trigger won’t be easy. Everyone will be running around saying “Wow, look at this stock—it’s fantastic!” And it will be fantastic.
Other Sell Signals
Here are some other warning signs that can be used as a post-eight-week sell rule for that stock you’re sticking with for a bigger gain.
The price-earnings ratio of a leading stock that meets all the growth parameters will expand more than 100% from where it was when the stock began its whole move.
For example, say a stock breaks out of a sound first-stage base at $50 and goes to $150. And say the $50 price is 95 times earnings (or 138% of the beginning price-earnings ratio of 40), that could be another sign you’re living on borrowed time.
Using a daily or weekly chart, draw upward-trending straight lines connecting three major lows along the absolute bottom of a stock’s temporary pullbacks in price, and then a second line connecting three major highs along the top. Pick points after the stock comes out of its first base and put a little time in between each plot point—a few months rather than a few weeks—so that what you’re plotting is the major trend. The lines you draw will not be exactly parallel, but they’ll be close.
If a stock goes through an upper channel line you can sell knowing that 75% to 80% of the time you’re near a top. All it takes is one penetration. Sell the stock as soon as it goes through—don’t wait to see what happens next. But don’t jump the gun, either. A stock that’s still working its way higher will often not penetrate the upper channel line but bounce off the top trend line back down in price, then turn and weeks later go back up to it again—staying inside the channel all the while.
Relative strength indicates how well a stock is performing relative to the overall market. Lagging relative strength signals weakness and loss of power and leadership. Avoid buying stocks with this flaw.
In Investor’s Business Daily, relative strength ratings run from 1 to 99, with 99 being the strongest. A relative strength of 90 means that the given stock has outperformed 90% of all other stocks in the last 12 months.
Models of the best-performing stocks in the Investor’s Business Daily historical database covering the last 50 years consistently showed an average relative strength of 87 before breaking out and advancing 100% or more.
If a stock’s relative strength drops below 70, this is another sign that a stock is beginning to lag the better-performing leaders and an indication that it should be considered for selling. The one possible exception would be a large-capitalization growth stock, the very size of which makes it harder to keep up. In this case, you might be able to tolerate relative strength dropping to the mid-60s. But relative strength under 60, even for the big companies, means the stock probably has neither the power nor the earnings momentum to become a real leader in the near future.
Industry Group Behavior
More than half the stock leaders in a market cycle will be part of a strong-performing industry group.
If you buy a leader in a leading group, keep an eye on the one or two other leaders in the same group. If you own Wal-Mart Stores, for example, you might also watch stocks like Home Depot, Kohl’s and other leading retail chains. If those stocks are making major tops, you’ve got to ask yourself if yours could possibly be next.
A stock that goes up substantially will usually split once or twice during a bull cycle. Companies like to split their stock to keep the price attractive to individual investors, among other reasons.
Stock splits increase the total number of shares outstanding, but not the overall market value. For an investor holding a stock, after it splits he will own more shares, but the total value of his holding remains the same. So, a split per se is neither a positive or negative development. Except, that is, when it is too large or occurs too frequently. Splits of 3-for-1, 4-for-1 or 5-for-1 are excessive and often mark the tops of stocks. It makes sense when you think about it: Excessive divisions suggest the stock has already run up a great deal or it wouldn’t be necessary to split it so far. A split is also vulnerable if the stock is split two or more times in rapid succession: a 3-for-2 split, for example, followed eight or 10 months later by a 2-for-1 split. For instance, Qualcomm had a 4-for-1 split at its climax top run-up in December of 1999. Only eight months earlier, it had been split 2-for-1.
That doesn’t mean you automatically sell a stock when it has an excessive split. But you need to be aware that numerous stocks tend to split right around their tops, when everyone sees it and is getting excited. Some professionals will sell right into that situation.
Subjective Sell Signals
There are a few sell signals that fall into the subjective category:
When you see a CEO’s picture on the cover of Business Week, Forbes or Fortune.
Don’t worry if the big magazines haven’t started writing feature articles about the company you own. The time to worry is when they do—Wal-Mart had gone up 10 or 20 times before the media really got to know and write about Sam Walton.
When you see the corporate equivalent of conspicuous consumption.
A big new headquarters may be the envy of all the other executives in town, but to you as a shareholder, it could be a sign that the company is starting to splurge and the stock has reached or is nearing a top. Headquarters didn’t come any bigger than the Sears Tower in downtown Chicago, started in 1970 and completed in 1973. Sears stock has generally underperformed ever since—for 30 years to be exact.
When the company indicates it wants to be the biggest in the field.
What usually follows is a merge and acquisition binge that leads to a hangover from which the original company rarely recovers. Does anyone remember the conglomerate craze led by Jimmy Ling? Ling-Temco-Vought sold for $170 in the summer of 1967, when it peaked.
Don’t Look Back
One final tip on selling stocks after a major move: When you sell, sell! Don’t get cute and unload just a small part of your position. Either you want out or you want in. If you want out, get out.
If you don’t sell all your position on the way up and the stock breaks down, you could start rationalizing: “Well, I missed a good chance to take my profit, so I’ll wait until it rallies back.” And then it drops some more and you say the same thing again.
The only way to avoid that typical psychological trap is to sell on the way up, when you’ve got a worthwhile gain, and to be happy with the gain.
Keep it simple. Investing is hard enough. Don’t complicate it by getting super-tricky.
This article was written by William J. O’Neil for the January 2004 issue of the AAII Journal. O’Neil is the founder of the stock brokerage firm William O’Neil & Co and Investor’s Business Daily. O’Neil is also the creator of the CAN SLIM investment strategy.