How to Stay on the Right Side of the Market

    by Chris Gessel

    On Monday, May 17, the stock market got hammered from all sides:

    • The Nasdaq gapped down and tumbled 2% to its lowest level for 2004;
    • Oil prices surged to new highs;
    • A car bomb in Iraq killed the president of the Governing Council; and
    • The election of a left-leaning government in India unleashed selling in that market as well as the scores of U.S.-listed companies that do business in that booming economy.
    How did market-savvy investors react to the sell-off?

    Calm detachment. Indeed, it’s easy to watch the market fall when you’re sitting safely on the sidelines in cash. Careful readers started taking money off the table a month earlier, weeks before the market averages started crashing through their long-term 200-day moving averages.

    What was their secret? Their inside information? Their good fortune?

    It was nothing of the sort. They used information readily available to anyone. Savvy investors simply analyzed the price and volume changes of the major market indexes and concluded, as they have countless times before, that it was time to start selling stocks.

    Institutional Investors: The Trendsetters

    Millions of retail investors as well as full-time traders of one sort or another make up the stock market. But it is the massive buying power of mutual funds, pension funds, banks and other big institutional investors that defines bull and bear markets. Once you learn to interpret institutional buying and selling, you will never be on the wrong side of the market again.

    It’s vitally important to trade with the general direction of the stock market. After all, three out of four stocks follow the market’s trend. When you’re in a rising, or bull, market, most stocks will appreciate. When the averages are falling in a bear market or intermediate correction, most stocks will also sell off.

    Growth stocks are more extreme. Ninety percent may lose value during a weak market. And their declines will be more severe. For instance, if the Nasdaq loses 15%, it is not uncommon for a volatile growth stock to fall 30% to 45% or more. During the nasty bear market of 2000 to 2003, scores of former high fliers collapsed 90%. At one point during the carnage, I found more than 1,600 stocks trading 90% or more below their all-time highs.

    Many of these stocks still have not recovered, even with the Nasdaq up 26% over the past 12 months. Sun Microsystems is a perfect example. The computer manufacturer used to rank up there with the likes of Microsoft, Cisco Systems and Dell Computer. Nearly a year and a half after the market’s ultimate bottom, Sun remains 93% below its August 2000 high.

    Price and Volume Analysis

    How do you judge the direction of the market before it becomes obvious and crushes your portfolio?

    You must analyze the daily price and volume changes of the Nasdaq, S&P 500 and Dow industrials. In general, you want to see the market:

    • Rising in heavier volume than the day before, which is called accumulation; and
    • Declining in lighter volume than the day before.
    However, the market doesn’t always cooperate. Sometimes the Nasdaq, S&P 500 or Dow will fall in heavier trading volume. That is distribution, which is caused by mutual funds and other big investors as they unload shares.

    A day of distribution here or there is no cause for concern. But when you see a flurry of higher-volume down days in a short period, you’ve been given a clear signal to get out of the way of the market’s heaviest hitters. Don’t get trampled when they head for the exits.

    Let’s look at some recent examples to see how this works.

    Distress Signals: Plummeting Volume

    The market seemed in great shape on January 26 this year. The Nasdaq rallied 1.4% that day to its highest level in 2½ years. The financial media breathlessly sliced and diced the market stats, marveling at its performance. After all, the Nasdaq had surged 72% in less than a year. The bear market had conclusively gone into hibernation.

    But there was a glaring problem: If the market was so good that day in January, why did volume plummet? In fact, Nasdaq trading shrank 14% to 1.96 billion shares. If mutual funds and other big investors believed in the continuing bull market, they didn’t show it with their buy orders.

    Figure 1.
    Nasdaq's Distress
    Signal In January
    (Source: Investor's Business Daily)

    What to Look For
    The initial red flag of a new high in low volume was soon followed by other distressing signals:

    • The following two days, the Nasdaq fell in heavier volume—the distribution continued to pile up; and
    • A week later, the Nasdaq gapped down to its 50-day moving average.
    Disciplined growth investors know that three to five distribution days in a week or two can cause serious problems for even the strongest bull markets. Indeed, the first real correction of the new bull market had arrived. Over the next seven weeks the market would rack up repeated distribution days of heavier-volume declines. During that period the market showed only one accumulation day (see Figure 1).

