Determining the Short-Term Direction of the Market
You may be investing in the best and brightest stocks in the market and still wondering why you are down on your position. Understanding the stock market’s direction is critical to any position you take in the market. Fighting the trend is a quick recipe for losing your money, no matter how profitable the company you are investing is. Understanding whether you are in a bull market, bear market or a flat market is equally important and key in assessing the potential for your trade.
Before initiating a long or short position, understand the stock markets direction and have an indication for whether or not it wants to move higher or lower. The best way to do this is to look at a broad market measure such as the S&P 500, NYSE (New York Stock Exchange), or the Dow Jones Industrial Average (DJIA).
Price and volume study is truly the key components that you need to study. Remember, indicators are all derivatives of these two key components.
Market Reversal Indicators
Many fail to act at market tops. When your indications give you a signal that a market top is at hand, sell a portion of your long shares out immediately. Here are a few signs that indicate a change in stock market direction.
The Law of Effort vs. Result – This key principle is very important for you to take note of when you observe it. When markets are initially breaking out, there will be heavier volume than the preceding days; however, when you start to noticed that volume is staying consistently high or even expanding BUT there is no substantial price acceleration, be alert. This is a tell tale sign of distribution and indicates that the stock markets direction may be about to reverse. What is this telling you? The public is very bullish and that there is a lot of buying going on but there is also a large force that is keeping the market capped out while they are selling to the public. The market will usually come under distribution during an advance rather than a decline. The larger institutions and hedge funds cannot sell when everyone else is; the large number of shares that they must sell will create an unfavorable situation for selling heavy sizes. They need to mask their selling in the face of strength so they can go un-noticed and dump their shares. If you get caught holding the bag on the initial sell-off, stay tuned for a bounce which will allow you to sell your shares out.
Volume – There is a misnomer that markets need to visibly show heavy volume on the downside in order to be considered a legitimate decline. This is not true. In reality, the first decline off the top will be on lower volume as it is not yet accepted by the public. Most times, you will actually see volume accelerate when the public begins to start accepting the fact that the stock market direction has actually turned lower. The mob mentality will have many sellers panicking at the same time resulting in heavy volume on a flush lower. The price, however, may be considerably off the highs before this happens.
Divergences between Market Indices – Keep a close eye on this. I tend to look at the NYSE to determine the bigger picture. The problem at times with the DOW is that it only has 30 stocks in it and that may show a different picture than the entire market as a whole. Therefore, keep an eye on the divergences between the different market averages to understand if a rally or a decline in one sector or index is contradictory to general market as a whole. For example, if the DJIA is up 1.5% and the NYSE is only up about .5%, we can clearly see that there is a markup in only a small part of the market. This can indicate that a change in stock market direction is near.
Interest Rates – This is a key indicator to watch as well. It simple, when the federal funds rate and discount rates are moved higher in succession by the Federal Reserve, a negative posture is taken by the markets. Alternatively, the first rate cut that comes after these increases can be seen to end the bear and bring in the bulls. Also, keep a close eye on M1, M2 money supply changes and the % changes in the Consumer Price Index (CPI)
Darlings to Dogs – It is typical to see a rotation into the laggards or dogs of the market near market tops. When you see many dogs moving higher, take note and heed the signal that you are receiving, which is that the market is getting ready for an important move DOWN.
January Effect – As discussed in our article on the January effect in the stock markets, a negative close for the month of January is a very bearish indication and leads to sizable market debacles in the following months.
Advance/Decline Line – The A/D line measures the cumulative number of stocks advancing versus declining on the NYSE. This indicator is not very precise; remember that market tops take quite a bit longer to form than market bottoms. Greed is a different animal than fear as fear hits everyone at the same time. The A/D line can start to show divergences far before the market tops out but it is making a clear statement in that the market is rallying on fewer stocks going higher. While it will not indicate the exact top, it will show you in advance that the market is beginning to sputter and to be on guard for a top formation being set up.
AAII Sentiment – AAII measures the sentiment of the non-professional rated investment community. It represents a ratio of bulls and bears out of the entire population of those polled. This indicator becomes of significance when the value of the AAII bull ratio get below 30% bulls. While the occurrences are rare, it is not something to ignore. When the bull ratio is below 30%, it is an indication that the public is very bearish. This indicator is to be used as a contra-indicator to the current direction of the stock market. Very bearish readings actually are very bullish for the market. As we mentioned above, fear is much easier to gauge than greed and using this principle as a guide, I would say that this indicator is best utilized to identify bottoms rather than tops.
Up/Down Volume on the NYSE – I look for days of strong advancing volume to declining volume after a decline to suggest a more meaningful bottom may have been put in. Using a trailing 30 days as a guide, if we see three 90% up volume days without a 90% down day on the NYSE, it is an indication of a more powerful advance in the coming months. While there may be short term conditions that warrant a pullback, the prospectus for the next 12 months is very bullish.
New Highs & New Lows – Another great tool that measures the percentage of stocks in an index are setting new 52 week highs and lows. It is an oscillator that ranges from 0 to 100. This indicator is more useful in locating market bottoms. A reading below 10% indicates that we should be on watch for a possible major shift in the stock markets direction to the upside.
VIX Volatility Index – The VIX is derived using the implied volatility in the S&P 500 index calls and puts. It is an expectation of the markets volatility over the next 30 days. The higher the volatility, the more fear there is in the markets. Again, this is a contrarian indicator and when this index reaches above 30, use your other technical indications and start looking for a change in the stock markets direction to the upside.
Cycles – While nothing is perfect, the 4-year cycle in the stock markets is uncanny with its reliability to provide substantial lows in the stock market. It is pretty simple; you should look for a low in the stock market every four years. Let’s look back in history, 2006, 2002, 1998, 1994, 1990, 1986, 1982 all provided amazing buying opportunities in the stock market. I said its not perfect, and the 1987 crash was one of those occasions. However, if one had bought the market in 1986, they would have been able to make substantial gains before the 1987 crash occurred. History suggests that we should look for this bottom in the August to October timeframe.
Conclusion
We have just reviewed some very basic, yet powerful indicators signaling a change in stock market direction. While none of them are perfect, keeping them on your radar will provide you with a distinct advantage over the rest.
Kunal Vakil is the co-founder of www.mysmp.com (My Stock Market Power) which provides free trading articles and videos to investors covering a broad range of trading topics. Prior to becoming a full time day trader, Kunal designed bond trading systems for one of the largest secondary mortgage market participants and provided management consulting services to many top financial services companies.