How To Spot New Leadership When A Bull Market Starts

The first nine months of 2022 were treacherous in the stock market. Each sell-off was met by relatively weak rebounds that triggered even more selling in areas of technical resistance, particularly at the 200-day moving average, resulting in a series of lower lows. Bad as general market conditions were, the damage done to certain sectors such as Stocks, such as growth and speculative growth stocks, have been devastating, with many ex-executives plummeting between 50% and 85% from their highs. Interestingly, the market was extremely oversold by many measures, particularly the psychological contraindications, for most of the year, yet continued to trend lower.

This points to one of the core tenets of O’Neil’s methodology: once the general market or an individual stock is in a downtrend, there’s no telling how far it will fall or how long it will take to recover. At O’Neil Global Advisors, we believe that we are in the interpreting business, not the forecasting business.

Therefore, rather than trying to predict the length and depth of a correction, it is generally best to wait on the sidelines for clear signals that a new bull market has begun. One signal is a follow-through day (FTD), which has occurred at the start of every major bull market we’ve studied for the past 120 years. Once that signal occurs, finding and investing in stocks that can potentially lead the new bull market is paramount.

From the perspective of the O’Neil methodology, we are interested in three main factors when trying to find successful stocks: the technical picture of the stock, the underlying fundamentals, and general market conditions. When general market conditions are poor, as they have been for most of 2022, broad market pressures will prevent even the strongest companies with the best prospects from moving higher. During these broader market downtrends, the strongest stocks will consolidate and form constructive bases.

When the pressure on the market finally eases, it will be the stocks with solid fundamentals and growth prospects that have completed constructive bases and are making new highs at the start of the new rally that will potentially be the new leaders.

The easiest way to identify these stocks is to focus on relative strength. Relative Strength (RS) measures a stock’s price performance relative to the stock market as a whole. Higher RS ​​stocks with rising RS lines outperform the major market indices as well as the single stock universe. Often a new leader’s RS line moves to new highs ahead of price, indicating impressive price outperformance relative to the broader market, which usually bodes well for future outperformance.

As these stocks form bases during market corrections, they will often provide subtle clues that they are under accumulation. This is evident in the Accumulation/Distribution (A/D) line and A/D Rating, both of which are proprietary measurements of O’Neil methodology used to identify stocks subject to accumulation (buy) or subject to distribution (sale).

Technical clues that suggest institutional accumulation include when a stock makes a higher low in the middle of the market and makes a lower low during a downtrend; a positive divergence, also reflected in an improvement in relative strength; gap-ups or big up days on high volume as the stock builds a base to the right; price and volume movements, where rallies generally occur on increasing volume and pullbacks on decreasing volume; Downside support on key moving averages, such as B. a rising line of the 50-day moving average; “shake-outs” and constructive price/volume actions such as moves higher at the end of a pullback (these often coincide with pullbacks in the broad market indices); several consecutive weeks (five or more) of price gains while the stock forms the right side of the basis; and finally strong price moves on large volume when the stock finally breaks out of a base.

Another characteristic of stocks that can represent new leadership in a bull market is heavy participation from industry groups. The relative strength of industry groups is a good measure of groups that are strong and improving. O’Neil tracks 197 different industry groups and assigns each group a group rank based on the price performance of each group’s components.

While belonging to a strong and improving industry group isn’t a requirement for a stock to be a leader in a new bull market, the fact is that leading stocks are usually part of leading industries. Strong industry support can be an important component in driving a stock’s price higher. Improving economic conditions and favorable fundamentals within an industry will benefit most, if not all, of the companies in this group. Our goal is to identify the strongest one or two stocks within an industry in terms of fundamentals and technical strength, as these are the best prospects for leadership in a new bull market.

Here are some examples of new lead at the start of a new bull market:

A recent example of a stock with these characteristics is TeslaTSLA
(TSLA). The stock is a leader in the automotive sector (specifically electric vehicles (EV)), an industry group that is gaining strength, rising from 174th to 51st in the industry group over the past nine weeks. It also has exposure to the energy solar space, which has been the top-performing industry for the past eight weeks.

The stock held above its late May low when the broader market made new lows in mid-June, a very positive price divergence. The stock found support at its 50-day moving average in early September as the broader market collapsed below its 50-day moving average, demonstrating strong relative strength. Additionally, the stock has shown constructive price and volume action, suggesting that the stock has been under accumulation as it has been based during the market correction. With strong fundamentals, improved sponsorships, and strong technicals, TSLA appears poised to become the market leader as broader market pressure eases and a new bull run begins.

In summary, while 2022 was a difficult time for US equity investors, the current bear market offers opportunities to reposition one’s portfolio. With history as a guide, the next bull market will likely be led by different leadership in terms of industry groups and individual stocks. By paying attention to the signals the market provides to identify these leaders, you can find some of the most profitable trades.

This article was co-authored by Charles Harris, Senior Vice President and Portfolio Manager at O’Neil Global Advisors. Mr. Harris has been a portfolio manager for the O’Neil companies since June 2000 and has traveled nationally and internationally speaking and teaching at workshops focusing on chart analysis, portfolio management and trading psychology. He has extensively studied market cycles since the early 1900s and the characteristics of leading stocks during this period, with a focus on psychological and secondary contraindications at market bottoms. He received his CFA
CFA
Designation 1998.