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    The Big Picture: How to Decipher What the Market Is Saying

    by William J. O'Neil

    To be a successful investor, you can't just buy a good stock. You have to buy the very best stocks at the very best time.

    And it's not enough for you to simply study the stock itself, you also need to analyze the market conditions in which it is trading.

    Five decades of historical studies on past market cycles show that three out of four stocks decline when the general market averages correct. That's why market direction is one of the several critical factors in making money in stocks. How do you tell which way the market is headed?

    You really don't need a crystal ball. The key is learning to decipher the day-to-day market action—in other words, what the market's doing right now. Successful investing isn't about following pundits' predictions or analysts' estimates or going by how you feel. It is about studying the market itself.

    There are a few key market indicators to look for that provide a trustworthy lens into how the market is behaving overall. In this article, we'll focus on the main indicators—the Nasdaq composite, S&P 500 and Dow Jones industrials. We'll illustrate how to use their daily price and volume activity to interpret today's market climate.

    The Market Is as the Market Does

    To be highly accurate in any pursuit, you have to carefully observe and analyze the object at hand. The stock market is no different. The idea may seem simple enough, but even with their hard-earned money on the line, you'd be surprised at how often people argue with the facts that are right in front of them.

    Many investors are sometimes misled by the shouting of opinions and prognostications. Listening to opinions about the market is one of the riskiest things you can do as an individual investor. You want facts, not personal opinions. If there's one lesson most learned from the 2000 three-year bear market, it's that arguing with the facts and simply hoping for the best is the easiest way to lose your shirt.

    Let's start by dissecting market activity and talk about what it's trying to tell you.

    The Interplay of Price and Volume

    The stock market is governed by the same forces as individual stocks: supply and demand. Throughout history, the best way to determine the market's health and direction has been to view the daily price and volume action of the three major indexes: the Dow, the S&P 500 and the Nasdaq. Volume bursts in these key indexes show where mutual funds and other institutional investors, the biggest driver of stock prices, are moving.

    In an up-trending market, you normally want to see prices and trading volume rise somewhat in tandem. This shows a market under accumulation, with more positive volume than selling volume: a good sign. On down days, in the majority of cases, you want to see volume lessen. This shows a lack of any significant selling—another good sign. But take note of days when the market shoots up in price to new highs on lighter volume. This shows a lack of institutional buying, which might be a warning sign.

    Even in the best of all bull markets, there will be days on the way up when selling suddenly overtakes buying—when an index closes down for the day on heavier volume than the day before. This shows distribution, and it is a potential red flag if that type of action continues to occur.

    One day of distribution is not enough to turn a rallying market downward, nor is it necessarily cause for alarm. Rather, take it as a signal to start watching the market more closely to see what happens next. Market cycles over the last 50 years indicate that it usually takes three to five distribution days over a period of up to four weeks to turn the market's uptrend into a downtrend. Every major market top in the past 100 years has revealed this negative price-and-volume action prior to the market's downtrend.

    Many people think of the great crash of 1929 as being a sudden, inexplicable event. Not so. In late 1929, just before the Dow gave way to a selling avalanche, the index posted a flurry of down days (distribution), each on heavier volume than the previous session, all of them saying to investors: "Get out." This activity pinpoints the mass exodus by institutional or professional investors—the heart and soul of the market. You might be asking how a market event almost 80 years ago tells us anything about today's market. The answer is that in the stock market, as in many things, history continually repeats itself because human nature (hope, greed, fear) doesn't change.

    The Nasdaq flashed similar warning signs in the spring of 2000, although almost everyone missed it because they were caught up in the predictions and hysteria of the moment. By March 30, the market had logged a series of heavy distribution days, a sign that a number of mutual funds, pensions or other big players were selling stock. Investor's Business Daily's market column "The Big Picture" warned people to get off margin, begin raising cash and only remain invested with extreme caution—not because of what we thought the market was going to do, but because we were reading what the market was actually telling us day by day. It was telling investors: "Sell."

    An investor who remains inflexible during a confirmed market downturn and argues with the market facts will usually suffer the consequences. The name of the game is to preserve profits you have built up in a bull market instead of riding them back down through a bear market period.

    Market Leaders

    Relying on the primary market indexes and studying their daily price and volume interplay is one of the best possible methods for analyzing the market's behavior and determining its overall direction and health.

    The second best method is studying the current and recent action of market leaders. Remember that history shows three out of four stocks follow market downtrends. When you see the best and the strongest stocks unraveling one after the other on heavier-than-average volume, that's telling you something about the market. Your job is not to figure out why it's happening, but to recognize that it's happening, and know what you need to do about it.

    What Defines a Market Leader?
    A market leader is a company that dominates its industry in a number of key fundamental and technical measurements. On the fundamental side, it will boast strong profit and sales growth, high return on equity or fat profit margins. Those gains are almost always the result of an innovative product or service that satisfies a need among consumers or other businesses.

    Figure 1.
    Nasdaq Market Chart
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    The other side of leadership is technical, meaning the company's stock performance. By definition, market-leading stocks outperform the vast majority of other securities. Huge winners during the 1990s, such as Cisco Systems and Microsoft, were outperforming the market averages, and at least 87% of all other stocks, before they launched into their massive price advances.

