Follow the Market Leader
And yes, I play the role of scofflaw this one time more -- copying & pasting from a subscribers-only website. Follow this link to the source, however, as this magazine, too, is worthy of your attention. And, arguably, your subscription.
Follow the Market Leader:
Identify Market Leaders and Follow Them to the Top
by: Dan Zanger
No access to information that major market players have? OK, but you can make your move by spotting a few characteristics of leaders and acting on them.
Have you ever felt sure that the market was heading in one direction only to get slammed when it turned around and caught you off guard? How many times have you waited for a bounce that never came, causing you to cover your position, then watched the market rally with a vengeance a few days or weeks later?
Who says you can’t time the market? What those who say you cannot time the market are really saying is that they cannot time the market, and they don’t know anybody who can! That does not mean you cannot. One of the best clues is to find a market leader and follow its signals.
Learning the Signals
A great example of a market leader, since it became public back in August 2004, is Google Inc. (GOOG). The stock formed a base in August 2004 for about a month after it became public while the NASDAQ was bottom testing. While the market bottomed in August, GOOG hovered between $95 and $112 for a few days then took off in the first few weeks of September. It ran hard to early November when it hit $200, doubling in just two months. In fact, it led the other Internet stocks and the NASDAQ.
In Figure 1 we see that GOOG bottomed in September and took off. Let’s move ahead to the period between December 2004 and April 2005. The NASDAQ was in a downtrend and dropped 12.5 percent while GOOG barely dropped at all. Nearly 30 trading days before the NASDAQ bottomed in late April, GOOG began to move higher. This showed GOOG’s tremendous relative strength and potential. More importantly, it provided a heads up that the market was in the final stages of the correction and was getting ready to turn up. If there was ever a leader of a market move, it was GOOG – no debate. By taking a cue from GOOG as a leader, you would have been in the market when it took off or reducing positions when the stock started to move horizontally.
Traders’ greatest mistakes are being late to the game and being afraid of the biggest movers in the market. The fast pace of big-moving stocks, like GOOG, often keeps traders frozen in fear, not unlike the fear of either failure or success that prevents many people at low-paying jobs their whole lives from doing what they truly want to do. Those who achieve success in trading often do so thanks to a no-fear attitude and deep-seeded desire for financial success.
(I disagree with the interpretation of this chart as a cup & handle, but that point is immaterial to the greater argument. --dmg)
Obviously, one of the single best ways to maximize profitability in the market is to have a great deal of money in the biggest-moving stocks at exactly the right time. Not only can the leader show when the market will take off or top; it also will convey a number of other things that are going to happen in the market days before they occur. This is because the “fast money” seems to be in the know about Fed actions and earnings reports of other leading high-beta stocks. The fast money gets in or out of the leaders due to the predictive high-beta movement before the news hits the television or the Internet.
But how do we find the big movers? What are some glaring similarities that all of the leaders share?
A Marriage of Fundamentals and Technicals
Most long-term investors tend to concentrate strictly on corporate and market fundamentals and ignore technical chart analysis. Most short-term traders ignore fundamentals and focus on the charts patterns. But the best traders use both technicals and fundamentals, and the weighting they place on each depends on their average time in the trade.
Because volatility has increased over the last decade while time in the trade has decreased, emphasis has shifted to using technicals — and for good reason. It also has become obvious in the last few years that stocks exhibiting certain chart patterns exhibit strong fundamentals. Often the bullish chart pattern will appear in advance of an earnings report or news release, and traders who know what to look for can use this to great advantage. Our top-ten list of both fundamental and technical characteristics of a market leader and how to use them appears across the bottom of these pages.
The Top-Ten List
#1 – Earnings Power
To be a real winner a stock needs earnings power – and plenty of it. Look for companies with earnings up more than 70 percent in the most recent quarter. Also, look for earnings results to have accelerated during the past two to three quarters. This means that earnings are still ramping up on a percentage basis. Most of the big movers have earnings up 150 to 400 percent quarter over quarter. For example, Taser Inc. (TASR) made a more than 5,000-percent move in 2003 and 2004 while earnings and revenue growth exceeded 200 percent or more every quarter for about six quarters. Another big mover that started in April 2003 and had similar earnings growth was Research in Motion (RIMM). See Figure 2.
#2 – Market Domination
Another aspect to look for is a stock in which the company was the dominant leader in its respective field. Qualcomm (QCOM) went from $225 to $800 (pre-split) in just six weeks. Yahoo! (YHOO) went from $80 to $400 (pre-split) in just three months in 1998 before GOOG was on the scene. Others include CMGI (a big mover during the Internet bubble that made a move of more than 6,000 percent in 20 months) and DELL, which went from $50 to $2,000 (pre-splits) over three years. All of these companies dominated their industries. DELL changed the way computer products were marketed, carried a small “just-in-time” inventory, in-home warranty service and the fastest computers of the day. This combination crushed competitors Compact and Gateway, and in so doing, made its shareholders rich. Market domination is the most overlooked aspect of selecting big winners in the market.
