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Market Leaders; a Double Edge Sword

November 08, 2013



Just as the leaders lead on the upside, they also lead on the downside. Why? After an extended rally or bull market, the market’s true leaders have already made their big moves. The smart money that moved into these stocks ahead of the curve will move out swiftly at the first hint of slowing slow. When the leading names in leading industry groups start to falter after an extended market run, this is a danger signal that should heighten your attention to the more specific signs of market trouble or possible trouble in a particular sector or industry group.

Most stocks experience a relatively severe decline in price after a phenomenal advance has run its course. This is normally due to profit-taking and the anticipation of slower growth ahead. A weakening general market is often the cause for subsequent price declines.

There will come a point when leading stocks stop making new highs, start to churn, or, even worse, buckle and reverse direction. This often happens before the overall market tops and gets into serious trouble. For example, in mid-1999, I started to point out the divergences and negative signals that specific stocks were flashing. At the time, some of the market’s key leaders were starting to top out, while the indexes continued to accelerate higher. For months I saw evidence that the ice was melting beneath the market, based on the action of leading stocks. Institutional clients kept asking me if I was sure about my opinion, because while the divergences were clear, the market averages kept powering upward. I was asked repeatedly, are you being too cautious?

Bull markets sometimes roll over gradually whereas bottoms often end with a sudden sell-off, followed by a strong rally. As the leaders start to buckle, the indexes can move up farther or start to churn, moving sideways. That's because cash stays in the market and rotates into laggard stocks. The indexes hold up or even track higher on the backs of the stragglers. Watch out! When this happens the end is near and the really great opportunities may have already passed.

Most investors miss these subtle signs, mainly because they become conditioned by the market’s previous persistence upward during the bullish phases. What’s the big deal if a few stocks start to crack, they tell themselves, as long as the Dow keeps heading higher; Right?

A bull market is always dominated by at least one sector and several sub-sectors. Within the top sectors leading a new bull market, the relatively few leading names that dominate the leadership during a bull market eventually attracts the attention of institutional money. The excessive, concentrated buying enthusiasm for those leaders can push their prices far above realistic valuations. As a result, those same issues tend to decline the most during the subsequent bear market. For those investors who hold on to the former leaders for too long, the results can be devastating.

Make no mistake; investing in leading stocks is indeed very risky if timed incorrectly. Market leaders and high flyers are great when they’re going up; however, the downside can be disastrous if you lack an exit plan. Without a sensible plan to minimize losses, your odds for a major setback at some point are almost certain.

Just as market leaders are out front on the upside, they also tend to lead on the downside. The smart money that bought these stocks will take their profits and move out much quicker than they came in.

My own scientific evidence and anecdotal review over 30 years of personal trading concludes that the chances of a market leader giving back most or all of its gains are high. This is why you must have a plan to sell and nail down profits when you have them.

History shows that one-quarter to one-third of past market leaders give back all or more of their entire huge advance. On average, their subsequent price declines are 50% to 80% depending on the period measured. In a post- bubble-type market such as in 1929-1930s and in 2000-2003, many leading stocks declined as much as 80% to 90%. This is not the type of decline from which a stock investor can recover. Most don’t come back, ever! For those who do recover, it generally takes five years or more.

Big profits can be made during periods of optimism, even in stocks that virtually everyone is aware of. However, if you’re late to the party, watch out! The same stocks that had been going up for a period of one to three years or more could be due for a major correction.

For example, the Tech stocks that led the 1998-2000 bull market were the biggest losers during the 2000-2002 bear market, and recovered, at best, only about half of their losses during the entire 2003-2007 bull market. History is littered with examples that the leaders of one bull market are rarely leaders of the next.

Financials and housing stocks were market leaders during the 2003-2007 bull market and then took the biggest losses during the bear decline in 2008. Therefore, if history is any guide, the leaders of one cycle should generally be abandoned as buy candidates for both bear market recovery rallies as well as for the next bull market.

Though, there is a caveat to this rough rule of thumb: If the leadership stocks or sectors started to emerge late near the end of the bull market cycle that preceded the subsequent bear market, then in some cases, they can lead during the bull market.

Very often, leaders of the "next" bull market, emerge from the most unlikely areas, but quickly reveal themselves through the application of sound price and relative strength analysis techniques. Keep an eye out for those stocks that hold up the best during this bear market correction; they could be the next cycle’s bull market leaders.

Mark Minervini 

 

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