You’ve likely seen or heard numerous talking heads and market experts say the current bull market, now in Year Nine, is extra-long in the tooth. That’s true.
William O’Neil, author of the growth investing classic “How to Make Money in Stocks” and chairman of IBD, has frequently noted that the typical market rally lasts three to four years, while a sharp correction runs for about nine months, possibly a bit longer.
That pattern has been tossed aside lately. The March 2000-to-October 2002 Nasdaq crash lasted for two years and seven months. A five-year bull run followed, which then set the stage for another violent decline. The January 2008-to-March 2009 bear market lasted for nearly 15 months from peak to trough.
Common sense would say that the extreme severity of decline in each of those bear markets is one reason why the rebounds in equity prices have lasted longer than average. The market simply needed more time to mop up those losses and stretch into new high ground. In the realm of equities, greed is slow yet steady most of the time; fear runs at a much quicker pace and thus tends to carry a sharp bite, like a habanero chili pepper that’s a little more picante than expected.
Many market pros stress that in the equities market, a bull doesn’t die of old age. Instead, the market falls in anticipation of a major economic decline. As an individual investor, you simply cannot read every quarterly report or digest every weekly and monthly report on the economy. You alone can simply not predict that the manufacturing industry is going into a deep freeze three months from now, that China’s real estate market will crash in November, or what the next country will be to default on its sovereign debt.
So is there a simpler way to take action when the market appears ready for a big fall? Absolutely. Watch the market itself. The market is the sum of buying and selling decisions by millions of money managers, both big and small. No one is smarter than the market as a whole. So why not track it on a daily basis and pay attention to instances of unusually strong professional selling? When the smartest members of the Big Money rush for the exit, you can see it. IBD calls it distribution.
Distribution days can be likened to a fine wine. A glass or two is fine. It’s social, and it’s probably good for your digestive system. But one too many will send you reeling.
A distribution day is defined as the loss of at least 0.2% (without rounding up) by a major index — the Nasdaq, the NYSE composite or the S&P 500 — as volume ticks higher than the prior session’s total. Tracking the accumulated damage is crucial to gauging a market’s health.
Why? Because distribution days almost always are signs that institutions are exiting the market. And, as the big funds control the bulk of daily volume and hence the overall market’s direction, you can’t expect stocks to rise without those big guns on your side.
How many is too many? For now, the market could probably withstand six or seven distribution days before rolling over — especially when most or all of those declines are small in scale. Indeed, the market has sometimes been saddled with as many as eight or nine technical distribution days, yet still lumber higher. Use the Market Pulse table in IBD’s The Big Picture Column every day to instantly track the exact distribution-day count. The column itself will go into the nuances surrounding the distribution as well.
Happily, a distribution day does not necessarily scar the market permanently. There are three ways a distribution day can fall off the count. The first is by the calendar. After 25 sessions, a distribution day expires. The count falls by one.
A second way a distribution day can fall off the count is for the index to rise 6%, on an intraday basis, from its close on the day the higher-volume loss appears. As with most problems, a bull market is a great curative.
The third way is far more painful. A broad market correction makes the distribution day count a moot point. Often, a high distribution-day count will presage that correction. Once the market falls into a correction, the big question is when it will regain its uptrend.
When a follow-through day arrives, signifying a new uptrend, the distribution-day count starts clean at zero for all three key indexes.
The distribution-day count could have kept you out of the market in early 2008, when a series of declines snowballed into the worst rout in recent memory. As it happened, the count rose as the indexes fell.
Look at the chart of the S&P 500 at the end of 2007. See how distribution days mounted just before the collapse: Dec. 11, 2007, -2.5% (1); Dec. 17, -1.5% (2); Dec. 27, -1.4% (3); Dec. 31, -0.7%(4); and Jan. 2, 2008, -1.4% (5). In each of these declines, volume rose on the NYSE.
On Jan. 4, 2008, you saw a 2.5% sell-off (6) and the sixth distribution day in 25 sessions. That’s the day the Market Pulse declared a market correction.
On Dec. 31, 2007, the S&P 500 finished the year at 1468. By Nov. 21, 2008, the large-cap index fell almost 50% to as low as 741. A six-week rebound didn’t achieve much, and in the first three months of 2008, stocks resumed their bear-market slide. By March 6, 2009, the S&P 500 notched a 12-year low of 666.79, a 54.5% slide from the 2007 peak.
(The original version of this story ran in the March 5, 2012, edition of IBD.)