As we saw in the previous section on Stock Market Timing, you can time the stock market — depending on how to you define it. The key is to focus on understanding stock market trends, including how to spot when they're changing and how to handle your stocks when they do.
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Whether we're in a bull market, bear market, intermediate correction, or some other form of choppiness and uncertainty, the five tiers of market exposure in The Big Picturehelps you manage your risk. In this section, we'll take a look at how you can track and handle major turning points, such as market tops and market bottoms. We'll also discuss the concepts of bear markets, bull markets and intermediate corrections and how they aid investors in understanding how to invest in stocks.
As noted in earlier lessons, trends in the market indexes deeply impact the performance of individual stocks, either pushing them up or pulling them down. Understanding that intertwined relationship is integral to learning how to buy stocks and when to sell stocks, as well as understanding how to read stock charts.
How Much Stock Market Exposure Should You Have Right Now?
| • Stock Market Tops • Stock Market Bottoms • Bull Markets, Bear Markets And Intermediate Corrections • |
Stock Market Timing: Market Tops
When an uptrend eventually tops and the stock market indexes begins to decline, the downturn takes most stocks down with it. You must learn to spot the warning signs the indexes flash when the stock market trend begins to weaken and fall into an intermediate market correction or bear market.
We've already seen how the The Big Picture and Market Pulse alert you to a weakening market, adjusting the recommended market exposure level as warning signs increase.
The graphic below provides just one example of what can look like as the indexes break down. Note that the same points made here on the Nasdaq about support and resistance and action at key moving averages also apply to the Dow, S&P 500 and individual stocks. They reinforce the importance of learning technical analysis and how to read stock charts.
Distribution Days
When the stock market is heading higher, there is no shortage of predictions and opinions about when the party will end. But such guesswork is often wrong. Using hunches to guide your stock investing will do more damage than good over the long term.
Also keep in mind that major shifts in market trend do not typically happen overnight. Warning signs will build up over time, giving investors time to adjust and avoid undue losses.
So rather than guessing or predicting, be sure to focus on what matters most: the price and volume action in the major indexes and leading stocks. The best way to track that is by learning how to read stock charts.
Price and volume action in the chart shows what institutional investors — the big money managers who drive the stock market up or down — are actually doing. And when it comes to seeing if institutional investors are shifting from buying mode into selling mode, the most effective way to do that is to track "distribution days."
What Is A Distribution Day?
"Distribution" is simply another word for selling. (You can easily track institutional buying and selling in individual stocks using the IBD Accumulation/Distribution Rating in Stock Checkup.)
Distribution days occur during a market uptrend when one or more of the major stock market indexes (i.e., Nasdaq composite, S&P 500 and Dow Jones Industrial Average) closes down 0.2% or more in volume heavier than the prior day. Volume does not have to be above average; just higher than the prior day.
= Indicates distribution day
In the stock chart above, note the correlation between price and volume. If the price drop came on lighter volume, that would be less worrisome, since it would indicate the selling wasn't that aggressive. But on distribution days (Points 1 and 2), the big price drop comes on rising volume, which points to institutional selling.
The stock market continually fluctuates, so one down day in increased volume is not necessarily a problem. But if you start to see a large number of distribution days within a short amount of time, that is cause for concern. It indicates that mutual fund managers and other institutional investors are starting to sell more aggressively.
When distribution days begin to cluster, risk management takes center stage. Be sure to protect your gains and prevent large losses by tracking and adjusting to any changes in trend in The Big Picture.
Stock Market Timing: Market Bottoms
When the market is in a correction, how do you know when that trend has changed and it's time to start buying stocks again?
Wait for what is called afollow-through day.
IBD's ongoing study of every market cycle since 1880 has found thatno bull market has ever started without a follow-through day.So instead of relying on hunches or predictions, wait for this time-tested signal to confirm the market has hit bottom and a new uptrend has begun.
What Is A Follow-Through Day?
A follow-through day indicates a rally attempt has succeeded, and the market direction has changed from a correction into a confirmed uptrend. It tells you it's time to startgraduallybuying stocks again.
Here are the key elements of a follow-through day.
- New Low: When the market is in a downtrend, look for at least one of the major market indexes (Dow, S&P 500 or Nasdaq) to hit a new price low.
- Attempted Rally: After hitting a new low, look for a day when the index closes higher. That might mean the index has stopped its decline, established a new "bottom," and is on its way to a rebound. But one up day isn't enough to tell if the market trend has truly changed. So we count that as Day 1 of an attempted rally. From there, as long as the index stays above the previous low, the attempted rally remains in place.
- Follow-Through Day: Marked by a big gain in rising volume during a market correction, a follow-through day indicates the attempted rally has potentially succeeded. To count as a follow-through day, at least one major index needs to close up 1.25% or higher in volume heavier than the prior day. Volume does NOT have to be above average; just higher than the prior day. Follow-throughs typically occur anytime from Day 4 or later in the attempted rally. They can happen as early as Day 3, but the first three days are usually too soon to confirm a new uptrend.
Get Back In Gradually — And Watch Out For Distribution Days
Not every follow-through day leads to a big, sustained uptrend. (But as noted earlier, no bull market or major new uptrend has begun without out one.) About 25% - 30% will fail, and the market will quickly fall back into a correction. That's why you want to get back into the market gradually when a follow-through day occurs and you see any incremental increases in the level of suggested market exposure, found in The Big Picture and on the homepage of Investors.com.
