Ways of Confirming Market Turns

"If you don't fail now and again, it's a sign you're playing it safe."

-- Woody Allen

Based on feedback from last week's column, Timing Market Turns, I've learned that readers want to know more about this subject. So, in today's column, I'll discuss how to confirm a market turn. It's important to have a way to know whether your call is right or, more importantly, wrong.

Different traders adapt methodologies to their own personalities. A lot of RealMoney contributors use technical levels. Others rely on ratios, such as price-to-earnings, price-to-sales or price-to-book. These may be good valuation methodologies, but they're usually not timely enough to catch trend reversals.

A Leg Up on Reversals

A big part of my trading tactics involves catching key inflection points in the major averages, specifically the Dow Jones Industrial Average, the S&P 500 and the Nasdaq Composite. I prefer to let the indices themselves confirm that a market reversal will have legs. Moreover, a failure to obtain that confirmation will mean my thesis is wrong, giving me an early opportunity to tighten up my stops or even to simply cut and run.

When it comes to spotting bottoms, it helps to understand investor psychology. After a long downtrend -- like we've been stuck in since Jan. 26 -- reversals are viewed skeptically. Shareholders have lost confidence, having been burned before by recent fake-outs. (See the March 24 move.) They're still too busy licking their wounds to believe in a reversal. (William O'Neil, founder of Investor's Business Daily, discusses this concept in his book, 24 Essential Lessons for Investment Success.)

But how can you tell whether a reversal is a mere dead-cat bounce or the start of a more lasting move? You can start by looking for follow-through days. According to O'Neil, a follow-through day happens when the market rallies more than 1% on higher volume than the previous day. (These days are also called confirmation days.)

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Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to [e-mail].

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