Weak Leaders May Signal Topping Market

When the market was topping in October-November 2007, what were the leaders doing?

Late 2007 was pretty much the end for the bull market that began in March 2003. An uptrend that began in late August was the last before the bear market of 2007-09.

Of course, it wasn't easy to see the end coming — it never is. But if you were holding one of the leading stocks in that rally, you were getting some negative messages.

Indeed, one sign of a topping market is abnormal action by the leading stocks. They may break out of late-stage bases, most of which will be faulty. Some climax tops may occur with a few leaders, while others suffer abnormal price breaks.

Let's take a look at four big gainers of that 2007 rally.

Russian steel producer Mechel OAO cleared a base intraday on Sept. 13, 2007, and closed above the buy point three sessions later. 1 In about three months, it rose 116% from the ideal buy point to a closing high on Dec. 26, 2007. 2

As it rose, it made new highs in low volume Dec. 3, 6, 7, 10 and 26 3 New highs in low volume suggested that funds had lost interest in the stock. It was time to sell. On Dec. 27, 2007, Mechel began a 34% correction.

DryShips bounced off its 50-day moving average on Aug. 22, 2007. That established a buy range, but a disciplined investor would have waited for the follow-through day three sessions later. Depending on the purchase price Aug. 27, an investor could have been shaken out when the stock dropped 7% the next day. Those who bought in the lower third of the day's range wouldn't have hit the 7%-down mark.

The stock doubled in two months.

By early October, trade was getting looser. The spread between the high and low of the day was 10% or more on Oct. 11, 16 and 19, and 20% on Oct. 30. Loose trade points to a lack of conviction.

By mid-November, DryShips was below its 50-day moving average and eventually corrected 63%.

Baidu also established a buy range with a bounce off its 50-day line. It nearly doubled from August 2007 to early November. Then it fell in fast trade in four of five sessions. It was time to sell.

Investors who held suffered a 30% decline as it shaped a cup-with-handle base. Action within the base, though, was looser and more severe than in previous consolidations. That was a bad sign. It cleared the buy point on Dec. 27, but volume was below average. That too was a bad sign. It fell 52% in the next three months.

VimpelCom broke out a day after the August follow-through. On Dec. 24, 2007, it made a new high in reduced volume. But this sell signal might have been difficult to recognize. After all, volume is typically low on the day before Christmas. Clearer clues would have come in a fast-volume drop on Dec. 27. An 8% loss on Jan. 15 probably would have been a rather late signal, considering the market was two weeks into a correction.

You have to wonder how much of a gain is reasonable to expect. An investor who bought at the August breakout had an 89% gain four months later.

The lesson? When the market is trying to give you a Christmas present, take it. Don't try to squeeze the last dollar out of a big winner.

Finally, when leaders falter and you sell, you will find fewer reasons to recommit that money. This will naturally raise your cash position, particularly if the market is under pressure or in correction.