THE MARKETS
THE BIG PICTURE: HOW TO DETERMINE
THE STOCK MARKET’S DIRECTION
By William J. O’Neil
William O’Neil’s
CAN SLIM strategy has
been a long-term
superior performer in
AAII’s ongoing study of
stock screens. But part
of his approach—
gauging the market’s
direction—is not
captured in our
screens, which focus
on individual stocks. In
this article, Mr. O’Neil
himself describes how
investors can
determine the stock
market’s direction.
For a more complete description of the CAN SLIM approach
and how it can be used as a
screen, see “How to Use the
CAN SLIM Approach to Screen
for Growth Stocks,” by John
Bajkowski, in the April 2003 AAII
Journal. A review of all the AAII
stock screens, many based on
the approaches of well-known
investment professionals,
appeared in the January 2003
AAII Journal (“Stock Strategy
Performance: Winners and
Losers in 2002,” by John
Bajkowski). Past issues can be
found on AAII’s Web site at
www.aaii.com.
Based on an exhaustive study of the greatest stock market winners dating
back to 1953, I developed the CAN SLIM™ research tool.
The CAN SLIM approach identifies companies with the same qualities that
previous big-winning stocks showed before they began their huge price
advances.
Here’s a quick rundown of what CAN SLIM stands for:
C: Current earnings
A: Annual earnings
N: New product or service; also, new price highs
S: Supply and demand: shares outstanding plus big volume demand
L: Leader or laggard
I: Institutional sponsorship
M: Market direction
As the last letter “M” shows, CAN SLIM isn’t just about identifying the
right stocks. It also requires that you analyze the general market. You can be
right on every individual stock factor, but if you’re wrong about the direction
of the general market, three out of four of your stocks will plummet with the
market averages and you will certainly lose money big time—as many
people did in 2000. Therefore, in your analytical tool kit, you absolutely
must have a reliable method to determine what direction the market is
headed. The key is to follow, interpret, and understand what the general
market averages are doing every day.
This is something you must do on your own. Conventional wisdom or
consensus thinking is seldom right in the market. I never pay any attention to
the parade of experts voicing their personal opinions on the market—it just
creates too much confusion and can cost you a great deal of money. The
only thing that works is to let the market indexes tell you the time to enter
and exit.
How do you determine the market’s direction? In this article, I’ll describe
the CAN SLIM approach, with a particular focus on identifying market
bottoms.
WHAT IS THE GENERAL MARKET?
The general market is a term that usually refers to the most commonly
used market indexes. These indexes tell you the approximate strength or
weakness in each day’s overall trading activity and can be one of your
earliest indications of emerging trends. These indexes include:
• The Standard & Poor’s 500: Consists of 500 of the largest U.S. companies. This index is a broader, more modern representation of market
action than the Dow.
William J. O’Neil is founder of Investor’s Business Daily, the only national daily newspaper that focuses exclusively on the investment markets using proprietary, databased
screens and ratings. He is also founder of William O’Neil & Co., a leading institutional
investment research organization based in Los Angeles.
Mr. O’Neil is author of “How to Make Money in Stocks,” third edition, 2002, published
by McGraw-Hill, and has a September 2003 launch planned for his new book “The
Successful Investor.”
AAII Journal/June 2003
3
THE MARKETS
FIGURE 1. HISTORICAL MARKET CYCLES
because they haven’t
been proven as effective.
Your best bet is to
learn to interpret daily
price and volume charts
of the key general
market averages. If you
do, you can’t get too far
off track, and you won’t
need much else.
SPOTTING MARKET
BOTTOMS
Source: Investor’s Business Daily.
• The Dow Jones industrial
average (DJIA): This index
consists of 30 widely traded
stocks. It’s a simple but out-ofdate average to study because
it is dominated by laggard,
old-line companies.
• The Nasdaq composite: The
more relevant and volatile
index in recent years includes
the market’s younger, more
innovative and fast-growing
companies. It includes over
4,000 companies that trade via
the Nasdaq network of market
makers, and it is more heavily
weighted toward the technology sector.
everyone who can be run out has
thrown in the towel, there isn’t
anyone left to take action in the
same direction. Then the market will
finally turn and begin a whole new
trend.
