How To Spot New Leadership When A Bull Market Starts

The first nine months of 2022 have been treacherous in the stock market. Each wave of selling has been met by relatively feeble bounces that have unleashed still more selling at areas of technical resistance, especially the 200-day moving average, resulting in series of lower lows. As bad as general market conditions have been, the damage in particular sectors, such as growth and speculative growth stocks, has been devastating, with many former leaders falling between 50% and 85% from their peaks. Interestingly, the market, by many measures, particularly the psychological contra-indicators, has been extremely oversold for the better part of year, and yet has continued to trend down.

This points to one of the core tenets of the O’Neil Methodology: Once the general market, or an individual stock, is in a downtrend, there is no telling how low it will go or how long it will take for it to recover. At O’Neil Global Advisors, we believe we are in the interpretation business, not the prediction business.

Therefore, rather than try to predict the length and depth of a correction, it is generally best to wait on the sidelines until clear signals appear that a new bull market has started. One signal is a Follow-Through Day (FTD), which has occurred toward the beginning of every major bull market that we have studied over the past 120 years. Once that signal occurs, it is paramount 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 we attempt to find winning stocks: The stock’s technical picture, the underlying fundamentals, and general market conditions. If general market conditions are poor, as they have been for most of 2022, the pressure of the broad market will prevent even the strongest companies with the best prospects from moving higher. During these broader market downtrends, the strongest stocks will consolidate and form constructive bases.

When the pressure on the market eventually lifts, it will be the stocks with solid fundamentals and growth prospects that have completed constructive bases and are moving to new highs early in the new rally 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 versus the overall equity 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 be moving to new highs in advance of the price, indicating impressive price outperformance relative to the general market, which typically bodes well for future outperformance.

As these stocks form bases during the market correction, they will often flash subtle clues that they are under accumulation. This will be apparent in the Accumulation/Distribution (A/D) line and A/D rating, both of which are proprietary O’Neil Methodology measurements used to identify stocks that are under accumulation (buying) or distribution (selling).

Technical clues that suggest accumulation by institutions include when a stock hits a higher low in the midst of the market hitting a lower low during a downtrend; a positive divergence that will also show up as improving relative strength; gap-ups or large up days on heavy volume as the stock is building the right side a base; price and volume action in which rallies generally occur on increasing volume and pullbacks on declining volume; downside support at important moving averages, such as a rising 50-day moving average line; “shake-outs” and constructive price/volume action such as upside reversals at the end of a pullback (these often coincide with pullbacks in the broad market indices); multiple consecutive weeks (five or more) of advancing prices as the stock builds the right side of the base; and finally strong price action on heavy volume as the stock finally emerges from a base.

One other characteristic of stocks that may represent new leadership in a bull market is strong Industry group participation. Industry group relative strength is good measure of groups that are strong and improving. O’Neil tracks 197 distinct industry groups and assigns a Group Rank to each based on the price performance of the individual components of 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 usually a part of leading industries. Having strong industry support can be an important component in propelling a stock’s price higher. Improving economic conditions and favorable fundamentals within an industry will benefit most, if not all, companies that are part of that group. Our goal is to identify the strongest one or two stocks within an industry in terms of fundamentals and technical strength, as these are the brightest prospects to lead in a new bull market.

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

A current example of a stock exhibiting these characteristics is TeslaTSLA
(TSLA). The stock is the leader in the automotive space (particularly Electric Vehicles (EV)), an industry group that is gaining strength, moving from Industry Group Rank 174 to 51 over the past nine weeks. It also has exposure to the Energy–Solar space, which has been the top ranked industry for the past eight weeks.

The stock held above its low of late May, as the general market was breaking to 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 general market was breaking down below its 50-day moving average, demonstrating strong relative strength. Further, the stock has demonstrated constructive price and volume action, indicating the stock has been under accumulation as it has been basing during the market correction. With strong fundamentals, improving sponsorship, and strong technicals, TSLA looks poised to be a market leader when the pressure of the general market lifts and a new bull run begins.

In conclusion, while 2022 has been a trying time for US equity investors, the current bear market offers opportunities to reposition one’s portfolio. With history as a guide, the next bull market is likely to be led by 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 the some of the most profitable trades.

This article was co-authored by O’Neil Global Advisors Senior Vice President and Portfolio Manager, Charles Harris. Mr. Harris has been a portfolio manager for the O’Neil companies since June 2000 and has traveled domestically and abroad speaking and teaching at workshops focused on chart analysis, portfolio management and trading psychology. He has extensively studied market cycles since the early 1900’s and the characteristics of leading stocks over this time period, with an emphasis on psychological and secondary contra-indicators at market bottoms. He received his CFA
CFA
designation in 1998.