Know when to hold and when to sell

By Ron Miesels
Globe Investor Magazine, April 25, 2008

Ron Meisels is the president of Phases & Cycles Inc. and a contributor to NA-Marketletter.com website.

A recent article in The Globe and Mail quoted William O'Neil, author of How to Make Money in Stocks, who suggested to "sell a stock when it's first sensed that it isn't acting right."

Well, if I know the average investor, he will sense that his stock "isn't acting right" when the stock goes 1 cent lower than the price he bought it. Hence, it is probably not a very good way to judge stocks. Instead of such a subjective emotion, there is a more objective measure that professionals have used for decades - the use of the 40-week moving average (40wMA).

Before we look at the fantastic power of this tool, let's define the terms. A 40-week average is the sum of the past 40 weeks' closing prices divided by 40. Other averages (10-week, 200-day, etc.) are constructed similarly. When this exercise is repeated week after week, this average will "move" and becomes a "moving average."

In the olden days before computers, charting moving averages was a tedious task, but today any one of these averages could be accessed instantly on chart services such as Globeinvestor.com or GlobeinvestorGold.com.

The above was the mathematical definition. My practical definition is that the 40wMA illustrates the rate at which money is flowing in or out of a stock. When buyers want to own the stock and are willing to pay more for this security (bid up the price), the 40wMA will rise as a consequence.

The opposite is also true: when there are more anxious sellers who would sell at any price, the 40wMA will fall. Therefore, when a rising 40wMA stops rising and begins to decline it shows that the sellers have gained the upper hand. Of course, since this tool measures the last 40 weeks, this average moves quite slowly, which is both its advantage and its failure.

The 40wMA will never give a sell signal at the top. The 40wMA could rise for weeks or even months before it turns and begins to descend. But whenever it reverses direction, whenever it turns down, the signal is clear: Get out of the position.

Losses in Bank of Montreal, Loblaw, Citigroup and Bear Stearns all could have been anticipated and prevented by the use of this simple tool. When the 40wMA stopped rising, flattened out and then began to fall for these stocks, it was time to "abandon ship." Did these signals come in time?

Definitely. The 40wMA signal for Bank of Montreal (now at $48.98) came at $69 on July 27, 2007 to prevent a potential 29-per-cent loss and for Loblaw ($29.40) at $71.65 on July 29, 2005 to prevent a potential 59-per-cent loss. For Citigroup ($26.13) it came at $50.73 on June 29th, 2007, to prevent a potential 49-per-cent loss and for Bear Stearns ($10.55) at $147.95 on June 18th, 2007 to prevent a whopping 93-per-cent loss.

Are there any stocks on our watch-list at this time? Any stocks that are close to giving a 40wMA sell signal? None at the moment, but we are watching CAE and Gildan here, as well as Altria and AT&T in the United States.

Is this signal infallible? Of course not. There are occasions when the moving average turns down, but the stock reverses soon thereafter and moves to new high. However, such occasions are so rare that it is better to act on the signal, than to subject oneself to a huge potential loss by trying to double-guess it.

Special to The Globe and Mail