Bear markets usually end while
business is still in a downtrend. The
reason is that stocks are anticipating, or “discounting,” economic
events months in advance. Similarly,
bull markets usually top out and
turn down before a recession sets in.
For this reason, use of economic
indicators to tell you when to buy or
sell stocks is not recommended.
The Figure 1 chart of the S&P 500
index shows several past cycles, with
the bear markets shaded.
STOCK MARKET CYCLES
STUDY THE MARKET DAILY
The winning investor should
understand how a normal business
cycle unfolds and over what period
of time. Particular attention should
be paid to recent cycles. There’s no
guarantee that just because cycles
lasted three or four years in the
past, they’ll last that long in the
future.
Bull and bear markets don’t end
easily. It usually takes two or three
pullbacks to fake out or shake out
the few remaining speculators. After
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AAII Journal/June 2003
In bear markets, stocks usually
open strong and close weak. In bull
markets, they tend to open weak and
close strong. The general market
averages need to be studied closely
every day since reverses in trends
can begin on any given day. Relying
on these primary indexes is a much
more practical and effective method
for analyzing the market’s behavior
and determining its direction. Don’t
rely on other, subsidiary indicators
Given current market
conditions, many
investors who follow the
markets have scaled
back stock holdings.
The big question now
is: How long should
you remain on the
sidelines? If you plunge
back into the market
too soon, the apparent rally may
fade and you’ll lose money; but if
you hesitate at the brink of the
eventual roaring recovery, opportunities will pass you by.
Again, the daily general market
averages provide the best answer by
far. At some point in every correction—whether mild or severe—the
stock market will always attempt to
rally. Don’t jump back in right
away. Wait for the market itself to
confirm the new uptrend.
A rally attempt begins when a
major market average closes higher
after a decline, either from earlier in
the day or the previous session. For
example, the Dow closes down 2%
and then rebounds the next day. The
session in which the Dow closes
higher is the first day of the attempted rally. Sit tight and be
patient. The first few days of
improvement can’t tell you if the
rally will succeed.
Starting on the fourth day of the
attempted rally, look for one of the
major averages to “follow through,”
meaning it shows a booming 2% or
greater gain on heavier volume than
the day before. This tells you the
rally is much more likely to be real.
The most powerful follow-throughs
THE MARKETS
usually occur on the fourth to
seventh days of the rally. Followthroughs after the 10th day may
indicate a positive but somewhat
weaker new uptrend.
A follow-through day should give
the feeling of an explosive rally that
is strong, decisive and conclusive—
not begrudging and on the fence,
and barely up 1%. The market’s
volume for the day should be above
its average daily volume in addition
to always being higher than the
prior day’s trading.
Occasionally, a follow-through
occurs as early as the third day of
the rally. In such a case, the first,
second and third days must all be
very powerful, with a major average
up 2% or more each session on
heavy volume.
There will be a few cases in which
confirmed rallies fail. A few large
institutional investors, armed with
their immense buying power, can
run up the averages on a particular
day and create the impression of a
follow-through. Unless the smart
buyers are back on board, the rally
will implode—usually crashing on
heavy volume within the next day
or two.
A follow-through signal doesn’t
mean you should rush out and buy
with abandon. It gives the go-ahead
to begin buying quality stocks as
they break out of sound price bases.
These leading stocks are a vital
second confirmation that the attempted rally is succeeding.
Remember, no new bull market
has ever started without a strong
price and volume follow-through
confirmation. It pays to wait and
listen to the market. Figure 2
presents a classic example of the
stock market bottom that occurred
in 1982.
How did the market act when
stocks began to rally this past
March?
As usual, they followed historical
precedent. The stock market got a
jump on the Iraq war rally before
the shooting began. Stocks turned
higher March 12 and followed
through three sessions later when the
major indexes surged more than 2%
in heavier volume.
That was the all-clear sign to start
testing the market. Since then, it’s
passed with flying colors. The
reason? Stocks with solid fundamentals have been breaking out of sound
price bases and rallying to new
highs.
