2-Step Method for Whipping the Bull

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One of the great mysteries on Wall Street is how to value stocks so you know what to pay for their future earnings.

Since the S&P 500 index has traded at an average historical P/E (price-to-earnings ratio) of around 15 times, many investors use that gauge to tell them if a stock is "cheap" or "expensive."

But this one-size-fits-all measure is not how top investors beat the bull because different sectors, let alone many dozens of industries, each have their own unique and subjective "rules" about valuation.

So what's the solution to this complicated mystery? It's really very simple and I have condensed it into 2 easy-to-follow steps for you.

Step 1: Ignore P/E and Focus on Earnings Momentum

In 1979, a paper by MIT Ph.D. Len Zacks published in the Financial Analysts Journal revolutionized the way institutional money managers would learn to select stocks.

His research proved that the most powerful force impacting stock prices were the earnings estimate revisions (EER) from Wall Street equity analysts.

He turned this revelation into a quantitative model that was deployed on Wall Street as the Zacks Rank in 1988. For nearly three decades, the model has proven itself to deliver verified market-beating returns, validating its robust design over many economic cycles.

And ranking the relative changes in EER has also become the preferred method of smart portfolio managers and investment banks around the globe, even though they often give it their own name and design tweaks.

An Elegant, Yet Simple Model

I'll spare you the differential equations and tell you the two most important parts of the Zacks Rank: Agreement and Magnitude.

Each day, the model gathers all the EPS estimate changes (EER) from investment banks and brokers and crunches them in an algorithm that sorts out the level of Agreement among the analysts and the Magnitude of their revisions.

And at the risk of oversimplifying my boss's grand design, I call this a momentum or "rate of change" model because it grabs the data we most want to know: how big are the earnings estimate moves and how many analysts are "voting" for this change.

We also know the direction of the biggest Agreement and Magnitude moves by virtue of where a stock falls in the Zacks Rank distribution, with big positive changes getting the #1 Strong Buy label and big negative changes earning the #5 Strong Sell tattoo.

That's how "the Rank" simplifies the mystery of picking growth stocks. Just focus on the EPS "momo!"

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Step 2: Harness Technical Timing to Multiply Your Edge

After I run my weekly screens for top-ranked companies in multiple industries, I put those 30 to 40 stocks through another set of filters that looks at their chart patterns, price momentum, volume trends and other technical criteria I value.

It's how I picked FireEye in March after it made a significant bottom near $10 following a 2-year slide from $50.

Or how I decided to "load the boat" with shares of Alibaba in January and February near $100 when everyone was saying "stay away from China - especially Chinese internet stocks!"

And it was why I grabbed NVIDIA and Lam Research when most investors were afraid to touch these high-flying chip stocks because they were already trading above most Wall Street price targets.

Buying fundamentally strong stocks is great, but if you can buy them with an extra "edge" at the bottom of a channel, in the middle of a consolidation that's "waiting to go higher," or on the volume breakout that coincides with an earnings "momo" catalyst, you can multiply your portfolio performance by a generous factor over the long-run.

The One-Two Punch of the Zacks Rank + Technical Analysis

Not too long ago, I was primarily a technical trader struggling to learn better equity analysis methods that worked consistently without spending thousands of dollars every month on multiple systems that all seemed to contradict each other.

And I was looking for a systematic yet simple way to quantify and qualify thousands of stocks by their fundamentals that didn't take me 20 hours a week either. With so many variables and metrics, I was often overwhelmed by the unlimited ways you could evaluate a company and its potential.

Then, in 2011 I found the Zacks Rank. I was thrilled at how it sliced through the chaos with a single metric that made the most powerful difference in stock returns: earnings momentum.

Plus, the model was designed to capture the heart of big stock moves that happen in between quarterly reports, which made it perfect for 1-3 month swing trading.

When I combined this fundamental "power tool" with my love for "finding money in the charts," I was amazed at the results. By trusting the Rank to do most of the heavy lifting in my fundamental analysis, I could look at more companies across more industries with complete confidence that the odds were stacked in my favor.

It didn't mean every trade would work out. It just meant that most of them would and the gains would far outweigh the losses. That has proven to be the case and I can't imagine trading stocks any other way.

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Good Investing,

Kevin Cook

Kevin, Senior Stock Strategist at Zacks, is a leading expert in technical analysis and what makes markets move. He provides commentary and recommendations for Zacks TAZR.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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