There is no such thing as the “Holy Grail” of investing.
It doesn’t exist. If it did, we’d all be filthy rich with our own island.
But there are ways to give yourself an edge, especially if you know how to exploit herd mentality. In August 2017, shares of Allstate (ALL) took a nasty hit as the fear of Hurricanes Irma and Harvey took their toll on most, if not all insurance-related stocks.
ALL shares fell from a high of $92.50 to $85.50 in days.
As fear ran amok, and traders ran for the exit doors, something interesting began to happen.
Momentum fell deep into oversold territory, telling us the herd was beginning to overreact. We knew it would be time to buy and soon, as pessimism raged.
Remember, it’s at points of max pessimism that you want to buy.
As Warren Buffett will tell you, “Be fearful when others are greedy; and greedy when others are fearful.” Or, as Sir John Templeton would tell you, “Buy excessive pessimism.”
Granted, we just can’t buy because others are selling en masse.
We need to know exactly where pessimism has reached its excessive high. We need to know when to jump into a trading opportunity.
So, we begin to watch what the herd is telling us, technically.
The Rubber Band Effect
If you pull a rubber band too far, too tight, what happens? It snaps back, right?
The same thing happens with stocks. If traders get too fearful, for example, they send stocks down too much, too fast. The rubber band is pulled too tight. Eventually, it’ll snap right back just like a rubber band.
But how do we spot that?
We look at several technical indicators, whose job it is to gauge momentum of the herd.
- Bollinger Bands (2,20)
- Relative strength (RSI)
- Moving average convergence divergence (MACD)
- Williams’ %R
- Money Flow (MFI)
If each aligns in oversold territory especially as fear is exploding, we have a good idea that the stock may be bottoming out. And it’s at that point where we want to buy.
Look at Allstate (ALL).
As Hurricane Irma began to become a painful memory, relative strength (RSI) fell to its lowest point in more than a year. That’s not sustainable at all. Plus, ALL was now at its lower Bollinger Band where it historically bounces.
MACD was at lows we haven’t seen since early 2016.
Williams’ %R was at its 80-line, oversold and ready to pivot higher.
The moment those technical indicators aligned in such a fashion, ALL became a buying opportunity traders could no longer fear.
The typical response to such technical reasoning is, “Any one can look at a chart after the fact and say, ‘I could have bought here.’”
But that’s not what we’re doing.
Look at back at any chart with these technical tools and you’ll see that for days or weeks after our indicators aligned, the stock was still rebounding.
It’s never an immediate bounce back.
If you can spot excessive fear, you can spot a potential profit. It’s not the Holy Grail, but it does come very close.