MARKET TURNS: OTHER CUES
Certain Psychological Market
Indicators Can Help
History shows that the market
tends to go up just when many
market “experts” are most skeptical
and uncertain. That’s where psychological market indictors come in.
Speculation in put and call options
is the get-rich-quick scheme for
many investors. You can plot and
analyze the ratio of calls to puts for
a valuable insight into crowd
temperament. Options traders buy
calls, which are options to buy
common stock, or puts, which are
options to sell common stock. A call
buyer hopes the price of the option’s
underlying stock or index will rise;
a buyer of put options wishes prices
to fall. The volume of call options is
generally higher than put options.
However, when the market seems
especially weak, put volume will
exceed call volume. When this
happens, option traders are extremely bearish and think that stock
prices can only go lower. The put-
FIGURE 2. RALLY AT 1982 MARKET BOTTOM
Source: Investor’s Business Daily.
AAII Journal/June 2003
5
THE MARKETS
call ratio jumps above 1.0, which
occurred at or near market bottoms
in 1990, 1996 and 1998.
The percentage of investment
advisers who are bearish is an
interesting measure of investor
sentiment. When bear markets are
near the bottom, the great majority
of advisory letters will usually be
bearish. Near market tops, most will
be bullish. The majority is usually
wrong when it’s most important to
be right. Typically, the indicator
flashes an impending market bottom
when bears exceed bulls. This
happened just last year in October
as the market hit its lowest point
since its March 2000 market top.
The short-interest ratio is the
amount of short selling on the New
York Stock Exchange (NYSE),
expressed as a percentage of total
NYSE volume. This ratio can reflect
the degree of bearishness shown by
speculators in the market. Along
bear market bottoms, you will
usually see two or three major peaks
showing sharply increased short
selling. There’s no rule governing
how high the index should go, but
studying past market bottoms can
give you an idea of what the ratio
looked like at key market junctures.
An index sometimes used to
measure the degree of speculative
activity is the Nasdaq volume as a
percentage of NYSE volume. This
measure provided a helpful tip-off of
impending trouble during the
summer of 1983, when Nasdaq
volume significantly increased
relative to the Big Board’s (NYSE).
When a trend persists and accelerates, indicating wild, rampant
speculation, you’re close to a
general market correction.
Interpret the Overrated Advance/
Decline Line
Some technical analysts religiously
follow advance/decline (A/D) data.
Technicians take the number of
stocks advancing each day versus
the number declining and then plot
that ratio on a graph. Advance/
decline lines are far from precise,
because they frequently prematurely
6
AAII Journal/June 2003
veer down sharply long before a
bull market finally tops. In other
words, the market keeps advancing
toward higher ground, but is being
led by fewer but better stocks. The
advance/decline line is simply not as
accurate as the key general market
indexes because analyzing the
market’s direction is not a total
numbers game. All stocks are not
created equal—it’s better to know
where the real leadership is and how
it’s acting than it is to know how
many more mediocre stocks are
advancing and declining.
An advance/decline line can
sometimes be helpful when a clearcut bear market attempts a shortterm rally. If the advance/decline
line lags the market averages and
can’t rally, it’s giving an internal
indication that, despite the rally
strength in the Dow or S&P, the
broader market remains frail. In
such instances, the rally usually
fizzles. In other words, it takes more
than just a few leaders to make a
new bull market.
At best, the advance/decline line is
a secondary indicator of limited
value.
Watch Federal Reserve Board Rate
Changes
Among fundamental general
market indicators, changes in the
Federal Reserve Board’s discount
rate (the interest rate the board
charges member banks for loans),
the federal funds rate (the interest
rate that banks with fund reserves
charge for loans to banks without
fund reserves), and occasionally
stock margin levels are valuable
indicators to watch.
As a rule, interest rates provide
the best confirmation of basic
economic conditions, and changes in
the discount rate and federal funds
rate are by far the most reliable.
Three successive significant hikes in
the discount rate have generally
marked the beginning of bear
markets and impending recessions.
Bear markets have usually, but not
always, ended when the rate was
finally lowered.