#3 – New Stocks, New Markets
The next piece of the puzzle is that all of these stocks were new or relatively new to the market. Also, most of them had new products that were being widely accepted, not only in the U.S., but also in most of the developed and emerging markets. Companies like GOOG are known and its products used around the globe – as are YHOO and RIMM.
#4 – Use Market Direction. Don’t Fight It
Most traders know that 60 to 70 percent of a stock’s move is determined by the overall direction of the market. But what is the best way to gauge which way the market is heading? Is there a better way than examining advancers minus decliners, waiting for an index trend-line break, or moving average crossover? Yes, and that is following the leader of the market. All that being said, however, even a strong stock will be fighting an uphill battle in a bear market. Look for strong stocks in a bull market – and laggards to short in a bear.
#5 – Little Known and Under Owned
The total number of shares that the public can buy is known as the float. Stocks that have a limited number of shares in the pubic float (less than 100 million shares) can experience explosive upside movements once they are discovered due to the small share supply. Taser (TASR) is good example of this. It started out with a float of just three million shares and now has a float of 57.2 million due to numerous stock splits. The stock price went ballistic in the process. There should be no more than 100 million shares in the float and the lower the better. Ideally, the goal is to find stocks that institutions are beginning to accumulate. This includes those with a higher degree of corporate executive insider ownership.
#6 – Patterns Tell the Real Story
This is where the fundamentals and technicals complement one another. Chart patterns will tell the trader that the stock is walking the fundamental walk and the market is recognizing this. You want to see the stock show good price action such as holding support and breaking resistance on increasing volume. Some of the best indicative patterns include bullish flag and pennant continuation patterns and cup-and-handle continuation patterns that show consolidation (see Figure 2). Remember bullish patterns are an indication of institutional accumulation.
#7 –Volume Holds the Key
Volume is the true indication, for those who know how to read it, of what market players are doing. During extended periods of consolidation, patterns like saucer and cup and handles are good indications that a move is imminent. But patterns by themselves are not much help unless there is volume support. Are traders buying dips or selling rallies? The first is bullish and is recognized by volume spikes following weakness or after a prolonged down move. The second is bearish, especially if volume builds after an extended up move, and means that either shorts are capitulating and covering or that Johnny-come-latelies are jumping on board. If volume increases as the stock drops, it means that the smart money is using rallies to unload and the shorts are borrowing to sell the stock short. When this happens, the ride usually is over. Bullish continuation patterns should show volume dropping as the pattern forms with volume spikes on the breakout. If there is no spike, the breakout is suspect.
#8 – Let the Leaders Tell You When to Go Long and When to Go Short
Never marry a stock (or the market). There are times to buy and times to sell, and market leaders provide advance warning that a reversal may be imminent. If the leaders begin to break down even in the face of good fundamentals, the market is probably not far behind. Once the market has turned, even a leader cannot fight the gravitational pull for long. No point in trying to trade or invest counter to the primary trend. When the market is going up, leaders will keep you in the trend, and when the market reverses and heads down, they’ll tell you when to sell and when it’s time to look for laggards to short.
#9 – Bullish Continuation Patterns
In a true bull rally, you should see a number of bullish flag and pennant patterns as well as gaps that generally aren’t filled for a while. It often appears as a stair-step-like pattern on the chart. When the breakouts happen on less volume than the prior breakout or gaps begin to get filled, the move is running out of gas. Sentiment also can be helpful. In a rally, stocks discount bad news. In a bear situation, they discount or ignore good news. Bad news, good action = bull. Good news, bad action = bear.
#10 – Other Considerations
Watching chart patterns and volume are two of the most powerful tools in picking market leaders. Other tools can be helpful, too. Technical tools such as trendlines, moving averages, the McClellan Oscillator, seasonal cycles and time cycles are examples. Look at the daily chart over a nine- to twelve-month period. Are there rhythmic dips and seasonal patterns? Resource and commodity stocks often exhibit distinct seasonal patterns based on growth and market cycles. Another important consideration is price. Cheap stocks rarely lead. Best to wait until they are more than $50 and become interesting to institutions.
Melding the Pieces
Each trader has his or her own criteria for picking a winning stock. But instead of just looking for stocks to buy or to sell, true leaders also can be used as a market proxy and provide a good indication of future market movement. Leaders that hold their ground when the market appears to weaken signal that the rally still is in play. When the market gets going again, the leaders will take off. Give yourself the proper time to understand fully the process before investing real money. Before trying any new methods, always paper trade it until you feel comfortable. Once you have mastered the art of identifying and playing the market leaders, you will be amazed at what can be done. No longer will you have to suffer the pains of trying to follow the pack and be a late to the party. And no longer will you have to suffer sub-par returns with sub-par stocks. Learning to identify market leaders is a no easy task, but efforts in that direction will be well rewarded. With your newfound skills, you will be the one to follow!