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How to Trade an Emerging Rally

June 06, 2014

Before jumping in with both feet, one of the confirmations that the market is indeed bottoming is for more stocks to set up behind the first wave of emerging leaders. During the first few months of a new bull market you should see multiple waves of stocks emerging into new high ground, while general market pullbacks will normally be contained to 3% to 5%.  Many inexperienced investors will be looking to buy a pullback, which rarely materializes during the initial leg of a new powerful bull market, which from the onset will appear to be overbought.


Typically, the early phase of a move off an important bottom has the characteristics of a “lockout rally.” During this lockout period, investors wait for an opportunity to enter the market on a pullback, but that pullback never comes. Instead, demand is so strong that the market moves steadily higher, ignoring overbought readings. As a result, investors are essentially locked out of the market.  If the major market indexes ignore an overbought condition after a bear market decline and your list of leaders expands, it should be viewed as a sign of strength.  In order to determine if the rally is real, up days should be accompanied by increased volume while down days or pullbacks have lower overall market volume. More importantly, the price action of leading stocks should be studied to determine if there are stocks emerging from sound, buyable bases.


Additional confirmation is when the list of stocks making new 52-week new highs outpaces the 52-week new low list and starts to expand significantly.  At this point, you should raise your exposure in accordance with your trading criteria on a stock-by-stock basis. As the adage goes, "It's a market of stocks, not a stock market."


In the early stages of a market-bottom rally it's absolutely critical to focus on leading stocks if your goal is to latch onto big winners.  Sometimes you will be early.  Stick with a stop-loss discipline, and if the rally is for real, the majority of the leading stocks will hold up well and you will only have to make a few adjustments.  However, if you get stopped out repeatedly, you may be too early.  If you get stopped out of a particular name doesn’t mean that you should walk away from the stock forever.


Often, a stock will create a “shake-out,” and then consolidate or “tighten-up” and then re-emerge.  This is a phenomenon I refer to as a “Failure Reset.”  The failure reset scenario sometimes happens when a stock establishes a base and makes a new high just as the overall market is beginning to correct. The stock usually falls back into its base while the market corrects.  Now that stock will likely consolidate as the correction or bear market unfolds. Some stocks will consolidate in an even tighter fashion, which increases the probabilities of success.  When the downtrend bottoms and the weight the market comes off the stock, it can fly right out again to new highs.


As you see a growing number of stocks emerging on the heels of the market’s leaders, you will start to observe what sectors are leading the market’s advance.  Leading industry groups can emerge even while other stocks continue to make new lows during the initial upswing. 





As a general rule, I buy strength not weakness.  True market leaders will always show superior relative strength, in particular during a market correction.  You should update your watch list on a frequent basis, weeding out issues that give up too much price, while adding through forced displacement new potential buy candidates that show divergence and resilience.  In addition to keeping your lineup of candidate buys current, this practice will sharpen your feel for the overall health and quality of the market and keep you focused on the very best companies.  Things begin to get exciting as the broader market indexes start to bottom and begin the first leg up in a new bull market.


At this point, you should concentrate on the new 52-week highs list.  Many of the market’s biggest winners will be on the list in the early stages of a new bull market.  You should also keep an eye on those stocks that held up well during the market’s decline and are within striking distance (5% to 15%) of a new 52-week high.  Conversely, every day there is a list of stocks to avoid printed in the financial newspapers: the 52-week low list.  I suggest you stay away from this list and all of its components.


If the market is indeed bottoming, a growing number of stocks will display improving relative price performance (relative strength) while they go through a comparatively tight price corrective process. Generally the correction for an individual stock from peak to low will be contained within 25% to 35%, and during severe bear market declines could be as much as 50%—but the less the better.  A correction of more than 50% is generally too much, and a stock could fail as it reaches or slightly surpasses a new high.  This is due to excessive overhead supply created by the steep price decline.


As the overall market is bottoming, your watch list should multiply over a number of weeks. The better stocks start moving into new high ground as the market rallies off its lows. This is a good sign that the market has either bottomed or is getting close to a bottom.  This is a critical juncture. Each emerging bull market tends to send up its unique set of leaders.  The leaders of the past bull market rarely lead the next rally, so expect to see some new and unfamiliar names.  Less than 25% of market leaders in one cycle will generally lead the next cycle.  It's important to recognize the new crop of top-performing companies and industries as early as possible.  Remember: listen to what the stocks are telling you, not the pundits.  This will be your best early-alert system.


The 95 best-performing stocks of 1996 and 1997 took just five weeks to surge 20%.  On average, these stocks gained 421%.  Among these 95 stocks, 21 jumped 20% within a mere week. Those went on to surge, on average, 484%.  In 1999, many of the best stocks took just one week to run up 20%; some did it in a mere three days.  All of them displayed superior relative strength before they advanced significantly.  


Mark Minervini

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