Relying on the primary market indexes and studying their daily price and volume interplay is one of the best possible methods for analyzing the market's behavior and determining its overall direction and health. The second best method is studying the current and recent action of market leaders. Remember that history shows three out of four stocks follow market downtrends. When you see the best and the strongest stocks unraveling one after the other on heavier-than-average volume, that's telling you something about the market. Your job is not to figure out why it's happening, but to recognize that it's happening, and know what you need to do about it.

What Defines a Market Leader?

A market leader is a company that dominates its industry in a number of key fundamental and technical measurements. On the fundamental side, it will boast strong profit and sales growth, high return on equity or fat profit margins. Those gains are almost always the result of an innovative product or service that satisfies a need among consumers or other businesses.

The other side of leadership is technical, meaning the company's stock performance. By definition, marketleading stocks outperform the vast majority of other securities. Huge winners during the 1990s, such as Cisco Systems and Microsoft, were outperforming the market averages, and at least 87% of all other stocks, before they launched into their massive price advances.

Notice that in definition of market leaders didn't include "number one in name recognition or brand awareness." That is not a relevant factor when determining a leading stock. Everyone knows and recognizes brand names such as Sears and Campbell Soup, but are their fundamental and technical performance numbers saying they are the current leaders in their respective industries? You should not be influenced by how many commercials a company has, how many magazine covers have featured the company's CEO, or how often you eat the food or buy the gas for your car. When the market hits bottom and rallies toward new highs, it's best to forget about most of the old familiar names. Historical research shows that just one of every eight past leaders reasserts itself as a leader in the next bull phase.

Follow Mainly the New Leaders

After a clear-cut downturn, the market will try to rally at some point. But the first few days of an attempted upswing tell you nothing about prospects for success. Instead, wait for a follow-through day, a powerful confirmation of the market's new uptrend. A follow-through occurs usually between the fourth and tenth day when one of the major indexes shows a booming gain of 1.7% to 2% or more on greater volume than the day before. In this kind of market follow-through strength, the first stocks that move to new high ground out of sound chart bases on big volume are typically the new leaders in the next bull phase. They'll likely go up farther and faster than other stocks, even after the others gather strength.

Because these new leaders don't show up and identify themselves until the market has definitely hit bottom and turned upward with a confirming follow-through day, you must be on your toes, ready to act decisively. New leading stocks will continually evolve from proper patterns for the next three months. In the period that follows, identify stocks leading their industry groups. Place them on a watch list and see how they perform. Look to see whether the big mutual fund managers are moving into these stocks. Investor's Business Daily has a daily list, "Where the Big Money's Flowing," and also "52 Week Highs & Lows" that separates the leaders from the market laggards. Track the daily price and volume action of the leaders against the major indexes. When you see new stocks hitting price highs as the market also rises, it indicates a healthy rally and overall upward trend. At the same time, when the majority of these new big leaders begin to break down, it could be your cue to an emerging overall downtrend.

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