In investing, many things are counterintuitive. What looks like a positive might be a negative, and vice versa. Yet these nuances will help investors make decisions in which growth stocks to buy and which ones to skip.
XLet's consider how two investors might see the same situation.
A Tale Of Two Investors: Mack And Jill
Mack dabbles in growth stocks the same way other people play the ponies. He plays hunches. Mack believes that people who study charts are making things more complicated than they truly are.
If Mack's stock rises, that's good. If it sinks, that's bad. He figures that's all he needs to know.
Occasionally, Mack goes online to look at a chart of a stock he bought. But he's only checking the price.
One day Mack signs on and sees his stock has been rising. The stock paused for a day, dropping modestly. The next four days look good to Mack. The stock crept up most days, with the lows progressively higher. Aren't higher lows supposed to be good? Mack read that somewhere once.
Later, Mack is thumbing through a copy of IBD Weekly that somebody left at work. He notices a chart of his stock in the IBD 50. It says, "beware the wedging handle."
Mack doesn't know or care what wedging is. He figures it's time to double down on this baby. Isn't contrarian investing what you're supposed to do? So if people are fretting over this wedging, Mack will outsmart the crowd and buy.
When To Buy Growth Stocks: Steer Clear Of Bases With This Chart Flaw
Jill's investment approach in growth stocks is the polar opposite of Mack's style. She's read "How to Make Money in Stocks" by IBD chairman William O'Neil three times. She studies charts and constantly tries to upgrade her knowledge.
Jill bought the same stock Mack did. But she bought it months ago when it broke out of a first-stage base, and sold it weeks later for a 20% gain, a smart portfolio tactic for growth stocks. She bought it back after it formed and cleared a second-stage base. She sold it for an 18% gain. Now the stock had formed a base-on-base, but Jill notices the wedging.
She knew that wedging refers to the lows in the handle drifting upward. The lows in a proper handle drift downward, providing a shakeout of weak holders.
A breakout from a wedging handle is less likely to work. Jill decides to look elsewhere.
How does this story end?
Anything could happen, but most breakouts from wedging handles fail. The odds don't favor Mack.
Not All Cup With Handle Bases Are Created Equal
In March-June 2004, Multimedia Games formed a typical example of wedging. First, the stock etched a cup base (1) after hitting a high of 27.24.
The decline within the base was mild at 23%. Then it drew a wedging handle (2). Notice how the lows of each day drift upward in quiet volume.
Multimedia broke out on July 6 in volume that was 73% greater than usual (3). The breakout immediately failed. Meanwhile, the market was in the midst of a steep downturn. The stock lost nearly half its value in the next five weeks.
A version of this column first ran in the Dec. 27, 2010, edition of IBD. In September 2014, Multimedia Games announced it would be acquired by Global Cash Access. Please follow Whitfield on Twitter at @IBD_PWhitfield.
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