Identifying Market Direction

Learning how to identify the general direction the market is headed can save you from severe loss. You can read countless books and study complex systems for selecting stocks, but if you ignore market direction, even the best stock won't save you.

Learning how to identify the general direction the market is headed can save you from severe loss. You can read countless books and study complex systems for selecting stocks, but if you ignore market direction, even the best stock won’t save you.

Just as you diagnose a patient’s condition by evaluating symptoms, certain techniques can be learned to evaluate market conditions to determine your investment strategy.

Such a system, CAN SLIM®, has been developed by William J. O’Neil. Based on studies of stock market winners since the 1950s, it consists of guidelines for selecting, buying, and selling stocks to maximize earnings. CAN SLIM also has time proven rules for interpreting market direction and trends.

O’Neil points out that an investor must learn to analyze the overall market correctly. The best way to determine market direction is to follow it, learn to interpret it, and understand what the averages are doing daily. It may sound overwhelming, but study and practice will bring success. The three most commonly used indices are: the Standard and Poor (S and P), the Dow Jones Industrial Average, and the NASDAQ Composite. These indices tell you the approximate strength or weakness of each day’s overall trading activity and are usually early indicators of emerging trends.

When the market is in an uptrend, it advances day by day, and the price action of the market averages should be closely watched, along with daily volume. Bull markets tend to open weak and close strong. Major news events, rumors of war, changes in discount rates can all affect the market. You want to see a market under “accumulation,” which means that there is a trend upward in prices and trading volume rises with more buying than selling.

Charts showing the volume, plus high, low, and closing prices of the various indices are helpful. Eventually, there comes a point where the selling overtakes buying. This “distribution” phase takes place over a few days. Now the market may again move briefly upward with increasing volume, but it does not really gain ground. Instead, it stalls. When stocks “top,” then start to drop, going into a marked decline, three out of four will follow the market’s trend and also drop in price. The three key market indicators will reflect this downward movement and the supply-demand ratio will shift.

O’Neil says time is critical at this stage, and investors should sell quickly before real weakness develops. Don’t buy on margin. Do raise as much cash as possible. This is a time when it is most important to stay in-sync with the market and not be swayed by what others say it ought to be doing. Many growth stocks can drop two to three times the market averages and may not come back up for several years, if ever. It’s of no value to make a gain during an up cycle only to lose it all during a down cycle.

Become familiar with charts reflecting the market cycles and understand their significance in your investment plans. Learn to interpret the daily price and volume changes reflected in the indices and watch the activity of market leaders. Just as you must observe your patient’s condition, you must also monitor market direction.

Michael Doran is Managing Director of the long/short equity fund, Emerald Bay Partners LP. Mr. Doran can be reached at (530) 677-1635 or sierracap@directcon.net.

CAN SLIM® and variations are marks of Investor’s Business Daily, Inc. and affiliates (‘IBD’). The CAN SLIM® Certified mark is licensed by IBD only to signify successful completion of IBD’s CAN SLIM® Training program. IBD does not license, review or approve of, and is not responsible or liable for any investment advice or other services provided by the user. The user is not an agent of, sponsored by, affiliated with, or owned by IBD and is not authorized by IBD to make any representations, warranties, or promises.