When the investing road gets bumpy, warning signs are nice to have. Is the stock market about to get worse and should you be applying the brakes? Or is it just a one-off rough patch that will soon smooth itself out?
One of the most important signs of an emerging stock market top is a series of distribution days. It acts as a warning sign to investors that it is time to raise cash and get off margin before the general market weakens further.
A distribution day can occur on any of the major indexes. When the S&P 500 or the Nasdaq (or both) falls more than 0.2% in higher volume than the previous day, we have a distribution day.
Higher volume shows that fund managers are busier selling. Even if volume is below average but higher, it still counts as a distribution day.
Sometimes an index may make little or no progress in price even as volume runs higher. That "churning" or "stalling" action also marks a distribution day. The main characteristic of a stalling day is that an index closes higher but in the lower half of its daily trading range.
Stock markets frequently turn lower and enter a correction phase after four, five or more distribution days over five weeks. It's also worrisome if a cluster of distribution days occur over several days.
Reading The Big Picture helps keep track of the market direction and the distribution days count. Using sell rules helps lock in gains and limit losses as the market conditions deteriorate.
Stock Market Tops Through History
In his book, "How To Make Money In Stocks," the late IBD founder William O'Neil observed that most distribution days occur when the market is advancing. But a single distribution day is not a reason for caution by itself. Watch to see whether more follow.
Once the stock market is in a correction, the number of distribution days does not matter any more. The top is already in, and investors should be looking for a rally attempt and a follow through day.
Distribution days don't last forever. They become irrelevant due to time and price action. If an index gains 5% from the closing price of a distribution day, that day is not counted any more. Similarly, a distribution day expires after 25 trading sessions.
Stock Market Top Of October 2018
The Nasdaq composite topped in August-October 2018, and left plenty of distribution clues.
The index fell more than 0.2% in higher volume on Sept. 4 and 5, 12 and 17 (1). Sept. 21's 0.5% drop came in big volume due to a "witching" session of options and futures expirations (2). Sept. 26 was a mild distribution day (3).
That was six distribution days within four weeks. Distribution got more serious Oct. 4, 10 and 11 (4). An added sign of weakness was that the index fell through the 50-day moving average on Oct. 4 (5). The stock market left little doubt it was in a correction.
On Oct. 10, the Nasdaq fell through the 200-day moving average. The index fell 17.3% below the 200-day line on Dec. 24.
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