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Why Stocks Face A Hard Road Back After Plunge From Highs

Buying a stock that has been beaten down sounds like a good idea, but it's actually very risky.

In fact, it's often better to buy high and sell higher.

Here's why: Stocks that fall well below their previous highs face a difficult road back. That's because current shareholders who are sitting on big losses tend to sell shares to break even or cut their losses if the stock rallies. This creates stiff resistance to further price gains, a concept that's known as overhead supply.

Some especially strong stocks can rebound fast from a deep correction, as Apple (AAPL) and Priceline.com (PCLN) showed coming out of the financial crisis of 2008-09. But most stocks take much longer to reach an old high.

Celgene (CELG) lost half its value during the financial crisis. That created a large pool of investors who were underwater and looking to sell once the stock got back to or near break-even.

The stock rose when a new bull market began in March 2009. But after getting as high as 65.79 in March 2010 (1), Celgene traded mostly sideways for nearly two years. Each time the stock tried to climb above resistance near 63 to 65, it ran into sellers.

It finally reclaimed its post-crisis high of 77.39 in March 2012 (2), two months after breaking out of a cup base two months earlier.

Celgene had always been among the leaders in the highly rated Medical-Biomed/Biotech industry group. But it took a long time to exhaust its overhead supply of shares coming onto the market every time the stock started to show strength.

It usually takes 18 months for the overhead supply to diminish, at which point those who still own the stock are probably in it for the long term and not likely to bail out at the old highs.

Celgene continued to get back on track. After a final correction of 27% (3) from the April 2012 high of 80.42 — much less of a decline than during the 2008 crash — Celgene jumped out of a base-on-base pattern to a new high in January 2013.

Celgene was added to IBD Leaderboard on Nov. 23, 2012, as the market confirmed a new uptrend. It more than doubled over the next year to a peak of 174.66.

Strong fundamentals justified the move. From 2008 to 2013, Celgene's earnings grew from $1.56 a share to $5.96. Sales leaped nearly threefold, from $2.26 billion to $6.49 billion. Its EPS Rating is now 94 and the SMR (sales growth, profit margins and return on equity) grade is a top-notch A.