Barry Ritholtz
Ways of Confirming Market Turns
 By Barry Ritholtz
Special to RealMoney.com

5/26/2004 2:33 PM EDT
URL: http://www.thestreet.com/p/rmoney/barryritholtz/10162423.html
 Trading Strategies BULLISH
  • The major indices can confirm a reversal.
  • This method can occasionally give false buy signals.
  • Overcome that by looking at breadth.
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    "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.)

    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.

    Regardless, investors can always place their stops just below the lows of the first rally day, which in this example is Tuesday, May 18. If that low is penetrated, then we clearly have a false follow-through day.

    Why does this method work? After the long selloff, anyone who wants or needs to sell has already done so. With supply drying up, the market finds an uneasy equilibrium. It takes very little additional buying to ignite a move up. Short-covering often starts the process, then institutional buyers start accumulating shares, which draws the attention of the technicians. Finally, the momentum players hop on board, and we're off to the races.

    Yesterday's action confirms my bullish stance. I'm now looking for another follow-through day on even stronger volume sometime over the next five trading days. If that occurs, then it would conform to my expectations for a new leg up, which could last anywhere from two to six months.
    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 barry.ritholtz@thestreet.com.

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