Ways of Confirming Market Turns

I prefer to see a rally on better than the 30-day average volume. This confirmation day ideally shows up in the fourth through the seventh day after the initial day of higher trading (post-reversal). It can even come as late as the ninth day, based on O'Neil's historical studies.

The Latest Example

In light of that, let's look at some recent action. On Monday, May 17, the market traded to a new low, only to close way above the intraday lows. The next day brought a gap up, followed by some very indecisive, low-volume activity. That exposed a certain amount of doubt on the part of the bulls. But the indices' inability to revisit the prior day's lows -- despite a ton of bad headlines -- also revealed that the bears lacked similar conviction.

Based on that action, I see the first higher day as Tuesday, May 18. By my count, yesterday's rally was the sixth day after the reversal. Today's IBD notes that yesterday's rally saw the "Nasdaq surging 2.2% in trading 24% higher [in volume] than the day before." That certainly qualifies as follow-through.

O'Neil claims he's "never missed the very beginning of a new bull market with this method of tracking the general market indices carefully." The caveat: About 20% of the time, this method proffers a false buy signal. That's typically caused by the actions of a few mega-cap stocks that disproportionately affect market-cap-weighted indices like the S&P 500. The same situation can occur with price-weighted indices like the Dow Jones Industrials.

We can control for these instances by looking at market breadth, and yesterday's breadth was excellent. The Nasdaq saw 2,233 advancing shares vs. 876 decliners, a 2.5-to-1 ratio. But what's really impressive is the up/down volume: 1.5 billion to 200 million, better than 7-to-1. The New York Stock Exchange was even stronger, with 2,778 advancers and only 566 decliners, an almost 5-to-1 ratio. The 1.3 billion shares trading up outweighed the 163 million down by better than 8-to-1.

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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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