If the uptrend takes hold and leading growth stocks start to move higher on heavy buying by institutional investors, you can start to get in more aggressively. If the uptrend fails, follow your sell rules and move safely back to the sidelines.
If you see distribution days right after or within a few days from the follow-through, look out! It could mean the nascent uptrend is not taking hold and will quickly fall back into a correction. Regularly check The Big Picturefor the current distribution day count and any alerts to changes in stock market trend.
The Big Money In Stock Investing Is Made In The Early Stages of New Uptrends
As noted earlier, the biggest winners typically launch new price runs right at the beginning of a new stock market uptrend.
It's all part of the market cycle. During the prior correction, they form chart patterns. Then they break out as the market direction changes, often on the actual follow-through day or within a few weeks.
Below are just two examples of how that same phenomenon happens in every market cycle.
Bull Markets, Bear Markets And Intermediate Corrections
Now that you have a basic understanding of market bottoms, market tops and how to track them using The IBD Methodology and The Big Picture, let's take a look at one more important concept: the difference between bull markets, bear markets and intermediate corrections.
A bull market is when the stock market is moving higher, and a bear market means it's trending down. But it's important to understand these two key points about stock market timing and overall stock market trends.
- New follow-through days and uptrends do not necessarily signal a new bull market.
- New downtrends do not necessarily indicate a new bear market.
To understand the difference between longer-term bull markets and bear markets, and the shorter-term uptrends and stock market corrections that occur within them, let's start with some definitions.
Whatever the current conditions, use The Big Picture as a guide to manage your risk and take advantage of opportunities.
Bear Markets Vs. Interim Corrections
Even within an upward-trending bull market, you will have what are called intermediate corrections.
In these periods, market indexes take a rest and pull back for a few weeks or a couple of months, then resume their climb. The depth of intermediate corrections varies, but the Nasdaq, S&P 500 or Dow indexes might pull back somewhere around 10%. That's a fairly mild decline — not enough to change the underlying bull market uptrend.
As a general rule, a decline of under 20% indicates an intermediate correction. A drop of 20% or more constitutes a bear market.
Although the length varies, bear markets typically last eight to nine months. Intermediate corrections usually last a few weeks to a few months.
Bull Markets Vs. Shorter-Term Stock Market Uptrends
As we saw earlier, a follow-through day — along with other factors — may mark the start of a new market uptrend. But it doesn't necessarily signal the start of a new bull market.
Simply put, a new bull market can only begin after a bear market has occurred.Look at the chart above for an example of how this works.
When the stock market had a follow-through day in March 2009, that did mark the beginning of a new bull market cycle. Why? Because it was preceded by a bear market, where the Nasdaq fell over 50% — much more than the 20% decline that indicates an official bear market.
But when the Nasdaq had another follow-through day on Sept. 1, 2010, that did not signal the start of a brand-new bull cycle. That's because the decline in the prior correction was less than 20%, making it an intermediate correction.
While lengths vary (particularly in recent years), bull markets typically last two to four years. The shorter-term uptrends that occur within the bull market generally last a few weeks to a few months.
Bulls, Bears And Intermediate Trends: Why It Matters
The reason it's important to distinguish between bull markets, bear markets and intermediate corrections is simple. The biggest gains are made in the early stages of a bull market cycle. That's the best time to buy stocks. By the time you get into the third year of a bull cycle, two things tend to happen.
- The stock market becomes more choppy and volatile. The bull market gets tired, and the enthusiasm found at the beginning of the cycle starts to fade. Intermediate corrections may become more frequent and deep. But as long as the underlying bull market trend remains in place, you may still find plenty of chances to make money in stocks. Just stay on your toes and stick to sound rules buying and selling stocks since you know a bear market will emerge at some point.
- Leading stocks start to peak, then decline. Nothing goes up forever. In the later stages of a bull market, mutual funds and other large investors will start to cash out of the big leaders, pushing the stocks lower. When that happens, it doesn't matter how great the company's earnings growth and products may be, it's time to protect your profits and cut any losses.
Understand this about stock investing. And following the five levels of market exposure in The Big Picture or on the homepage of Investors.com will help you manage risk accordingly.
In a bear market, the growth stocks that led the prior bull market decline 72% on average. Stock market history shows only 1 in 8 bounce back to lead again in the next bull market cycle.
So when the stock market begins to weaken, take steps to protect your gains and avoid big losses. Only time will tell if the downturn becomes an interim correction of a full-fledged bear market.
Either way, stick to sound rules for how to buy stocks and when to sell stocks. That will simultaneously safeguard your portfolio during the downtrend and lay the groundwork for capturing additional profits in the next uptrend.
Learn More About How To Invest In Stocks
Use the links below to learn more about stock investing and how to invest in stocks using IBD and The IBD Methodology — and discover how to stay both profitable and protected.
- How To Invest In Stocks: Investing For Beginners
- How To Make Money In Stocks: 3 Key Factors For Stock Investing
- Stock Market Timing: Can You Time The Stock Market?
- How To Handle Changing Stock Market Trends
- How to Buy Stocks
- When To Sell Stocks
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