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Market Leaders: A Double-Edged Sword

July 29, 2014



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 those stocks ahead of the curve will move out swiftly at the first hint of slowing growth.

 

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.

 

Most stocks experience a relatively severe decline in price after a superperformance phase has run its course.This is due to profit taking and the anticipation of slower growth ahead. Scientific evidence and my personal experience indicate that the chances of a superperformer giving back most or all of its gains are high.

 

You must have a plan to sell and nail down profits when you have them. History shows that one-third of superpeformers give back all or more of their entire advance. On average, their subsequent price declines are 50 to 70 percent, depending on the period measured.

 

In a post-bubble-type market such as 1929–1930s and 2000–2003, many leading stocks declined as much as 80 to 90 percent. This is not the type of decline from which a stock investor can recover. For those who do recover, it generally takes 5 to 10 years or more.

 

In the later stage of the general market’s advance, the same leaders that lead the bull market up will alert you to weakness in their underlying sectors as well as potential upcoming weakness in the broader market. Your portfolio will be your best barometer.

 

Your watch list of potential stock candidates should bring you into the market early in the bullish phase as leading stocks set up and emerge into new high ground. Later, you will be forced out of the market—stock by stock—as many of the same issues start to churn, buckle, or accelerate their advance over a number of weeks in a parabolic fashion ahead of the inevitable bear phase or market correction.

 

Leaders tend to top around the same time thegeneral market starts to show signs of distribution. It’s important to keep your sights on the trees rather than on the forest. 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 occurs 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 uptrend 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? Wrong!

 

A bull market is always dominated by at least one sector and several subsectors. Within the top sectors leading a new bull market, the relatively few leading names that dominate the leadership during that market eventually attract the attention of institutional money. Buying enthusiasm for those leaders can push their prices far above realistic valuations. As a result, those issues tend to decline the most during the subsequent bear market.

 

For investors who hold on to the former leaders for too long, the results can be devastating. Investing in leading stocks is indeed very risky if it is timed incorrectly. The highfliers are great when they’re going up; however, the downside can be disastrous. If you don’t have a sensible exit plan to minimize losses, it is certain that you will experience a major setback at some point.

 

Big profits can be made during periods of optimism. However, if you’re late to the party, look out below. The same stocks that have been going up could be due for a major correction. For example, the technology 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 showing that the leaders of one bull market are rarely the leaders of the next. Financials and housing stocks were market leaders in 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 both for bear market recovery rallies and for the next bull market.

 

There is one caveat to this: if the leadership stocks or sectors started to emerge near the end of the bull market cycle preceding the subsequent bear market, in some cases they can lead during the bull market.

 

One thing for certain is that very often the leaders of the next bull market will emerge from the most unlikely areas but quickly reveal themselves through the application of the price analysis techniques discussed in this chapter. Follow the leaders and you will participate in and profit from many of the most exciting entrepreneurial companies this country has to offer.

 

Excerpt from Trade Like A Stock Market Wizard by Mark Minervini (McGraw Hill Publishing –2012)



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