Page 344 - How to Make Money in Stocks Trilogy

220 A WINNING SYSTEM

A rally attempt begins when a major market average closes higher after a
decline that happened either earlier in the day or during the previous ses-
sion. For example, the Dow plummets 3% in the morning but then recovers
later in the day and closes higher. Or the Dow closes down 2% and then
rebounds the next day. We typically call the session in which the Dow finally
closes higher the first day of the attempted rally, although there have been
some exceptions. For example, the first day of the early October market
bottom in 1998 was actually down on heavy volume, but it closed in the
upper half of that day’s price range. Sit tight and be patient. The first few
days of improvement can’t tell you whether the rally will succeed.
Starting on the fourth day of the attempted rally, look for one of the major
averages to “follow through” with a booming gain on heavier volume than
the day before. This tells you the rally is far more likely to be real. The most
powerful follow-throughs usually occur on the fourth to seventh days of the
rally. The 1998 bottom just mentioned followed through on the sixth day of
the attempted rally. The market was up 2.1%. A follow-through day should
give the feeling of an explosive rally that is strong, decisive, and conclu-
sive—not begrudging and on the fence or barely up 1½%. The market’s vol-
ume for the day should in most cases be above its average daily volume, in
addition to always being higher than the prior day’s trading.
Occasionally, but rarely, 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 1½% to 2% or more each session in
heavy volume.
I used to consider 1% to be the percentage increase for a valid follow-
through day. However, in recent years, as institutional investors have
learned of our system, we’ve moved the requirement up a significant
amount for the Nasdaq and the Dow. By doing this, we are trying to mini-
mize the possibility that professionals will manipulate a few of the 30 stocks
in the Dow Jones average to create false or faulty follow-through days.
There will be 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 getting back on board, however, the rally will implode—
sometimes crashing on heavy volume within the next several days.
However, just because the market corrects the day after a follow-through
doesn’t mean the follow-through was false. When a bear market bottoms, it
frequently pulls back and settles above or near the lows made during the
previous few weeks. It is more constructive when these pullbacks or “tests”
hold at least a little above the absolute intraday lows made recently in the
market averages.