How to Follow Up on a Follow-Through Day

Posted 02/04/2010 09:35 AM ET


IBD Executive Editor Chris Gessel discusses why the current correction is normal and healthy — and why you need to pay close attention to any heavy selling in the first few days of any new rally.

IBD: Over the last couple of weeks, we've seen many companies come out with great earnings reports only to see their stocks go down. How should an investor interpret that kind of action?

Chris Gessel: When you see stocks acting this way, it's generally reflecting a larger negative in the market. In fact, before the market was officially in a correction, it was bouncing around a bit. Companies we're coming out with good numbers, and the market would react poorly. We're seeing even more of this right now that the market has truly started to correct.

Ultimately, it's a reflection that we're in a bad market. And when the market is going down, it doesn't really matter what the fundamentals are or what the story behind the stock is. Most stocks are going to follow the trend of the market, and that's why you need to reduce your exposure and raise cash.

IBD: Of course, even in a correction when you're not looking to buy stocks, you do want to keep an eye on companies that are reporting stellar earnings...

CG: Absolutely. It's during this time when the bases that will propel these stocks higher, once the market turns around, are being formed. So this is a great time to be trolling the market and looking for those companies with great earnings...and maybe there's something changing in their industry or their product or their management. And maybe they're not falling as much as the overall market.

When the market does rebound, these stocks are typically the ones that will shoot out and become the next batch of leaders.

IBD: On January 29, The Big Picture said "the mood of this market is stubbornly negative." What are some of the signs of that negativity?

CG: I think the most basic sign is the daily price and volume changes of the market.

Just take a look at the daily chart of, say, the Nasdaq. You see a lot of big red spikes in the volume on down days, but when the market does bounce back, as it did on Monday (Feb. 1), the volume is much lower.





Generally, over the last 2 to 3 weeks, you've seen the market sell off in heavier volume, and rise in lower volume.

IBD: With the market in a correction, we're waiting now for what we call a follow-through day, a sign that the market direction may have shifted upward. What should investors do when the follow-through day occurs?

CG: There's one important thing to remember about a follow-through day: It's not a green light to go in and buy like crazy. What it says to you is, "OK, it's time to consider buying."

Hopefully, your watch list is up to date. The market follows through, and maybe one or two of the stocks that you've been following break out. You go ahead and start buying positions in those.

But let's say nothing on your watch list — which you've screened for solid fundamentals and other CAN SLIM traits — is breaking out. At the same time, however, you're seeing other stocks take off — stocks that really don't have the great earnings, liquidity, and other traits that are typical of big winners. That's got to give you pause.

We've seen that in some rallies, where there's not a lot of good leadership. And usually what happens is, without good leadership, the rally peters out.

How can you tell if a Follow-Through Day is Likely to Succeed — or Fail?

IBD: IBD research shows that a certain percentage of follow- through days aren't going to work. What other signs might indicate if a new rally is likely to succeed or fail?

CG: We've done a lot of study on that over the years, and the factor that has the biggest influence on whether a follow-through succeeds or fails is distribution (heavy selling) within the first 5 days after the follow-through.

Let's say we have a follow-through day on a Monday. If you get a distribution day on Tuesday or Wednesday, it's extremely negative for that rally. Almost all such rallies will fail.

If you get to Day 3 with no distribution days, it starts getting better, but it's still pretty negative to have a distribution day.

If you don't have a distribution day until Days 4 or 5 of the new rally, the failure rate is only around 30%.

Once you get past those initial 5 days after the follow-through, the longer you go without a distribution day, the odds of that rally working increase.

IBD: So if we see a distribution day within the first 1 or 2 days after a follow-through day, it's a big red flag.

CG: Absolutely. But that's not to say the rally can't work.

A couple have — most notably, rallies that came right at the end of major bear markets, such as in 1982 and last year. In March 2009, there was a distribution day soon after the follow-through day.

But in most other rallies, if not all, over the last few decades, distribution in the first day or two is a very, very negative sign.

IBD: Let's say you have a distribution day within the first couple days of a new rally, but then a little later, a quality stock you're watching takes off. Should you go ahead and buy it, but just be very aware of that red flag and be ready to sell, perhaps a little earlier than normal, if your stocks starts showing signs of trouble?

CG: Yes, absolutely. Whatever kind of market you're in, it's important to follow sound sell rules.

As with any new rally, you want to stick your toe in to test the waters. You don't want to dive in head first, but you also don't want to sit there and say "because of that distribution day, there's absolutely no way this rally can work, so I'm not going to buy any stocks."

Whenever you argue with the market, you get into trouble, either on the downside or the upside.

When stocks are breaking out and moving higher, you need to respect that and go after them — but carefully.

IBD: Anything else our readers should be paying particular attention to right now?

CG: I would just point out that IBD research shows the correction we're having right now is very normal and healthy.

We've looked at a lot of market bottoms, and how they rally, especially after big bear markets like the one we had in 2008.

What we've seen since the new uptrend started in March of last year is on the outer edges of how long and how far the market goes up before having its first intermediate correction. So we're definitely due for a correction. It will give stocks a chance to catch their breath and make new bases.

The challenge for investors is to remain positive and keep searching the market for those stocks that are setting up. When the markets turn, it's usually the stocks that break out on the first day, or the first few days, of a new rally that really become your big leaders.

If you get discouraged, or start losing interest in the market, and then the market turns around, the biggest opportunities may be passing you by.

You just have to stick with it, and follow the rules. IBD's rules are based on over 120 years of market facts, and if you follow them closely they'll serve you well.

So build your watch list, and keep reading The Big Picture and watching the IBD Market Wrap video to make sure you're ready to act when a new uptrend begins. The time you put in now will definitely pay off later.