Using former leaders to predict a correction

No one wants to admit that the good times are almost over, but sometimes the writing is on the wall (like at a party where too many people have already thrown up).

When the market begins its painful transformation from a bull to bear, there are a few things to look for. Price and volume are a good indication: volume dries up on the days where the market moves up and it increases on down days. Also, fundamental evidence helps a lot too: good news has less of a response, while mediocre news weighs heavily. These are indicators of fewer optimistic buyers in the market.

There is another, much simpler sign of a weakening market and that’s the movement of a former hyperactive leader. If you have been watching a stock that was moved up a lot because of wanton optimism, it can often foreshadow the new market direction. If it starts to make a downward move, there is a good chance the market will follow.

Consider XM Satellite Radio, a good example of a stock that rode the new bull market optimism. Since 2003, XM has moved up on the good will of optimistic investors, but has seen a precipitous drop in price in the last few months. What this shows me is that investors are beginning to get that dose of pragmatism that dashed the market gains of the go-go 90’s in a matter of months. Be forewarned, if XMSR is an indicator of the decreasing confidence of investors, the correction may be coming soon.

Chart courtesy of Stockcharts.com

With resistance breaking down and the stock hitting new lows, it looks as if people are skittish again. If that means they are unwilling to buy a former leader near or below its 52 week low, then chances are they are cutting back on other purchases as well. Not a good sign for the health of the bulls.

I do want to make one caveat: no stock can be considered an indicator for the whole market. Leaders, however, do function as one piece of the puzzle. If fundamental and technical evidence makes you think things are about to turn, than a move by a stock like XMSR can serve as another solid piece of evidence.

So for now, it looks like the good times may be coming to a close. Fortunately, one of the strengths that we are trying to play to is flexibility, which can make these changing tides a good opportunity. Keep reading for more on how to brace for changing market conditions.