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CANSLIM Overview

M is for Market Direction
Part 2: Detecting a Market Bottom

"The fastest way to take a bath in the stock market or go broke is to try to prove that you are right and the market is wrong."

- William J. O'Neil

Pride goeth before a fall, according to the old proverb. And that certainly is true with the stock market. Investors often hang on to stocks in the face of a declining market because they're convinced they should rise, and conversely, stay on the sidelines when they should be jumping back in.

But predicting the market direction, as noted before, is no easy task. O'Neil says you don't have to predict the market. You just have to watch it and see what it's doing. "The whole idea is to be completely objective and recognize what the market is telling you, rather than try to prove that the thing you said or did yesterday or six weeks ago was right."

Bottom Signals

This is a tricky business because if you jump back into a market too soon, an "apparent rally may fade", but if you "hesitate at the brink of a roaring recovery, opportunities will pass you by."

So what do you look for? According to O'Neil, you should watch for "the first time an attempted rally follows through on anywhere from its third to tenth day of recovery." You want to look for a volume increase accompanied by a price rise of 1% or more on the Dow or S&P.

But beware. There are occasions where a "valid follow-through abruptly fails" followed by a rapid decline on large volume.

For safety, O'Neil recommends waiting for a second confirmation. This second follow-through usually happens on the fourth to seventh day of the attempted rally. Such a follow-through, particularly if the market was strong on the first, second and third days of the rally, should be explosive. It should be "strong, decisive, and conclusive, not begrudging and on the fence".

Other Indicators

The market itself is the primary indicator, but O'Neil notes a few others. Most interesting (and others besides O'Neil have noted this), is the sentiment of market analysts. When "the great majority" of investment newsletters are bearish, it is often indicative of a bear market bottom. Conversely, most newsletters are bullish near a top. As O'Neil puts it, "the majority is almost always wrong when it is most important to be right".

He also notes that the market usually anticipates events. So the stock market usually bottoms out while business is still on a downtrend, anticipating a recovery. Similarly, the market may recover anticipating an interest rate decrease. (Or in the case in the Spring of 2000, an end to increases!) This means that you cannot use economic indicators to predict the market. It will be too late.

Other indicators include the upside/downside volume. When the volume in stocks going up starts to outpace the volume in stocks going down, it could be signaling an impending intermediate upturn, even as the markets continue to decline.

Another indicator is short interest. Historically there have been two or three peaks in short-selling near a market bottom.

Then there is the odd-lot index. Odd-lots, supposedly, are bought and sold by less informed investors, who tend to be wrong at important turning points. So if the volume of odd-lot sales declines, then there could be a market upturn.

Another important indicator is the cash position of mutual funds and pension funds. Bull markets begin when their cash positions are higher than normal and bear markets begin when cash positions are lower than normal. The reason, of course, is obvious. Funds low in cash cannot support the market if it starts to decline. Funds flush with cash are in a position to give impetus to a market.

All of these are secondary indicators to O'Neil, the primary one the rally and follow through indicators noted above.

False Indicators

O'Neil is very skeptical of the short-term overbought/oversold indicator. He says it is very unreliable and often gives false signals.

Another popular indicator that O'Neil frowns on is the Dow Theory. This indicator says that an upturn in the industrial average must be confirmed by an upturn in the transportation average before you can safely assume a return of a bull market. O'Neil says it may have been useful when it was the railroad average, but with airlines added and its transformation into a transportation average, the Dow Theory is now too slow to be practical.

As I indicated in the first part of this article, I'm skeptical of the possibility of accurately forecasting the market (as are most market analysts). Nevertheless, it is useful to follow the markets and the indicators. It should be apparent when a market is in decline, even if temporarily. And as O'Neil says, you fight the market to your detriment.


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