To be highly accurate in any pursuit, you have to carefully observe and analyze the object at hand. The stock market is no different. The idea may seem simple enough, but even with their hard-earned money on the line, you'd be surprised at how often people argue with the facts that are right in front of them. Many investors are sometimes misled by the shouting of opinions and prognostications. Listening to opinions about the market is one of the riskiest things you can do as an individual investor. You want facts, not personal opinions. If there's one lesson most learned from the 2000 three-year bear market, it's that arguing with the facts and simply hoping for the best is the easiest way to lose your shirt. Let's start by dissecting market activity and talk about what it's trying to tell you.

The Interplay of Price and Volume

The stock market is governed by the same forces as individual stocks: supply and demand. Throughout history, the best way to determine the market's health and direction has been to view the daily price and volume action of the three major indexes: the Dow, the S&P 500 and the Nasdaq. Volume bursts in these key indexes show where mutual funds and other institutional investors, the biggest driver of stock prices, are moving.

In an up-trending market, you normally want to see prices and trading volume rise somewhat in tandem. This shows a market under accumulation, with more positive volume than selling volume: a good sign. On down days, in the majority of cases, you want to see volume lessen. This shows a lack of any significant selling another good sign. But take note of days when the market shoots up in price to new highs on lighter volume. This shows a lack of institutional buying, which might be a warning sign.

Even in the best of all bull markets, there will be days on the way up when selling suddenly overtakes buying when an index closes down for the day on heavier volume than the day before. This shows distribution, and it is a potential red flag if that type of action continues to occur. One day of distribution is not enough to turn a rallying market downward, nor is it necessarily cause for alarm. Rather, take it as a signal to start watching the market more closely to see what happens next. Market cycles over the last 50 years indicate that it usually takes three to five distribution days over a period of up to four weeks to turn the market's uptrend into a downtrend. Every major market top in the past 100 years has revealed this negative price-and-volume action prior to the market's downtrend.

Many people think of the great crash of 1929 as being a sudden, inexplicable event. Not so. In late 1929, just before the Dow gave way to a selling avalanche, the index posted a flurry of down days, each on heavier volume than the previous session, all of them saying to investors: "Get out." This activity pinpoints the mass exodus by institutional or professional investors the heart and soul of the market. You might be asking how a market event almost 80 years ago tells us anything about today's market. The answer is that in the stock market, as in many things, history continually repeats itself because human nature doesn't change.

The Nasdaq flashed similar warning signs in the spring of 2000, although almost everyone missed it because they were caught up in the predictions and hysteria of the moment. By March 30, the market had logged a series of heavy distribution days, a sign that a number of mutual funds, pensions or other big players were selling stock. Investor's Business Daily's market column "The Big Picture" warned people to get off margin, begin raising cash and only remain invested with extreme caution not because of what we thought the market was going to do, but because we were reading what the market was actually telling us day by day. It was telling investors: "Sell."

An investor who remains inflexible during a confirmed market downturn and argues with the market facts will usually suffer the consequences. The name of the game is to preserve profits you have built up in a bull market instead of riding them back down through a bear market period.

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