    Notice that in my definition of market leaders I didn't include "number one in name recognition or brand awareness." That is not a relevant factor when determining a leading stock. Everyone knows and recognizes brand names such as Sears and Campbell Soup, but are their fundamental and technical performance numbers saying they are the current leaders in their respective industries? You should not be influenced by how many commercials a company has, how many magazine covers have featured the company's CEO, or how often you eat the food or buy the gas for your car. When the market hits bottom and rallies toward new highs, it's best to forget about most of the old familiar names. Historical research shows that just one of every eight past leaders reasserts itself as a leader in the next bull phase.

    Follow Mainly the New Leaders
    After a clear-cut downturn, the market will try to rally at some point. But the first few days of an attempted upswing tell you nothing about prospects for success. Instead, wait for a follow-through day, a powerful confirmation of the market's new uptrend. A follow-through occurs usually between the fourth and tenth day when one of the major indexes shows a booming gain of 1.7% to 2% or more on greater volume than the day before. In this kind of market follow-through strength, the first stocks that move to new high ground out of sound chart bases on big volume are typically the new leaders in the next bull phase. They'll likely go up farther and faster than other stocks, even after the others gather strength.

    Because these new leaders don't show up and identify themselves until the market has definitely hit bottom and turned upward with a confirming follow-through day, you must be on your toes, ready to act decisively. New leading stocks will continually evolve from proper patterns for the next three months.

    In the period that follows, identify stocks leading their industry groups. Place them on a watch list and see how they perform. Look to see whether the big mutual fund managers are moving into these stocks. Investor's Business Daily has a daily list, "Where the Big Money's Flowing," and also "52 Week Highs & Lows" that separates the leaders from the market laggards. Track the daily price and volume action of the leaders against the major indexes. When you see new stocks hitting price highs as the market also rises, it indicates a healthy rally and overall upward trend. At the same time, when the majority of these new big leaders begin to break down, it could be your cue to an emerging overall downtrend.

    Leaders and Downtrends
    When a severe correction hits the market, the biggest leaders tend to drop the most.

    Why?

    For one, they have the most gains to lose. Many of the strongest stocks that drove the Nasdaq to a peak of 5132 in March of 2000 fell 90% below their highs (Sun Microsystems, CMGI, EMC, etc.). While the major averages were selling off in heavier volume, leading stocks were simultaneously breaking down, a clear sign some institutions were selling and the market was turning south. After a long market advance, you can be fairly sure it's headed for trouble if most of the market's stock leaders start acting abnormally. Our studies over the last 50 years show that when a market leader finally tops, on average, it will decline 75%. That's why you, as a serious investor, must have a simple, proven method to recognize a topping market and take defensive action.

    What to Do Today

    Track the averages and watch the behavior of the better-quality growth stocks with excellent institutional sponsorship, and you should be able to stay in phase with the market.

    A few facts to keep in mind:

    • The economy is improving as a result of the broad-based tax cuts,

    • Companies have cut costs during the 2000 three-year bear market and are still lean and efficient,

    • Consumers have paid down their installment debts over the past few years and continue to benefit from low interest rates.
    As with most things, be patient and stay objective in your market and stock analyses. Don't let anyone's opinions or predictions blind you to the facts. Keep your emotions from getting in the way of sound decisions, and keep to the facts:
    • Monitor the charts of the three major averages—the Nasdaq, the S&P 500, and the Dow—for unusual price and volume behavior.

    • Compare the behavior of the averages to the behavior of the big market winners: Are they finding support at their 50-day moving average? Are they breaking down badly and not rallying well?
    In doing these things, you build a stronger level of understanding market behavior as it happens. You'll learn to recognize the signs that should give you a solid plan of attack-one that relies on the most relevant market facts. Remember, personal opinions can frequently be wrong, whereas markets seldom are.

    Table 1 summarizes the market trend indicators you should keep an eye on.

       TABLE 1. Market Trend Indicators
    UP-TRENDING MARKETS
       Price and Volume Indicators
    • Prices and trading volume rise in tandem

    • Confirmation: Follow-through days (days 4 through 7 from the initial rally) where one key market index is up 1.7% to 2% on greater volume than the day before

    • On down days, volume will lessen
       Market-Leading Stock Indicators
    • New market-leading stocks: the first stocks to move to new price highs as the market is also rising on big volume

    • Institutional money moving into the new leaders
    DOWN-TRENDING MARKETS
       Price and Volume Indicators
    • Market index closes down on heavier volume than the day before

    • Confirmation: three to five follow-through days of distribution (when an index closes down for the day on heavier volume than the day before) over a period of up to four weeks

    • On up days, volume is lighter
       Market-Leading Stock Indicators
    • Majority of new leaders stop making new highs

    • Institutional selling of new leaders


    William J. O'Neil is founder of Investor's Business Daily, a national daily newspaper that focuses on investment markets using proprietary, databased screens and ratings; and he is the founder of William O'Neil + Co. Incorporated, a leading institutional investment research organization headquartered in Los Angeles. Mr. O'Neil's best-selling books, "The Successful Investor" and "How to Make Money in Stocks," are published by McGraw-Hill. In March 2004, "The Successful Investor" was named one of the best business books of 2003 by the Library Journal.


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