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CANSLIM Overview

M is for Market Direction
Part 1: Detecting a Market Top

"When the forgotten old dogs begin to bark and spearhead the market's advance, the stock market is on its last feeble legs."

- William J. O'Neil

Although conventional wisdom says market timing is a mug's game, William O'Neil disagrees. "Recognizing when the market has hit a top or bottomed out is 50% of the whole complicated ballgame," he says.

He points out that it is "prudent or fashionable" for people "to say or believe they are long-term investors...to stay fully invested through thick and thin," and he notes that many institutions follow this policy. But he argues that such a strategy is inflexible and can bring tragic results, "particularly for individual investors". He recalls the disastrous bear market of 1973-1974 as a warning. The average stock plunged 70% over that period as the Dow dipped 50%.

O'Neil's view is reflected in another common piece of investing lore - the trend is your friend. In other words, don't fight the market. Whenever I hear that phrase I think of the Bobby Fuller Four song - I fought the law and the law won. Don't fight the market 'cuz the market will win!

So how can you recognize when the market is topping or bottoming? It isn't easy as the April 26, 2000 issue of Hulbert's Financial Digest points out. Most market timers were significantly more bearish in the Fall of 1999 just before the market soared than they were in February just before the market collapsed. These timers obviously missed the call on the late 1999 bull run and were less concerned in early 2000 than one would have expected if they were accurate predictors.

Methods of predicting the market vary, but we'll consider only O'Neil's observations.

It Comes Down to Economics

Although O'Neil doesn't state it in exactly these terms, it all comes down to economics - the law of supply and demand. One should watch the daily price and volume charts of the general market indexes, he says and learn to recognize key telltale signs of an impending trend reversal.

He says that certain changes in volume and price indicate selling or distribution. When institutions and professional investors start to sell, it means a trend reversal is imminent.

He says most people miss these signs because they occur while the market is still advancing. But the signs, he says, are clear. They are:

  • The strong market leaders often sputter first, ahead of the general market.
  • Some low priced, low quality speculative stocks begin to move up. (See quote at top of this article!)
  • The market averages have moved into new high ground.
  • Market volume increases while the price level stays the same or rises only marginally. The Dow shows stalling action.
  • This usually occurs in the third to ninth day of the advance.
  • There are often significant divergences between different market averages.

These are the key factors, and O'Neil says one, notably the volume increase while prices falter, occurs on just one or two days, so if you miss it, well, you miss it. But we do get a second chance. After these indicators occur and the market turns, O'Neil says the market will have an attempted bounce back. If the first attempted rally fails, it is a sign that a market reversal is in progress.

How do we know a rally has failed? If the rally sputters in its third, fourth or fifth day, or if the rally recovers less than half of the market drop, it is a sign of market weakness.

Another sign is if the first market resurgence ends abruptly on the second day with a strong opening in the morning but closing down at the closing bell.

Interest Rates & the Market

Everybody already knows this, but O'Neil emphasizes it, so let's say it again. Increases in the Federal Reserve Discount Rate, particularly three in a row, usually mark the beginnings of a bear market. 2000 was different. The buoyant optimism after the feared Y2K bug proved to be ephemeral led the market higher through a third increase. But the fourth increase eventually proved too much. And there was a fifth one to boot.

O'Neil notes that an FRB rate increase in September 1987 led to the October 1987 crash. But rate increases are not primary indicators. They help confirm a break. O'Neil notes there were three occasions in which a market reversal was not predicted by a rate increase.

Conclusions

O'Neil makes a number of other points and it is recommended that readers check out the book. It is well worth reading and goes into much more detail than I can here.

That said, what do I make of O'Neil's observations? O'Neil includes several charts in his book of selected market tops to illustrate his point about increasing volume and faltering prices. And frankly, I find them to be far too subtle for my poor brain to discern. If he hadn't put the arrows in the charts pointing out the tops, I never would have known where they were. Really.

Moreover, O'Neil mentions a number of market tops to study to see his point more clearly. He mentions: second week of September 1955, third week of November 1955, second week of April 1956, second week of August 1956 and so on through December 1968, sometimes as many as three a year. That's a lot of tops, and nearly all are intermediate short-term tops. It makes more sense to hang on to stocks through all these little blips rather than to be constantly trading in and out of the market.

I'm still of the opinion that it is extremely difficult, if not impossible, to accurately predict broad market movements. This is, in my opinion, the most difficult element of O'Neil's CANSLIM method to use effectively. And possibly, the least useful.

I'm more inclined to try and predict the peaks of individual stocks than of market averages. But that's for another article at another time.

But if you are interested in assessments of market conditions (and I do believe they are worth looking at), there are a number of resources that do just that. It's a lot easier than trying to figure it out yourself. These include a website called Pitbull Investor which uses a CANSLIM approach and has a page called their Stock Market Crash Index. This handy page indicates the current status for major American indices as well as for various sectors.  Canadian investors will find Super Stock Picker's Market Timing Indicator useful.

 

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