This points to one of the fundamental principles of the O’Neil methodology: once the general market, or a single stock, is in a downtrend, there is no telling how much it will drop or how long it will take to recover. At O’Neil Global Advisors, we believe we are in the business of interpretation, not the business of forecasting.
Therefore, rather than trying 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 Follow-Through Day (FTD), which has occurred towards the start of every major bull market we have studied for the past 120 years. Once that signal occurs, it is crucial 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 stock’s technical picture, underlying fundamentals, and general market conditions. If general market conditions are unfavorable, as they have been for most of 2022, pressure from the broad market will prevent even the strongest companies with the best prospects from climbing. During these broader market downtrends, the stronger stocks will consolidate and form constructive foundations.
When the pressure on the market eventually builds, it will be stocks with solid fundamentals and growth prospects that have completed constructive foundations and are moving to new highs at the start of 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 the performance of a stock price relative to the general stock market. Higher RS stocks with rising RS lines are outperforming major market indices, as well as the individual stock universe. Often, a new leader’s RS line will move to new highs before price, indicating impressive price outperformance relative to the overall market, which generally bodes well for future outperformance.
As these stocks form a foundation during market correction, they often emit subtle clues that they are accumulating. This will be evident in the Accumulation / Distribution (A / D) line and the A / D rating, both of which are proprietary measurements of the O’Neil methodology used to identify stocks that are either accumulating (buying) or distributing (selling).
Technical clues suggesting build-up by institutions include when a stock hits a higher low in the middle of the market hitting a lower low during a downtrend; a positive divergence that will also reveal itself as an improvement in relative strength; gap-ups or big days of ups on high volumes as the stock is building a base on the right side; price and volume action in which rises generally occur as volume increases and withdrawals as volume falls; bearish support on major moving averages, such as a rising 50-day moving average line; “Shake-out” and constructive price / volume actions such as upside reversals at the end of a pullback (these often coincide with pullbacks in general market indices); multiple consecutive weeks (five or more) of price advancement as the stock builds the right side of the base; and finally strong price action on high volumes when the stock finally breaks off a base.
Another feature of stocks that can represent new leadership in a bull market is the strong participation of industry groups. The relative strength of the industry group is a good measure of the strong and improving groups. O’Neil tracks 197 distinct industry groups and assigns each a group rank based on the price trends of the individual components in each group.
While being part of a strong and improving industry group is not a requirement for a stock to be a leader in a new bull market, the fact is that leading stocks are usually part of leading industries. Having strong industry support can be an important component of driving up a stock price. Improving economic conditions and favorable fundamentals within an industry will benefit most, if not all, companies within that group. Our goal is to identify one or two strongest stocks within a sector 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 start of a new bull market:
A current example of a stock that exhibits these characteristics is Tesla
The stock held above its late-May low as the general market was hitting 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 falling below its 50-day moving average, demonstrating strong relative strength. Additionally, the stock demonstrated constructive price and volume action, indicating that the stock accumulated as it rested during the market correction. With solid fundamentals, improving sponsorships and solid techniques, TSLA looks poised to become a market leader when the pressure from the overall market builds and a new bull run begins.
In conclusion, while 2022 was a difficult time for US equity investors, the current bear market offers opportunities to reposition their 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 some of the most profitable trades.
This article was co-authored by Charles Harris, Senior Vice President and Portfolio Manager of O’Neil Global Advisors. Mr. Harris has been a portfolio manager for O’Neil companies since June 2000 and has traveled home and abroad speaking and teaching seminars focusing on chart analysis, portfolio management and trading psychology. He has thoroughly studied market cycles since the early 1900s and the characteristics of major stocks over this time period, with a focus on psychological and secondary counter-indicators at market lows. He got his CFA