We expected, like most other commentators, that the rally would continue into the New Year. How wrong we were! The markets reached new highs early on Monday morning but then profit taking took hold and we saw the indexes fall back to their levels of late November (NASDAQ) and early December (DJI and S&P 500) by week's end. A significant event occurred on Tuesday when we saw the fifth distribution day in 13 sessions on the NASDAQ and our market model issued an 'Exit' signal. This indicated the end of the current rally for the NASDAQ and we saw further selling on that market through to week's end when the NASDAQ closed just above its low for the week down 4%. This compares with a loss of 1.7% for the DJI and 2.1% for the S&P 500. These two indexes showed some resilience on Thursday when they closed higher, which was consistent with the model not having issued an exit signal for those indexes. We discuss our market enter and exit signals further in our weekly 'Top Tip' below.

With the markets trending strongly downwards, there were inevitably fewer breakouts with just 9 being successful this week. Nevertheless, they returned a maximum gain of nearly 6% for the week and closed 2.7% higher at the end, substantially beating the markets once again. Some gains were substantial: ROV bucked the trend on Tuesday and reached 19.8% above its pivot before closing for a gain of 18.5%.

Business Services, Healthcare and Finance were the best performing breakout sectors, with 2 successful breakouts each.

Interpreting Market Signals

William O'Neil writes "You can be right about every one of the [acronym] factors, 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" (How to Make Money in Stocks 3rd Edition p. 48). In fact, the 'M' is so important, that some wags have suggested the acronym should really be MILSNAC.

Looking at a chart of the major indexes will tell you quickly the trend of the market. However, to asses the strength or weakness of that overall trend, O'Neil stresses the importance of counting Accumulation Days (days when the market closes higher on volume larger than the previous day) and Distribution Days (days when the market closes lower on volume larger than the previous day) as important indicators of market tops and bottoms. Our 'Market Signals' model uses these principles to generate 'Exit' and 'Enter' signals

Exit Signals

O'Neil says 'three to five days (in recent years it's been five days) of volume distribution over a span of two to four weeks is sufficient to turn the market's uptrend into a downtrend.' (The Successful Investor. p3). In our opinion, this general prescription is too vague to be useful, so we set about determining if the advice had any overall value, and what were the precise number of distribution days over what period for each market

We applied these rules to the three major market indexes back to 1950 for the Dow and S&P, and back to 1984, for the NASDAQ, and found they are broadly correct but a literal interpretation generated several false downturns and also missed some important ones. We also found there were important differences between the three market indexes as to how many distribution days over what period reliably signaled a downturn.

Each day, our Market Signals model uses the values we obtained to determine if the number of distribution days meets the threshold value for each index, and if so we issue an 'Exit' signal for the index. If the signal was previously at 'Enter' then we highlight the changed condition of the index.

Enter Signals

O'Neil advises that market bottoms can be recognized when the downtrend stops and one of the market indexes is up about 1.7% or more on the fourth through eleventh day of the rally. (The Successful Investor, p.9). Over the years O'Neil has modified his percentage gain requirement from 1% to 2% (HTMIS, v3, p.65).

Once again, we applied these guidelines to the three major market indexes and found them to be generally true but that again there were several false signals generated which would have caused anyone following the advice to underperform the index. We were able to determine our own enter signal values for each of the three indexes to the point where during the recent bear market no false signals were generated in the S&P or Dow, and only three in the NASDAQ.

Results combining Enter and Exit Signals

If you had bought the NASDAQ index on January 2, 2004 and then sold it on each exit signal and then re-bought it on each enter signal during 2004 until the exit signal issued on Tuesday of this week, then you would have gained 20% while the index itself gained only 4% through to yesterday. The following chart shows the index and the periods for which you would have been in and out of the market, and the gain made at each enter/exit point (right hand axis).

Of course, one year is not statistically significant, but you can see the model applied to data back to 1950 for the DJI and S&P 500, and back to 1984 for the NASDAQ, on our web site.

How to React to the Market Signals

Tuesday of this week was the fifth distribution day in 13 sessions. By late morning it was obvious the market was going to close down on higher volume and that the model would therefore issue an exit signal, so I liquidated all holdings. For those of you who are less risk averse, a prudent strategy would have been to:

1. Eliminate margin call exposure.
2. Sell all weak holdings
3. Review other holdings and lock in profits where further gains were problematic, such as if a support level had been violated.
4. Be very cautious about taking any new position. Only one out of four stocks will make gains when the market is trending down.

This is a time for patience while we wait for the market to bottom. An upswing will be confirmed when the market model signals 'enter' which for the NASDAQ can be any time between the 4th and 11th day after the bottom provided the index gains at least 1.5% in a single session. While some stocks (such as ROV this week) can make significant gains while the trend is bearish, stocks in general will drift downwards or sideways. Personally, I will wait for an 'Enter' signal before putting more money at risk, but I'll be assiduously reviewing charts through the ChartBrowser and be compiling a personal watchlist for when that day comes.