This is the seventh in a series of posts where we're looking at gauging the stock market's direction.
If you would like to know more, please just download our free report How to Gauge Stock Market Direction.
When do market tops occur?
Historically, market tops occur after the averages move into new high ground and show several days of large and increased volume, with either very poor price progress or actual declines in the averages. A series of distribution days (institutional selling) mark the end of a bull market.
A distribution day occurs when one of the major stock indexes falls on above average volume. When the market piles up four or five distribution days in just a few weeks, and the uptrend seems to have stalled, chances are it’s heading into a correction, especially when you notice many top stocks falling heavily in great volume.
The best time to bank a profit
If you believe that the market’s major trend has changed from up to down, you can bank some or all of your profits by switching out of your equity based fund investments and moving into cash. When investing in stocks and shares ISAs, be aware that it’s not about selling (withdrawing money from your ISA) – it’s about switching (keeping the money invested in the ISA wrapper).
By parking your money in cash on a temporary basis, it means that even if the market crashes, your money will be safe.
In fact, although equity ISAs could be dropping like stones, a Cash Park will actually be rising in value. After moving into cash, you simply sit, wait and remain patient. Many investors don’t realise that it is possible to park in cash. Some mistakenly think that once you are invested in a fund, you have to stay in that fund. Some wrongly think that to switch into a Cash Park would adversely affect their annual allowance – it doesn’t.
Why it’s smart to keep a close eye on leading stocks
Throughout the year, come rain or shine, we love to watch the daily activity of the market’s best stocks. The reason we watch them like a hawk is because they tend to lead the market higher or lower – before the general market catches on.
This means that they are a very good indicator of which direction the market is likely to head next. For example, back in 1999 during the technology bubble, leading stocks at the time were equities such as Yahoo! and Microsoft. As you can see on this 20 year chart of the NASDAQ Composite, the general market topped in March 2000.
The market may have topped in March 2000, however Microsoft (ticker symbol: MSFT), a leading stock at the time, topped in December 1999, giving investors a signal that the bull market might be close to a top.
Yahoo! (ticker symbol: YHOO), another leader at the time, topped in January 2000, which was another clue that a top was coming.
As we mentioned, it also happens on the flip side too. Stocks such as Rio Tinto (ticker symbol: RIO) and BHP Billiton (ticker symbol: BHP) were two of the leading stocks at the start of the bull market that began in 2009.
It’s interesting to note therefore, that BHP Billiton bottomed in November 2008, four months before the market turned around.
It’s also interesting to see Rio Tinto (another leader in 2009 and 2010) bottoming out in December 2008, which was three months before the 2009 bull market began.
It’s also good to know that a leading stock can become a laggard stock. We class a leading stock as one that has an RS (relative strength) rating on MarketSmith of 80 or above and an EPS (earnings per share) rating of 80 or above.
Stocks’ ratings change on a daily basis, which means it’s probably a good idea to always have a list of stocks that you class as leaders and continually work on adding new members to the list and removing stocks that no longer match your leading stock criteria.
How to spot a stock market bottom
So, how do you know when a market correction has hit bottom? We keep our eye on a number of things, such as the behaviour of the US indexes, the activity and personality of leading stocks and we also look for a follow-through day. This is a day that helps to confirm that institutional investors are going all in. The follow-through is a concept coined by William O’Neil and can be summarised as follows: you look for an increase in total market volume from the day before and substantial price progress for the day, up at least 1.7% or more in any index.
We like to see a follow-through occur on either the NASDAQ Composite or S&P 600. The phenomenon of a follow-through day has occurred in every new bull market throughout history, though not all follow-through days result in a new bull market. A follow-through on the fourth day or later of an attempted rally is likely to be an indicator of follow-through buying from institutions with conviction. A first, second, or third-day rally attempt off a market bottom can often be little more than short-covering.
Observing how the general averages are acting is essential in helping you gauge the market’s future trend or direction. However, there are some key indicators that can give you a head start when spotting market turning points. One of the things that we like to see happening to confirm that the market is strong and vibrant, is the way that the NASDAQ Composite, the NASDAQ 100 and the chip sector are acting.
We refer to the NASDAQ 100 as the NASDAQ Composite’s big brother. The NASDAQ 100 is formed of the 100 largest stocks listed on the NASDAQ Composite and includes giants such as Microsoft, Google and Cisco Systems. Chips are a common term for semiconductors. The main index for chips is the PHLX Semiconductor and is commonly known as the SOX.
A giant magnet
If the market is rising but being led by the Dow or the S&P 500, meaning that the NASDAQ Composite, the NASDAQ 100 and the chip sector are lagging, it means that the rally (uptrend) is more prone to fail. But if the NASDAQ Composite, the NASDAQ 100 and the chip sector are leading the market higher, it tells you that the rally is more likely to succeed. By watching the market every single day, we’ve noticed that these three key indicators act like a kind of giant magnet.
In other words, when they are weak, they tend to pull and lead the market down, but when they are strong they tend to pull and lead the market up. We like to watch the NASDAQ 100’s action in two ways. We look at the chart of the NASDAQ 100 and we look at the chart of the QQQs, which is the exchange traded fund (ETF) that tracks the movement of the 100. By watching the QQQs, we can carefully study the behaviour of the NASDAQ 100.
With chips, we like to watch the SOX and the SMH, which is the exchange traded fund that tracks the performance of a number of major semiconductor companies. Included in the SMH are Intel, Texas Instruments and Applied Materials. The NASDAQ Composite, the NASDAQ 100 and the chip sector are three key indicators that can give you early signals to act. We watch them very closely and we suggest you do too.
How to read the market like a professional
The market has worked in exactly the same way since it began in the late 1800s. It is always about supply and demand, and the way to analyse supply and demand is through looking at price and volume behaviour on charts. Institutional investors can be bullish one minute but then discover some new information that overrides their optimistic outlook. At the end of the day, to read the market effectively, you have to remember that it really does not matter what is happening news wise. Regardless of what the news or any market commentator is saying, if the price and volume action is positive, then that’s good, period. And that goes for the downside too. If all the news headlines are positive but the market’s behaviour is saying the opposite, then you had better be thinking about switching into the safety of cash. The lesson here is simple. Do not look to the news or economic data to tell you what is going on or going to happen. Instead, find out what is really going on by studying the daily market activity using stock charts.
We hope this series of blog posts will help you get in sync with the market’s direction and so help improve your investment returns. Remember, if you would like to know more, please just download our free report How to Gauge Stock Market Direction.
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.
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ISACO are a specialist in ISA and SIPP investment and together with our clients have an estimated £75 million actively invested1. To help investors like you, we offer a high end service called ‘Shadow Investment’. Put simply, we invest and you invest beside us. As we grow our wealth, you grow yours.
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If you have over £250,000 actively invested, click here to arrange a free financial review (valued at £495) with Paul Sutherland, ISACO’s Managing Director.1 Internal estimation taken January 1st 2015 of total ISA and pension assets owned by the ISACO Investment Team and ISACO premium clients.
2 December 31st 1997 - December 31st 2014 ISACO 105.5%, FTSE 100 27.6%.
3 December 31st 2011 – December 31st 2014.
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