How To Find The Next Stock Market Bottom? Use This Chart Technique – Investor's Business Daily

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The hardest thing in investing is to harbor no bias.

XOn Oct. 18, 1990, the major newspapers painted a dark picture. Stories included a report that U.S. industrial output in September rose 0.2%. But analysts dismissed it, saying they saw six months of weakness ahead. Another story said housing starts fell for an eighth month in a row — the longest slump since 1959. Another report said the government was dragging its feet on rules for handicap access, which stalled apartment building.

And an ever-helpful Congress was contemplating a tax increase.

Stocks were in the third month of a bear market. The Nasdaq was 28% off its peak. Newspapers reported that one stock newsletter writer was telling clients to remain “100% short.” The expert said he didn’t expect “a tradable bottom” until the Dow dropped 12% more.

What was IBD saying?

Well, nothing. IBD was waiting for a follow-through day.

A follow-through day is a mechanism for confirming a new uptrend. The benefit of focusing on this, rather than the news, is that it is more reliable. An investor acts on the follow-through day regardless of what anybody thinks.

IBD also was identifying stocks worth watching in the column “Stocks In the News” (now called Stock Spotlight). Names on Oct. 18 included AST Research, Borland Software and others.

Oct. 18 proved to be an important day. Coverage in the next issue of IBD reported “a surprising and powerful follow-through”: a gain of 2.7% in the Dow to 2452, 2.3% to 305 in the S&P 500, and 2.2% to 334 in the Nasdaq — all in greater volume vs. the prior session.

The rally occurred on Day 5 of a new rally attempt that had begun Oct. 12. Before that first up day, the Nasdaq had corrected more than 31% from its mid-July peak of 470; the S&P 500 had fallen more than 20%. Most follow-through rallies happen on the fourth day or later. Remember, volume on that day simply has to be higher than the prior session, not above average.

This follow-through gain confirmed that the rally attempt that began Oct. 12 was the potential beginning of a new uptrend. The confirmation meant investors could buy fundamentally strong stocks breaking out of sound patterns.

Acting on a follow-through day — when news or experts provide many reasons not to buy stocks — is difficult. And the days after a follow-through day can be tense, too.

In the first two days after the Oct. 18, 1990 follow-through, the Nasdaq rose. Then it fell six straight sessions, shaving off 4% but not undercutting the previous low.

One day involved a distribution day — a sizable loss in rising volume. But one distribution day usually isn’t enough to kill a rally, and an uptrend is intact as long as it doesn’t undercut the previous low.

Staying positive during this pullback had to be tough. But those who followed the rules won big. In six months, the Nasdaq rose 53%. Gains from breakouts included: AST Research and Borland, up 212% and 194%, respectively, in six months; Apple, up 62% in about four months; and Microsoft (MSFT), up 71% in two months.

(A version of this column first appeared in the May 20, 2011, edition of Investor’s Business Daily. Please follow Whitfield on Twitter at @IBD_PWhitfield for more stock market commentary.)

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