Understand the ‘M’ in CANSLIM

What does the ‘M’ in CANSLIM stand for?

According to William O’Neil (www.investors.com) , it represents the overall health and direction of the major market indexes. It is very important to understand and recognize what type of market you are in before you ever place a position (this may not include day traders but is extremely important to trend traders). How can you realistically make money and set goals based on a blind strategy without knowing if the current market is in bear mode, bull mode, up-trending, down-trending or if it is trading sideways. The market trades sideways with only slight deviations from an average about 80% of the time. This leaves us with a market that trends up or down with sustainable swings only 20% of the time. Three-quarters of all listed stocks will follow the general direction of the major indexes which include the NASDAQ, the DOW and the S&P 500.

By ignoring the ‘M’ in CANSLIM, your portfolio may get hit with losses if you are trading on the wrong side of the trend. Simply picture a river and understand that it is much more difficult to swim up-stream than it is to swim with the current downstream. The stock you buy may have a nice basing chart pattern and excellent fundamentals but it may come under pressure and move in the opposite direction you anticipated due to the general market weakness and/or sector weakness. The same can be said in a bull market; a stock that is a sub-par performer may act strongly and give the investor solid gains due to sector strength and/or overall market strength but the gains are primarily due to sister force (in this case, a bit of luck helped your position).

Study the market and you will see that stocks move in groups and many of the stocks in a strong industry will move in tandem. The same holds true for weak markets; if you own a stock in an industry that is starting to churn or breakdown, it may be wise to pull in a portion of you position to lock in gains before the bottom drops. More times than not, the leading stock in an industry group must conform and move in the direction of the others. A perfect example can be the home builders, they have moved in tandem for the past seven years. If you look at their weekly charts for the past six years, you will see that they all have the same patterns but with different numbers. The image provided is from a case study I did back in 2005. Nothing has changed from 2005 to 2007 with this industry as they are all traveling the same road.

As many of you know, I also use the daily new high and new low ratio (NH-NL) to compliment the overall strength that the market is presenting. The price and volume alone can fake out many investors and lead them down the path of faulty investing. In order for the market to be a formidable bull, the NH-NL ratio must compliment the general outlook and present us with at least 500 new highs per day on a consistent basis. When both the NH-NL ratio and the ‘M’ in CANSLIM are strong, we can justify placing larger positions (maximum 1-2% portfolio risk) and label the market as a bull. William O’Neil, the founder of Investor’s Business Daily, states that many of the most profitable stocks over the past 50 years made their advances when the overall market was strong, not weak. The NH-NL ratio is always comprised of the strongest stocks in the current market and we know that these individual leaders are responsible for the bulls and the bears.

How can an investor monitor the market action to tell if it is weak or strong?

As mentioned above, the first thing to look for is a breakout of one or more of the major indexes with volume greater than average. Next, I look for the daily new high/new low ratio (NH-NL) to be entering new high territory and reaching new highs of 500-1,000+ stocks per day. We have not had one day exceed 1,000 new highs since 2004 which shows us that a true bull run ended in 2004 (from 2003). This is not to say that the recent up-trend hasn’t been great but it wasn’t a true bull market in my opinion based from my research and analysis. In 2003, we had multiple instances when 1,000+ new highs were reached (this happened several times during the same week). Bear markets only form when the NH-NL ratio turns negative and this has not been the case since last summer. Only 9 of the 52 weeks in 2006 gave us a negative NH-NL ratio, hardly a sustainable bear market (consider it more of a correction or consolidation).

Sideways markets are typically tougher to trade than a market that is trending in one direction, whether it is up or down. Sideways markets whipsaw investors up and down and typically cause frustration that leads them to make poor decisions. It may be wiser to sit in cash during an extended sideways market if your portfolio is taking consistent losses. Re-group, monitor the ‘M’ in CANSLIM and look for a new basing pattern or trend to form. Never throw good money after bad!

Coming out of a bear market; the strongest stocks which may take the early leadership will typically have the highest relative strength ratings while confidence is still low. These new leaders will typically emerge from a few specific industry groups that are gaining strength and making gains on the heaviest volume. When a new trend confirms, the first 10-15 weeks will be crucial as the biggest winners will breakout during this time. It is not to say that additional winners can’t breakout after the first 15 weeks of a new up-trend but the odds decrease and your risk rises. When the follow-through occurs in the indexes, you must see an increase in market volume from the previous day and substantial price advances that equal or exceed 1%-2% for the NASDAQ, DOW or S&P 500. When we see two or more of the indexes follow-through on the same day, it increases the validity of the new up-trend and you can start grabbing shares in potential leaders.

If the market starts to make new highs on large volume but it is not moving as high as it was during the entire length of the up-trend, it may be topping. This is the first sign of churning and the first red flag to play tighter defense on your longs. I will immediately turn to the NH-NL ratio to gage the strength of the individual leaders to give me a glance at the broad market strength. One of the biggest black eyes that an investor can receive is during the topping of a long bull market where they made extensive gains and have emotions that are telling them they are genius. If an investor ignores the ‘M’ in CANSLIM and holds their winners while the market tops and then starts to decline, their gains will be erased quicker than they were accumulated and their egos will be shot. Bulls always climb mountains while bears usually jump out the window. When red flags appear, such as moving average violations, support levels violated and the decline of the NH-NL ratio, it is time to lock in profits and move to cash until things settle and you can figure out what is happening. It is not necessarily the best time to short but you can begin building your watch lists for candidates that may want to join the bear jumping out the window.

Never listen to personal opinions on the market offered by talking heads because they are usually wrong or don’t understand the key factors that decide if the market is going up or down. It is most important to understand the exact condition and health of the market today rather than trying to predict where it will be in 6-12 months. Everyone is always trying to predict where the market will be in twelve months or at the end of the year. Who the hell cares? This is a complete waste of time as investors and traders must be able to change their opinion and beliefs of the market on a dime.

Is the market currently up-trending, moving sideways or down-trending?
Did the trend just change?
Can you see a change or did you miss the change?

If you make predictions, you may become married to these predictions and overlook major market signals. When you understand these questions, your trading results will improve dramatically. You could be the best stock selector in the world but that doesn’t mean a damn thing if you buy and sell against the trend because you don’t study or understand the ‘M’ in CANSLIM. Always know the exact direction, health and conditions of the ‘M’ in CANSLIM before you ever put on a trade.

Remember, you could be right in every aspect of your stock analysis but if you are wrong about the direction of the market, you will most likely lose money.