Distribution and the Downside

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Understanding the Process

When a stock is being accumulated, it spends a lot of time backing and filling. I call it base-building. It is essentially the process by which new investors are buying shares and old investors are selling. Accumulation is very different from aggressive buying. It is a very slow and frustrating process.

During this accumulation, the stock may rally and sell off numerous times for an undetermined period of time, typically longer than the average person has patience for. For example, a stock might rally from 50 to 60, surpassing its previous high of 57, only to turn around and come right back down to 50 again. Then, just as it appears ready to break down through 50, it rallies again back to the 60 area. Often it makes a marginal new high and then simply retreats back to the 50 area again. This type of up-and-down action tends to frustrate most investors, wearing on their patience, causing them to sell. Heck, who wants to watch paint dry anyway?

A very good example of a stock that did this is Amgen (AMGN - Cramer's Take - Stockpickr). Beginning in fall 1997, Amgen was trading from the low 20s to the high 20s, down from a high of 35 or so. Each time Amgen eked out a higher high, I thought, "This is it; here it goes finally," but each time I was disappointed. It barely budged past the new high and immediately came right back down. This lasted about eight or nine months. Finally in July 1998, Amgen blew past its old high of 35. But that lasted only two weeks before the stock fell all the way back to under 30. It took an additional four months before this stock finally got going and never looked back.

Basically, it took Amgen one year to build a base from which it could launch a sustained upside move. During that year, this stock was being accumulated, a period during which it was hard to make any money trading that stock. Eventually the buyers ate their way through the sellers who were left, leaving nothing but buyers in the market. How do we know it wasn't being distributed? Simple: It was making higher highs, not lower highs.

When stocks make lower highs, we are concerned that they are under distribution. Distribution occurs when selling, but not aggressive selling, is taking place. Perhaps it's more like profit-taking: This type of selling is not the sort where you call your broker and say, "Hit the bid and get me out." It's more like, "I think I'll take some money off the table."

That's how stocks make lower highs: Investors are no longer chasing them up; they are now using rallies to sell into. We call this distribution. Eventually the stock can no longer absorb all the selling, and it collapses.

This is why we pay attention to the number of stocks making new highs. If that number is increasing regularly, then we believe stocks are being accumulated. If that number is shrinking, as it currently is, then we begin to believe that stocks are being distributed.

The same way accumulation takes a long time, so does distribution. We don't know how long it will take before the shrinking number of new highs will translate into a meaningful downside move in the averages. In 1987, the peak number of new highs was in early March, and the Dow and S&P did not make their highs until late August, nearly six months later. This indicator is considered an early warning sign that the rally is narrow and that many stocks are under distribution

The group to keep your eyes on now is technology. These stocks have just begun rallying after some very deep corrections. If they fail to make new highs on their rallies this time up, we should be concerned. Failing rallies become fewer new highs, which means distribution is taking place. At this point, I have put Applied Materials (AMAT - Cramer's Take - Stockpickr) at the top of my "potential failing rally" list.

On the positive side of the ledger, I still write down AlliedSignal (ALD - Cramer's Take - Stockpickr), Coke (KO - Cramer's Take - Stockpickr), General Electric (GE - Cramer's Take - Stockpickr), Merck (MRK - Cramer's Take - Stockpickr) and Johnson & Johnson (JNJ - Cramer's Take - Stockpickr) in the DJIA.

Elsewhere, the drugs continue to be good charts with Abbott Labs (ABT - Cramer's Take - Stockpickr) and American Home Products (AHP - Cramer's Take - Stockpickr) on the list. Financial stocks continue to act well, but I would not chase them. Buy 'em on dips. Chase (CMB - Cramer's Take - Stockpickr) seems to be digesting its gains well in here and can be bought into this dip.

On the negative side, Philip Morris (MO - Cramer's Take - Stockpickr) may not break due to all the support below but does not trade well. Kimberly-Clark (KMB - Cramer's Take - Stockpickr) seems stalled out below its resistance.

Does that mean the rally is over? Probably not. This rally still has some momentum left in it. It will not be overbought until later this week and other trend indicators say the trend is still up. What concerns me most is the narrowness of the rally: When stocks stop making new highs, it says they need a rest. It's best not to chase stocks on the upside at this point.