This 'Fundamental Flaw' Could Be Costing You Money Every Day
When it comes to investing, you should always stick to the fundamentals. This refrain, or some version of it, is what many new investors are taught.
In ouropinion, that's terrible advice.
A metric such as the price-to-earnings (P/E) ratio, for example, is often cited as a way to measure the fundamental health of a stock. A low P/E ratio is thought to signify stocks that are "cheap" or that are currently trading at an attractive valuation relative to their peers.
But the goal of investing and trading is not to own "cheap" stocks or fundamentally healthy stocks, it's to make money. That means finding stocks that are likely to appreciate in value -- and quickly.
Now, don't get it wrong, we are not saying that fundamentals such as P/E ratios (especially when using the forward, rather than the traditional trailing variety) are completely irrelevant or should be ignored. We are also not saying that fundamentals such as earnings growth should be cast aside as immaterial. What we are saying is that these factors don't matter unless the stock is likely to move higher.
And relying solely on such metrics is a "fundamental flaw" made by many traders.
In "How to Make Money in Stocks," Investor's Business Daily founder William O'Neil writes, "Our ongoing analysis of the most successful stocks from 1880 to the present shows that, contrary to most investors' beliefs, P/E ratios were not a relevant factor in price movement."
By only looking at fundamentals, many investors are ignoring what we consider to be the most important metric for identifying potential winners, relative strength (RS).
Basically, relative strength states that stocks that have outperformed in the past will continue to do so, while those that have been the weakest will continue to underperform, In other words, those "cheap" stocks can stay cheap for a long time.
Of course, this will not always be the case, but relative strength is one of the few technical indicators that has actually been proven to work.
Professor Eugene F. Fama of the University of Chicago was awarded the 2013 Nobel Prize in economics for proving that relative strength was one of the most important factors in a stock's future price movement.
Separately, James P. O'Shaughnessy, author of "What Works on Wall Street," calculated that using a relative strength-based system would have beaten the market by an average of 3.65% per year over the past 83 years.
As you can see, some of the world's top investing minds have looked at the data and concluded that relative strength is a much better way to screen for potential winners. Of course, if you can find stocks with attractive fundamentals and a strong RS ranking, that's even better.
The bottom line here is that if you were screening for stocks based on traditional P/E metrics, you might have passed a big winner by in favor of something that looked cheaper. This "fundamental flaw" can cause you to miss out on substantial gains. If you want to make double-digit gains in a relatively short amount of time, relative strength is one of the best tools available to select your trading candidates.
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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.