Market Tops basics

Markets that are in a topping process tend to show money coming out of the market as it is advancing. Institutions due to their large holdings cannot exit positions quickly. So they try to ease it out without tipping off the world what they are doing. Astute investors who can read charts can see their footprints anyway.

A way to track money flow is to watch for distribution in major indices. The strict definition of distribution is an index closing down on volume higher than the day before. If you consider that index price multiplied by volume represents the aggregate amount of money traded in the underlying index components on any particular day then you can see that this is an attempt to track daily money flow. Up on higher volume is money coming into the market, down on higher volume is money coming out of the market. The market does not go up every day and it is quite normal to see a market go down on lower volume during an advance. It is when the volume is higher than the day before when the market pulls back that is the warning sign. So a market that shows 3-5 or more distribution days over the last 4 weeks leads us to consider that the market may be getting into trouble.

IBD has further refined the definition of distribution to an index that closes down by 0.2% or more on higher volume. Less than this could be viewed as insignificant distribution. We tend to track the following indices for evidence of a topping market: Dow Industrials, S&P 500, NASDAQ and NYSE Composite. Personally I pay much more attention to the NASDAQ than the other indices. The Dow only has 30 stocks that are usually market laggards. It is so much watched for historical reasons that we have to watch it also. The S&P500 and NYSE Composite truly represent a large portion of the market. For CANSLIM investors, picks seem to be more concentrated in the NASDAQ market however. Chris Kacher in his market timing model only watches the NASDAQ.

A more subtle form of distribution is represented by churning or stalling. Let’s say the an index moves up 2% on substantial volume one day. On the very next day the same index moves up 0.1% on even higher volume. What is happening? In my view the increased buying is being met by increased selling. It is these willing sellers that are beginning to tip their hands. New buyers are being readily sold stock by the institutional holders. They want to get out and they are more than happy to use the increased buying to unload their positions.

Chris Kacher’s definition of churning is something like the following: Index up 0.1% or less on volume higher than the day before. The day should show a longish upper tail. In Candlestick speak this means that the price closes in the lower range of the day after trading higher. How much higher, I can’t remember if he defines this exactly, perhaps someone else has read his book: Trade like an O’Neil Disciple. The bottom line for me is that if the day in question trades in a narrow range visually on a chart compared to prior days trading range and the close in not in the lower half of the range, then ignore the churning signal.

Now for the obvious question: What about those yin-yang market direction calls this year in IBD. This is in my opinion the most challenging market conditions I have ever seen and might be the most challenging period in the last 70 years. Plain and simple the market is just tough right now. Few people are alive who can talk about trading in the 1930s and 1940s but that is where I left off the analogy to market conditions. We are trading in interesting times where the existence of the Republic is being undermined by out of control spending. It is unclear that we have the resolve to make the tough decisions as a nation. Why wouldn’t the market be tough when so much is at stake?