Today’s Trading Lesson From TradingMarkets
How I Gauge
Market Direction by Watching Individual Stocks
By Loren Fleckenstein
Traders first learn to use chart
patterns to time buy and sell decisions on individual stocks. But don’t miss
the forest for the trees. The time you spend combing the charts for trades
also can furnish you with an invaluable gauge of the overall market.
Pattern formations don’t just crop
up in individual stocks. They also proliferate among groups of stocks and at
key turning points in the general market. Cup-with-handle bases, rare near
the end of extended rallies, come out of woodwork at market bottoms. Bearish
distribution and patterns such as head-and-shoulders tops and climax
sell-offs often precede market tops.Â
To spot such turning points, you
must be able to do more than recognize different patterns. You must have a
memory for their absence or scarcity
prior to their proliferation. So when a pattern multiplies across many
individual stocks, you’ll detect the change. At minimum, this requires that
you scan hundreds of stocks at least once a week. Many professional traders
set aside Sunday evening to perform this research.
While that may sound like a tall
order, databases and other research products can help you accomplish this
task in several hours.Â
As an intermediate-term momentum
trader, I break down my weekly market survey into two parts.Â
First, I use TradingMarkets’
StockScanner to generate a list of all stocks with a one-year relative
strength score of 90 or higher. Stocks also must have last closed at 15 a
share or high. This is “my market” — the waters that I prefer to fish in.
It also enables me to track the market leadership as high RS stocks are, by
definition, leaders. Then I comb through the list, eyeballing each
individual chart, eliminating those issues which fail to meet my other
Of course, I could generate a more
refined list by instructing the program to screen for more variables than
price and relative strength. This would enable me to spot potential trades
in far less time. But it would defeat my ability to get a handle on the
composition (industries, market cap, etc.) and character (bullish, bearish)
of the market leadership.
I scan the entire list, making a
mental note of the industries and sectors that appear in greatest numbers on
the list. I also glance at the shorter-term relative strength scores to get
a general sense of which areas of the market are retaining leadership and
which may be giving way. Then I dive into the individual charts.
It’s just as important for me to
know when leadership stocks with are not
forming sound bases as when they are recovering or breaking out. I want to
know if the leaders are forming the right sides of correction-recovery
patterns, tightening in
flat bases, reversing off bottoms, being
accumulated in sell-offs, becoming increasingly extended,
failing on breakouts, churning near their highs or showing other signs
of distribution, trading wide and loose, etc., etc.Â
No single indicator will give you
this depth of insight into the fabric of the market. You must eyeball the
charts of hundreds of leadership stocks every week. If stocks sell off or
break out en masse, everyone will notice it. By then, it’s too late. You
want to see things coming. And that requires a perspective that comes from
peering into the charts of the leaders on a regular basis.
As I flip through the charts of my
listed stocks, I watch for recurring themes. For instance, perhaps the
right-side recoveries in a given week are looking more V-shaped (and thus
prone to failure) than U-shaped. Maybe I’ll notice churning near the highs
in a large number of stocks of a particular industry group.
Once I’ve gone through the chart
of every listed stock, I have a good handle on the leaders. And I’ve
refreshed my list of target stocks for real-time tracking throughout the
week. I know the state of my market.
Next, I take a step back and check
out the internals of the general market. I probably won’t trade the sub-90
RS names, but I still don’t want to overlook promising base builders that
fall outside my RS criteria. If the base looks particularly sound, and the
stock shows signs of a relative strength turnaround in the near term, I may
still be interested.
For this check, I go to the
Stocks Building A Base screen and again eyeball the individual stocks.
For more on how to use this TradingMarkets indicator, read Kevin Marder’s
How To Use The TradingMarkets.com “Stocks Building a Base” Screen.
When the market is bottoming after
a correction, scads of high RS stocks will complete sound bases. That’s a
valuable sign of a nascent rally. Combining this analysis of the market’s
microstructure with a proven macro indicator or signal, like the
follow-through day, can significantly improve your odds of entering the
market at the right moment in time.
As a rally ages, fewer and fewer high RS stocks will be in sound bases. They
will become further and further extended. The leaders continue to extend,
without new leaders coming up from behind out of sound bases. This tells me
that a rally is growing long in the tooth. If this occurs, I’d definitely
throttle back on margin if I were on margin, and I’d look for opportunities
to take partial profits.Â Â
These are extremely useful signals, especially given the fact that high RS
stocks lead the market. So they can change direction ahead of the major
Be alert to concentrated pattern
formation and price moves in specific industry groups. Biotechs, for
instance, came out strong as a group in June-July 1999. Semiconductors
weakened and came under distribution in August-October 1997.Â
Let’s look at a few examples.
(Note: The following charts are priced to reflected subsequent stock
broke out of two consolidation zones in June 1999. The company, which came
public in February of that year, is a picks-and-shovels business. It sells
cloning kits used by researchers for genomics companies and other biotech
ventures to make DNA cloning samples.
The stock popped out of a
narrow-consolidation zone on June 7 on low volume, then began digesting its
gains in a tightening trading range (see Point A).
If you prefer to buy on breakouts when volume expands with price, you would
have missed this move. However, the advance, if you had spotted it, could
have alerted to you something stirring the stock, especially given the
constructive trading action among other biotechs. When the stock cleared the
second, higher range on June 28 (Point B),
it did so on a powerful expansion on June 28.
On June 29, Biogen (BGEN)
broke out of a 12-week cup-with-handle base on heavy volume (see
Point A in the
posed a more difficult challenge in terms of finding an entry point, but the
correction-recovery pattern was clearly etched in the chart. I’ve indicated
the stock’s trading action on June 29, 1999 (Point
A) just to give you common time reference points with Biogen.
Those with a real stomach for volatility could have caught the breakout on
July 13 (Point B).
Semiconductors, market leaders in
1997, began breaking down as a group ahead of the Black Monday sell-off on
Oct. 27 of that year.
peaked on Aug. 6, 1997 (Point A), tried
to rally back on light volume but fell short, then sold off the next session
on Aug. 22 (Point B) on heavy volume.
There still was ambiguity. The stock closed near the high to the day’s high.
Big gap down on Oct. 15 (Point C).
Applied Materials (AMAT)
peaked on Aug. 20, 1997 on mediocre volume (Point A).
The stock headed lower over the next two sessions, gapping down on double
normal volume on Aug. 22 (Point B). From
there, notice the dry-up in volume, followed by heavy distribution on Oct.
16 (Point C).
The Best Trading Books, Video Courses and Software To Improve Your Trading