    What to Do
    However, just the first few days in January and early February told investors it was time for caution.

    That means booking at least partial profits on winning positions and avoiding new stocks. If you tried to buck the market, you probably discovered nearly all your new buys quickly down 7% to 8%, which triggers an immediate sell for disciplined growth investors. One way or another, the market’s action and sound trading rules were moving growth investors into cash.

    Rally Confirmations: Spotting Follow-Throughs

    The Nasdaq sold off for eight weeks until it gained some traction around its 200-day moving average in late March. The daily price and volume action of the major market averages not only signal when it’s time to get out, they also can tell you when it’s time to retest the market waters.

    The key is not to jump in at the first sign of strength but to wait a few days for a confirming rally, which we call a follow-through day.

    What to Look For
    After a prolonged decline, the market will try to rally and establish a new uptrend. Once the market reverses, keep a close eye on the major averages. If their strength is for real, you typically will get a big up day on heavier volume four to seven days into the attempted rally. Follow-throughs may occur as late as the 10th day of the rally. But once you go beyond that period, they become less and less powerful and indicate a weaker rally.

    In this environment, you want to see one of the major averages surge 1.7% or more on heavier volume than the day before. It’s also encouraging when the volume is higher and above average. Ultimately, you want to see convincing power, not a begrudging move in slightly heavier trading.

    On March 24, the Nasdaq set a new low for the year but then reversed and closed a few points higher for the day. That was Day 1 of the attempted rally. It delivered a huge 3% move the next day. Yet that was too early for a valid follow-through. On Day 8, the Nasdaq followed through with a 2.1% gain in heavier and above-average volume (see Figure 2).

    Figure 2.
    Nasdaq's Attempted
    Rally in March 2004
    (Source: Investor's Business Daily)

    What to Do
    It was time to retest the market.

    A follow-through shouldn’t be used as an excuse to barrel back into stocks. Buying with abandon can leave you overextended and dangerously vulnerable to a market reversal. Instead, you should carefully look for quality stocks breaking out of sound bases. If your first stock shows a profit, cautiously shop for another. If the market is in good shape, you’ll soon assemble a portfolio of leading companies.

    The point to remember is that every major advance in the stock market has been confirmed by a follow-through day. But not all follow-through days lead to a bull market.

    Unfortunately, that was the case in early April. A blowout employment report triggered the April 2 follow-through. Investors who weeks before were worrying about deflation suddenly switched gears. Inflation and possible Federal Reserve interest rate hikes became the overriding concern. Selling soon overwhelmed the market.

    On April 13, the Nasdaq logged its first clear distribution day. Two more followed over the next five sessions. It was time to turn cautious. After all, the market had three distribution days in just six sessions. At the same time, new breakouts were failing and falling back into their bases. Cutting losses automatically moved growth investors into cash. Any doubts about the market’s direction were removed April 28 and 29 as the stocks sold off in heavier volume again. Growth investors were back on the sidelines, waiting for the market to regroup.

    A Stock Investor's Motto: Be Prepared

    Keeping a sharp eye on the market is key—don’t ignore it, even when it’s weak. A major bull market can appear in as little as four days. You need to keep your watch lists up to date and stocked with fundamentally superior stocks that are forming sound bases.

    A big turnaround in the market may seem unlikely right now. Between Fed rate hikes, oil prices, the election, Iraq and terror fears from around the globe, there’s plenty of pessimism.

    Of course, you could have said the same thing in March 2003. The U.S. was on the brink of war with Saddam. Corporate profits still looked dismal. The economy was shedding thousands of jobs each month. Yet against this backdrop of gloom and doom, the Nasdaq made a stand on March 12. The tech-heavy index slumped in the morning but reversed in the afternoon. It surged the next day, and took it easy the following session.

    On March 17, four days into the attempted rally, the Nasdaq followed through with a 3.9% vault in the heaviest volume that year. The market had turned, despite the headlines.

    Over the next few months, scores of leading stocks broke out. Gains of 50% to 100% or more became common.

    You never know when the market will rally. But you can always be prepared to profit when it does.

    Chris Gessel is deputy editor of Investor’s Business Daily. To find out more information on stocks cited in this article and for a free two-week trial to Investor’s Business Daily and, call 800-831-2525.

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