Market Snapshots: Analyzing the Daily Action

    by Mike Webster

    To sail a boat successfully, you must know which way the wind is blowing.

    To invest successfully, you need to know which way the market is going. And when the market’s direction changes, you must change with it.

    The first two parts of this series on The Markets explained some of the basics of spotting market tops and bottoms (“The Big Picture: How to Decipher What the Market Is Saying,” by William J. O’Neil, April 2004; and “How to Stay on the Right Side of the Market,” by Chris Gessel, July 2004; available in the AAII Journal archives on In this article, we delve deeper into our analysis of general market behavior by discussing market actions you should be examining on a daily basis.

    The Market Never Changes

    What explains the shocking similarity of the roaring 1920s and infamous crash in October 1929 with the wild 1990s and the popping of the bubble in March 2000?

    Simply this: In 70 years, the market hasn’t changed because human nature hasn’t changed.

    All of the major advances in technology over the years haven’t changed the psychology of investing. The Internet, providing everyone with instant information and quick, cheap transactions didn’t keep a bubble from recurring. Investors operated then just as they do now with the same basic emotions—hope, fear, and greed. And as long as human nature remains unchanged, the market’s behavior will repeat itself, over and over.

    The bubble is just an extreme example of how emotions dictate the daily fluctuations of stock prices. You can see this phenomenon every day with every trade.

    The general market reflects this emotional pattern happening every day across thousands of stocks. Take a look at any stock that went up or down by $1 today. Did anything in the company change? Probably not. The emotion in the marketplace made it go up or down.

    We look for price patterns to analyze market trends. By studying past market turns, you can see price patterns in the general market indexes. For example, the bear market in 1998 formed a classic double-bottom pattern. This pattern, as with all patterns, is created by human emotion.

    A pattern is just something that allows us to have precedent so we know what to expect. When a stock or index forms a certain chart pattern, you can start to anticipate what it should do to be “acting right.”

    However, in addition to looking for market patterns that are similar to historical patterns, you can also form a picture of market trends by analyzing the daily market actions.

    What to Look for

    Interpreting the daily market isn’t simple, but with time and a little work anyone can do it.

    What should you look for?

    Let’s start with a classic clear-cut accumulation (buying) day, and a classic distribution (selling) day.

    Healthy Market Characteristics
    In a perfect world, a healthy accumulation day has the following characteristics:

    • The indexes are rising on heavy volume (above average and above the prior day’s volume),
    • The indexes show a large spread (difference between high and low),
    • The indexes are closing higher than their open,
    • The indexes are closing in the top part of the daily range,
    • The indexes show more advancing volume than declining volume,
    • The indexes show more advancing issues than declining issues,
    • Growth industries (medical, retail, technology) are leading the market,
    • Defensive industries (utilities, oil & gas, metals) are doing poorly,
    • Leading quality stocks are up on heavy volume,
    • Stocks are breaking out of sound bases,
    • Intraday market volume figures on the indexes are increasing as the market rallies intraday,
    • The market is rallying on any good news, and
    • The market is recovering quickly from any negative news.

    Sick Market Characteristics
    If you reverse most of these, you get a classic clear-cut distribution day (selling day):

    • The indexes are falling on heavy volume (above average and above the prior day’s volume),
    • The indexes are showing a large spread (difference between high and low),
    • The indexes opened higher than their closing,
    • The indexes are closing near the low of the range,
    • There is more declining volume than advancing volume,
    • There are more declining issues than advancing issues,
    • Defensive industries are up on the day,
    • Growth industries are down big on the day,
    • Leading quality stocks are down on heavy volume,
    • There are only low-quality break-outs—if any at all,
    • Intraday market volume declines on any rallies,
    • The market is moving significantly lower on bad news, and
    • The market is not rallying much, if at all, on good or even great news.

    Often, the market will experience some kind of combination of the two, where some positive action might be mixed with some that is clearly negative. The key is to learn how to recognize both, so that you know how aggressive or conservative you should be in your trading. Reacting properly at these key turning points is critical to making money in the market and, better yet, keeping it.

    The Subtleties

    While many investors quickly learn how to recognize these traits, many get frustrated by some of the market’s more subtle shifts and turns. Here are some other things to look for as you go through your daily review of the market.

    Volume Shows Conviction
    Volume in the market is the ultimate clue to the conviction of its overall state. It is all the more interesting that popular news programs only announce whether the market went up or down, and often don’t include whether it was on lighter or heavier volume than the preceding day.

    Oddly enough, it’s not uncommon to hear a news reporter say volume is light when it’s really heavy. I can only gather they are referring to the fact that it’s not near record-breaking levels. But remember, you should look at volume first compared to the prior day and, second, compared to its 50-day average. Whether the market went up or down is only half the story. Volume is the true test of market conviction or the lack thereof.

    For example, going up on light volume can actually be worse than going down on light volume. It means that the market is just drifting higher without any real conviction or institutional power behind it. This is okay occasionally, but you don’t want it to be the overall theme of the market. When it rallies, the market should have powerful volume behind it that shows there is real demand. Likewise, you would like it to drift down on light volume, showing there is not much selling pressure.

    You can look at this on a daily level, but it’s also helpful to study the intraday volume figures. Look to see what the volume did during the day as the market started to rally. In a healthy market you will see the volume start to pick up, and then fade as the market pulls back. Following this will give you an edge that most market participants won’t have.

    Constructive Down Days
    Ideally, you want one or two up days to be followed by a couple of light volume pullback days. This allows the market to digest its gains. It’s also constructive to have a little fear in the market.

