How to Spot New Leadership When a Bull Market Begins

The first nine months of 2022 have been treacherous in the stock market. Each wave of selling has been met with relatively weak bounces that have triggered further selling at technical resistance areas, especially at the 200 day moving average, resulting in a series of lower lows. As bad as overall market conditions have been, the damage in particular sectors, such as growth and speculative growth stocks, has been devastating, with many former leaders down 50% to 85% from their peaks. Interestingly, the market, by many measures, particularly psychological contraindicators, has been extremely oversold for most of the year and yet has continued to trend down.

This points to one of the basic tenets of the O’Neil Methodology: once the overall market, or an individual stock, is trending down, there is no telling how low it will fall or how long it will take to recover. At O’Neil Global Advisors, we believe we are in the interpretation business, not the prediction business.

Therefore, rather than attempting to predict the length and depth of a correction, it is generally better to wait on the sidelines until clear signs appear that a new bull market has begun. One signal is a trailing day (FTD), which has occurred towards the start of every major bull market we’ve studied over the last 120 years. Once that signal occurs, it is critical to find and invest in stocks that can potentially lead the new bull market.

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

When the pressure on the market finally dissipates, it will be stocks with strong fundamentals and growth prospects that have completed constructive bottoming and are moving toward new highs at the start of the new recovery 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 against the broader stock market. Higher RS ​​stocks with rising RS lines are outperforming the major market indices as well as the universe of individual stocks. Often a new leader’s RS line will move to new highs ahead of price, indicating impressive price outperformance relative to the broader market, which generally bodes well for future outperformance.

As these stocks form bases during the market correction, they will often show subtle clues that they are building up. This will be evident in the Accumulation/Distribution (A/D) line and the A/D rating, which are proprietary O’Neil Methodology measures used to identify stocks that are under accumulation (purchase) or distribution (sale). ).

Technical clues that suggest accumulation by institutions include when a stock makes a higher low in the middle of the market making a lower low during a downtrend; a positive divergence that will also show up as an improvement in relative strength; gap-ups or big bull days with high volume as the stock is building the right side of a base; price and volume action in which rallies on increasing volume and pullbacks on decreasing volume generally occur; bearish support at important moving averages, such as a rising 50-day moving average line; “jogs” and constructive price/volume action, such as reversals to the upside at the end of a pullback (often coinciding with pullbacks in broad market indices); several consecutive weeks (five or more) of price increases as the stock accumulates the right side of the basis; and, finally, strong price action on high volume as the action finally emerges from a bottom.

Another stock feature that can represent new leadership in a bull market is strong industry group participation. Relative industry group strength is a good measure of groups that are strong and improving. O’Neil tracks 197 different industry groups and assigns a group ranking to each based on the price performance of individual components within each group.

While being part of a strong and improving industry group is not a requirement for a stock to lead in a new bull market, the fact is that leading stocks are generally part of leading industries. Having strong industry support can be an important component in driving a stock price higher. Improving favorable economic conditions and fundamentals within an industry will benefit most, if not all, of the companies that are part of that group. Our goal is to identify the one or two strongest stocks within an industry in terms of fundamentals and technical strength, as these are the brightest prospects to lead a new bull market.

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

A current example of a stock that exhibits these characteristics is TeslaTSLA
(TSLA). The stock is a leader in the automotive space (particularly electric vehicles (EVs)), an industry group that is gaining steam, rising from 174th to 51st in the industry group in the past nine weeks. It also has exposure to the Solar-Energy space, which has been the top-ranked industry for the past eight weeks.

The stock held above its late May low as the broader market was making 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 was breaking below its 50-day moving average, demonstrating strong relative strength. Additionally, the stock has shown constructive price and volume action, indicating that the stock has been building up as it has been building during the market correction. With strong fundamentals, improved sponsorship and strong technicals, TSLA appears poised to be a market leader when overall market pressure dissipates and a new uptrend begins.

In conclusion, while 2022 has been a challenging time for US equity investors, the current bear market offers opportunities to reposition the portfolio. With history as a guide, the next bull market is likely to be led by a different leadership in terms of industry groups and individual stocks. Being alert to the signals the market offers to identify these leaders can help you find some of the most profitable trades.

This article was written in collaboration with O’Neil Global Advisors Senior Vice President and Portfolio Manager, Charles Harris. Mr. Harris has been a portfolio manager for O’Neil Companies since June 2000 and has traveled the country and abroad lecturing and teaching workshops focused on chart analysis, portfolio management and trading psychology. He has extensively studied market cycles since the early 1900s and the characteristics of major stocks during this time period, with an emphasis on psychological and secondary contraindicators to market lows. He received his CFA
appointment in 1998.

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