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Have you noticed that often at inflection points in the market, before a new trend is started, we see a sort of ‘thrashing’ about in the breadth figures?
You can see what I mean in this chart of the daily advancers and decliners for the Nasdaq index:
Notice that before the recent market top, there was a contraction in the market breadth. The trendlines I’ve drawn by the way, are not 100% accurate, they’re just guideposts. But see how the internal workings of the market were getting squeezed? Becoming less volatile and smoother. Until it went plop!
It might seem imperceptible to you, especially if you’re new to charts in general and especially to the crazy looking advance decline charts. But depending on your natural visual abilities and the amount of time that you spend training your visual acuity, you will find the subtle contraction and expansion taking place.
Another example was in the summer of last year when we had another expansion (in June and July 2006). To see a closer look at the breadth at that time, take a look at my previous mention of the advance decline numbers.
So why do does the market exhibit this characteristic?
I think it is because at times of panic we see extreme herding take place. The market rushes towards one direction: sell!
But then, paradoxically, it immediately turns on its heals and goes the other way within a short time frame. This is exactly the sort of behaviour that studies like Lowry’s 90-90 day or Marty Zweig’s 9-to-1 pin point. If you are in the market at these times it can be jarring. You see wild swings in your portfolio and it seems almost random. But it isn’t.
The market is simply doing what it must to flush out the weak hands, to throw the maximum number of people into the wrong positions, so that when the new trend is established, it has fuel to propell it. Unfortunately for those who are on the wrong side of the emerging trend, the fuel is their capital going up in smoke.
As the incorrectly positioned player slowly realizes their mistake, they begin to close out their positions. As they do, the trend is given fuel to continue and intensify. Of course, there is also a lot of money that simply stands aside and waits this out. Their contribution as mo-mo (or momentum players) is to jump on the trend once it is established and to squeeze the losing side for all they’ve got.
So which do you want to be? The one that gambles or the one that stands aside and lets the dust settle before riding a trend?
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