    Here’s what you want to see in a “good” down day:

    • Index down only slightly less than it’s recently been up,
    • Light volume relative to previous day and average volume,
    • Small spread,
    • Closing in the middle range or higher,
    • Declining volume shouldn’t be dramatically higher than advancing volume,
    • Declining issues shouldn’t be dramatically higher than advancing issues,
    • No leading quality stocks breaking down, and
    • No major industry group rotation.

    Churning Day
    A churning day is a classic example of how the market can fool many people. That’s because it’s a distribution day that normally occurs when the market closes up for the day (see Figure 1).

    Figure 1.
    Churning Day:
    One Example
    Churning can be defined as heavy volume without further price progress. So, even though the market is up, it will be up less than average. It will also close mid- or lower-range—another sign of weakness. These two things alone would not be enough for extreme concern, but once you add the heavy volume, it’s a red flag.

    Churning is a sign that institutional investors are dumping their positions. In order for fund managers to safely sell millions of shares of their stocks without causing the prices to collapse, they must sell on days of strength. So a churning day signifies hundreds of fund managers trying to unload large quantities of stock without crushing the market. Bottom line: There is just too much supply (stock for sale) compared to demand, but not quite enough to send the market into negative ground.

    The thing that makes churning days even trickier to spot is the fact that they typically happen as the market is still advancing. So if you are just watching the evening news, you may think it sounds like it was a constructive day, when in fact it was a distribution day.

    One churning day alone is not cause for concern, but once you start seeing them along with other distribution days, you need to start easing out of the market.

    The Impact of the News
    Another way to understand the character of the market is to observe its reaction to the daily news.

    This is another way in which the market fools many people. Sometimes good news is bad news, and sometimes bad news is good news.

    What does this mean?

    • A strong market will be able to brush off bad news and rally strongly on any good news.
    • In a weak market, you may see a temporary rise after some surprising positive news, but it will be short-lived and fall back to fresh new lows. And in an environment like this, bad news can be deadly, causing the market to break wide open.

    Earnings Season
    You should also pay close attention to how the daily market reacts during earnings season:

    • In a strong bull market, stocks that meet or exceed estimates will break out or extend recent gains. Even stocks that report disappointing earnings may actually go up, with the mindset that the bad news is out of the way.
    • In weak or fragile markets, even great earnings won’t seem to matter. Often a stock will beat earnings estimates, guide higher and still not go anywhere. It’s times like this that you want to be very careful. If you are in a stock that actually reports disappointing earnings or guidance, you may be looking at a 20% or more gap down.

    Since 9/11, news of terror alerts, threats and ongoing war has impacted the market in a way many assume to be totally unprecedented. But it may surprise you to know that, in fact, the market has reacted no differently to this news. It reacts based on its current state depending on whether it is weak or strong.

    When the market was healthy in most of 2003, for example, it responded to terrorist-related stories by going down for an hour or two, and then gradually rebounding back up. That’s the type of market you want to trade in, because it indicates the big money is stepping in to offer support.

    On the other hand, there have been times when the market was so jumpy that any rumor, no matter how small or unsubstantiated, would send stocks into a tailspin for a day or so. That’s the market to avoid.

    Advances and Declines
    There are three main advance-decline items to look at each day. The first two represent that day’s advancing, declining and unchanged volume and number of stocks. This gives you more detail on how widespread the move was for the day.

    On a day in which the market is strongly up, you want to see both the majority of the volume and number of stocks advancing. This is generally the case. The key is to look for any divergences. A warning sign would be a decent market increase, but where advances and declines were at about the same level.

    The other advance-decline data to be aware of is the running tally of advancing and declining issues. The ratio of the number of stocks advancing each day versus the number of stocks declining each day can be displayed graphically on a market chart to show the trend. The advance-decline line can be useful when there is a short-term rally during a prolonged bull market. If you see a diversion between the advance-decline line and the major market indexes as they attempt to rally, it’s a warning sign that the broader market remains relatively weak.

    The advance-decline line should be a secondary indicator. You should focus on the daily price and volume action. Keep in mind, bull markets will occasionally continue to advance as the advance-decline line tops prematurely and begins to decline.

    Picturing the Action

    How can you form an overall picture of the market from these daily market actions?

    You should keep a tally of good days and bad days. There are some days that are more critical than others. The most important are the initial rally day, follow-through day and then each distribution day. But every day counts and should be analyzed.

    While you can keep a mental tally, a better approach is to mark up a chart.

    To analyze the daily action, I start each morning with charts showing the major indexes, along with key information to analyze the daily activity. I mark all the positive things in blue and bad things in red, and then post it on my wall next to my monitor. This way, if everyday I’m using the blue pen most of the time, I know I’m in a healthy market. Once the red ink starts dominating the pages, look out!

    It’s also helpful to mark exactly where you are right now in big letters. So I’ll put something like “5th day” in blue, meaning today is a possible fifth day follow-through, or “3 in 14” in red, meaning there have been three distribution days in the last 14 days. The more you mark up the chart, the more in tune you will remain.

    Putting in the Time

    When it comes to investing, the market never changes, because human nature doesn’t change. Hope, greed and fear will always drive the movements in the market.

    However, the fact that the market never changes is the key to investment success if you are willing to do your homework. By studying the past and learning to interpret what the market is doing right now, you will be able to recognize market trends, which is critical to capitalizing on the opportunities of the market and protecting your gains.

    While market trend changes take place over time, a focus on the daily actions of the market can help you understand the overall market direction. And like anything in life, the more time and effort you put into this, the more rewarding it will be.

    Mike Webster is an in-house portfolio manager for William O’Neil & Co., Inc.

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