Money market indicators mirror
general economic activity. At times,
I follow selected government and
Federal Reserve Board measurements, including 10 indicators of the
supply and demand for money, and
indicators of interest-rate levels.
History proves that the direction
of the general market, as well as of
several industry groups, is often
affected by changes in interest rates
because the level of interest rates is
usually tied to a tight or easy Fed
monetary policy.
For the investor, the simplest and
most relevant monetary indicators to
follow and understand are the
changes in the Federal Reserve
Board discount rate and the federal
funds rate.
Changes in T-bill rates and the
erratic, tricky federal funds rate
sometimes help predict impending
discount rate changes. The monetary
base and the velocity of money are
other measures sometimes used by
professionals. The Fed also watches
economic data such as unemployment figures, inflation data, gross
domestic product (GDP), and many
others.
The bear market and the costly
protracted recession that began in
1981, for example, were created
solely because the Fed increased the
discount rate in rapid succession in
September, November and December of 1980. Its fourth increase, on
May 8, 1981, thrust the discount
rate to an all-time high of 14%.
That finished off the U.S. economy,
our basic industries, and the stock
market.
Such actions and their result
starkly demonstrate how much our
federal government—not Wall Street
or business—may at times influence
our economic future. However, Fed
rate changes should not be your
primary market indicator because
the stock market itself is always
your best barometer. My own
analysis of market cycles turned up
three key market turns that the
discount rate did not help predict.
THE MARKETS
SPOTTING MARKET TOPS
Look for distribution
After a long advance, the stock
market will inevitably turn lower.
The correction may be relatively
mild, or it may be severe, such as
the bear market that started in
March 2000. During the 30-month
bear market period ending last
October, the Nasdaq plunged as
much as 78%. Hundreds of stocks,
including well-known names like
Sun Microsystems, dived more than
90%.
As bad as the bear market was, it
was fairly easy to spot. Like other
market tops, there were repeated
days when the major stock indexes
fell in heavier volume than the day
before. This is called distribution. It’s
a sign that institutional investors such
as mutual funds, pension funds and
other big players are selling stock.
Three to five distribution days over a
week or two can kill even the
strongest bull market.
At the same time that you see the
major averages selling off on heavier
volume, leading stocks will also start
breaking down.
Together, these two indicators
should push you into cash as you sell
your market-leading stocks. You’ll be
safely on the sidelines when the
majority of other investors are still
hoping for a rebound.
THE BIG PICTURE SUMMARY
To summarize this complex but
vitally important topic: Learn to
interpret the daily price and volume
changes of the general market
indexes and the actions of individual
market leaders. Once you know how
to do this correctly, you can stop
listening to all the costly, uninformed personal market opinions of
amateurs and professionals alike.
The key to staying on top of the
stock market is not predicting or
knowing what the market is going to
do, but knowing what the market
has actually done recently and what
it is currently doing.
One of the great values to this
system of interpreting the market
averages’ price and volume changes
is not just the ability to recognize
major market tops and bottoms, but
also the ability to track each rally
attempt when the market is on its
way down. By waiting for powerful
follow-through days, you can
normally prevent yourself from
being drawn into the market prematurely when the rally attempts
ultimately end in failure. In other
words, you have rules that will
continue to keep you out of a
declining market so that you don’t
get sucked into phony rallies.
A LONG-TERM VIEW
If this sounds a bit daunting, don’t
worry. If you want some guidance,
you might follow the discussions in
Investor Business Daily’s “The Big
Picture,” a daily market analysis to
help investors spot key turning
points in the stock market.
What’s my own long-term big
picture view?
Because the market went through
three years of correction, which is
almost unprecedented, I feel very
strongly that the worst is over—and
that it’ll be a slow, steady recovery
process. I would expect to see
recovery with the aid of the Tax Cut
Stimulus Package and with the fight
against terrorism having made
significant progress.
The country is in a rebuilding
process that should continue for the
next few cycles, and those willing to
keep doing their homework and
follow proven time-tested investing
rules and strategies should do well
in the future. ✦
AAII Journal/June 2003
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