Ask Colin

I have come across you and other experienced traders saying that the strong stocks at the beginning of a bull market tend to stay the winners. How do I recognise these stocks at the beginning of a bull market?

Investment and trading literature is full of this kind of "rules". Indeed, there are so many of them that books have been written just about collections of these "rules". It is important to understand the nature of these "rules".

The first thing about them is that they should properly be called "general observations" rather than "rules". They are general tendencies that have been observed over many market cycles, rather than behaviours that can be measured and relied upon invariably. They are not scientific observations in that sense. However, that does not mean that they have no value or that they are wrong. The danger is not in this area, but that people hear them and try to use them with a degree of precision that is quite unrealistic.

What many of us who have been around for a while have noticed is that a small group of stocks seem to do well right through each bull market. When we look back it is surprising how they began their run very early in the bull market and were often the among the last standing when the bull market is over. However, there are many other stocks that seem to start out like them, yet fail. So, how should this information be used?

The way I use it is to start buying strong stocks when I feel there is convincing evidence that we are somewhere near the bottom of a bear market. Strong stocks are those making new highs. The assumption is that, if I buy a portfolio of these stocks, with luck some of them will be the leaders that run right through the bull market. Then the usual process comes into play where I try to let the winners in my portfolio run and weed out the rest as they fall out of trend. Hopefully in this way, I catch some of the winners and hold them. Holding them is, of course, the difficult thing psychologically for most people.

My approach is quite the opposite of most inexperienced investors. Firstly, they hesitate to get into the market at all in the early stages of a bull market. When it is well advanced and they decide to get in, these leading stocks seem to have already gone up too much, so they buy dogs that have not moved up much yet in the hope that they will become winners. Their best course in hindsight will, of course, have been to have bought the winners, not the dogs. My approach makes it easier to buy them, because I am acting earlier, before they have gone too far.

One other aspect is interesting: the darlings of one bull market are rarely the darlings of the next one. This seems to have something to do with companies that become very successful getting fat and lazy. Usually, good management hands over to weaker management and the company spends time in the dog house working its way out of its difficulties.

There is one other common trap. Many inexperienced investors lack historical perspective as to how long a bear market can run. Long and strong bull markets tend to lead to longer bear markets than do short and weak bull markets. After a long and strong bull market there are lots of investors who think that every rally in the bear market is a new bull market. And bear markets always seem to feature strong rallies. These are known by old hands as "sucker rallies" because they draw back into the market those who do not recognise them for what they are. Psychologically, a bear market is not played out until all the "suckers" have learned their lesson the hard way and do not go back in on each rally. Then we get the rally that does start a bull market. This game is not easy. It requires a lot of judgement that comes form experience. We need to have a clear game plan and iron discipline, especially on cutting losses when we get it wrong.