I am not getting overly excited about the 3.55% move in the DOW, the 3.98% move for the NASDAQ and the 3.71% jump for the S&P 500. Today’s action does raise some interest but trend reversals and new bull rallies can’t be confirmed after one day of action. All major bull markets started with a reversal and then a follow-through within the next four to ten trading days.
This idea was first revealed by William O’Neil, the founder of Investor’s Business Daily, and became a cornerstone in his CANSLIM investing method. I believe this theory to be accurate but it is not an exact science. Before I describe this method, I would like to be clear that my indicators are still pointing down and my screens are still focusing on shorts. It’s a good time to write about reversals and follow-through days even though I don’t think this rally has legs but my opinions must be checked at the door.
The key to understanding this follow-through philosophy is that reversal signals usually occur after a significant market correction, not a minor market correction. The reversal and follow-through in 2003 was classic and one I like to refer back to when looking at the present market. Both the reversal and follow-through days must move at least 2% to the upside on above average volume.
If today acts as day 1 of a possible reversal, then the next two days are not very important except for one fact: the market must not undercut today’s low as that would kill the start of a new rally. As long as prices stay above today’s low, the rally attempt is safe.
The follow-through day should come within four and ten days of today’s reversal although O’Neil’s original rules stated that the follow-through should come between day 4 and day 7. One of the major indexes must move higher by 2% or more on larger volume than the previous day to qualify for a follow-through. Multiple indexes participating with a follow-though shows conviction that the market has sustainability to move in the new direction.