How to gauge the stock market's direction

Posted by Stephen Sutherland on Wed, May 22, 2013 @ 01:30 PM

How to gauge the stock market%27s directionEven if you have a real knack for picking the best fund, if you invest and are wrong about the trend of the market, your portfolio is going to suffer. This happened to thousands of uninformed investors in the great bear markets of 2000–2002 and 2007–2009. Many investors mistakenly think that it is all about choosing the best investments to park your money in.

Whilst finding quality investments is important, it’s not as crucial as getting in sync with the market’s trend and direction. This means it’s essential you have a reliable method to determine which way the market is heading. If your desire is to become really good at this, it is going to take time and plenty of hard work. Throughout your investment journey, you will ideally need to know if we are in a bull (up) or a bear market (down).

Is the market healthy or unhealthy?

If we are in a bull market, what stage are we in? Are we are in the early or later stages? I've found that to win with investing, you have to watch what the market is doing and interpret what it means. For example, is the market behaving well? Or is it weak and acting out of character? This means to achieve investment success, it helps if you have a good handle on the market's current health and likely future direction. The best way I’ve found to achieve this is to watch what the general market averages are doing on a daily basis.

Discover where Stephen invests

In his bestselling book, How to Make Money in Stocks, William O’Neil said: ‘Don’t let anyone tell you that you can’t time the market’.  According to O’Neil, the mistaken belief that no one can time the market evolved more than 30 years ago when most funds that tried it were not successful. This is because they had to buy and sell at exactly the right time but due to their asset size problems, it took weeks to raise cash and weeks to re-enter or get back invested into the market. Therefore, the top management at these funds imposed rules on their fund managers that required them to remain fully invested (95–100% of assets).

Can the market be timed?

Even though a stock market legend like Bill O’Neil says that it's possible to time the market, opinions are divided on this highly debatable topic. My belief is that the market can be timed – although it is extremely difficult and to always get it right is impossible. In the 2003–2007 bull market, we used a tactical timing approach. This approach involved attempting to exit the market every time it experienced a correction – something we found extremely difficult to execute. Because of the many mistakes we made, it hurt us financially especially in the later stages of the bull market. Using this tactical approach, our aim was to spot intermediate market tops and move into cash. It really was a costly lesson which resulted in underperformance in 2005, 2006 and 2007. We like to learn from our mistakes and when something is not working, we change it.

Since 2008 we’ve used a strategic timing approach and it has proved to be far more effective. Strategic timing is less frequent than tactical and involves staying fully invested during bull market phases. The goal is to get out of the market into cash once the bull market has finished its run. This is when we believe a major downtrend has been triggered and a new bear market has begun. During the bull phase, we make one or two switches to our portfolio each year. During bull markets our goal is to identify which areas, sectors and countries the big money is flowing into and invest in them.

This means during a bull phase we make switches out of any funds that show underperformance and into ones we believe offer greater growth potential. This change has resulted in outperformance during this latest bull market. Sometimes you just have to be honest with yourself when something isn’t working, admit to yourself that you've made a mistake and then make the change. Hopefully by me sharing this with you, you won’t make the same mistake we made and try to time the market too frequently.

Gauging the stock market's direction

But how do you read and analyse the market? If you buy into our thinking, each and every day, your job will be to try to determine the stock market’s health.  To do this, you simply observe and study the major indexes carefully.

We track and analyse the following US indexes:

  • The NASDAQ Composite
  • The S&P 600
  • The S&P 500
  • The Dow Jones Industrial Average

Even though we like to keep an eye on all the world exchanges, our main focus has always been on the US markets and there are four reasons why we do this:

  1. The US is the world’s largest economy.
  2. The US is the leading market to watch for clues of future direction.
  3. The US stock market index’s long-term growth exceeds other world exchanges.
  4. Our philosophy involves watching the behaviour of US institutional investors.

The other indexes around the world that we watch are the FTSE 100, the Nikkei 225, the Shanghai Composite, the Bombay Sensex and the RTS.

As well as watching the four main US indexes, we believe it’s crucial to watch the behaviour of the leading US stocks and sectors. By studying these four indexes each and every day, plus the action of leading stocks and sectors, you can keep a close eye on the market's character and quickly notice any significant changes in the market's personality, which can help you to spot market tops and bottoms.

As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.


ISACO is a specialist in ISA and SIPP Investment and the pioneer of ‘Shadow Investment’, a simple way to grow your ISA and SIPP. Together with our clients, we have £57 million actively invested in ISAs and pensions*. 

Our personal investment service allows you to look over our shoulder and buy into exactly the same funds as we are buying. These are investment funds that we personally own and so you can be assured that they are good quality. We are proud to say that by ‘shadowing’ us, our clients have made an annual return of 12.5% per year over the last four years** versus the FTSE 100’s 7.4%. 

We currently have close to 400 carefully selected clients. Most of them have over £100,000 actively invested and the majority are DIY investors such as business owners, self-employed professionals and corporate executives. We also have clients from the financial services sector such as IFAs, wealth managers and fund managers. ISACO Ltd is authorised and regulated by the Financial Conduct Authority (FCA). Our firm reference number is 525147.

* 15th November 2012: Internal estimation of total ISA and pension assets owned by ISACO Investment Team and ISACO premium clients. 
** (31st December 2008 - 31st December 2012). 
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Topics: Investment outlook, Investment strategy