The "M" in CANSLIM

...What does the “M” in CANSLIM stand for?

According to William O’Neil, it represents the market and direction it is heading in. Over the past several months, you have listened to me write about the “M” in CANSLIM almost every single week. Some of you have wondered why I put so much emphasis on this one letter in the CANSLIM acronym. It is very important to understand and recognize what type of market you are in before you ever make a stock purchase or place a large position. If you don’t know if the current market is a bear, a bull or if it is trading sideways, how can you realistically make money and set goals based on a blind strategy. Markets trade in trends and 75% of all listed stocks will follow the general direction of the major indices which include the NASDAQ, the DOW and the S&P 500. If the market health is poor and a bear market has developed but you don’t know about it because you haven’t assessed the health of the “M”, you may lose money by placing a long position in a stock. The stock you buy may have a nice chart pattern and excellent fundamentals but it may come under pressure due to the general market weakness and sector weakness. The same can be said in a bull market: a stock that is sub-par may perform strongly and give the investor solid gains due to sector strength and overall market strength. Study the market and you will see that stocks move in groups and most of the stocks in a strong industry will move in tandem (up). 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 potion of you position to lock in gains. More times than not, the strongest 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 five years. If you look at their weekly charts for the past several years, you will see that they all have the same patterns but with different numbers.

I trade based on two major criteria: a strong up-trending market (a bull market) or a market that has reversed to breakout and follow-through telling us that the “M” in CANSLIM is gaining strength.

Second, I 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 strong, 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 and labeling the market as healthy. William O’Neil, the founder of Investor’s Business Daily, states that many of the best stocks over the past 50 years have 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 indices 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. In 2005, we have not had one day exceed 1,000 new highs to date (October 22, 2005 – almost 10 complete months of trading). In 2003, we had several instances when this number was reached multiple times in one single week. In 2003 we were in an obvious bull market and in 2005 we are in an obvious sideways market. On a side note: 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 because you will never know if the market will be up or down the next day. In bull markets, stocks move higher and in bear markets they move lower and a trend can be targeted but sideways markets provide us with many head fakes!

During bear markets, the strongest stocks that propel the market back to the bull side will typical have the strongest relative strength ratings when everything is weak and investor confidence is low. These stocks will become the new leaders and will typically emerge from a few specific industry groups that are gaining strength. When the market reversal happens, 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 market, 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 indices follow-through on the same day, it increases the validity of the new up-trend.

Markets typically top after a prolonged period of higher highs and the first sign of a possible climax run or topping of the NH-NL ratio. 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. If price progress is poor and the volume continues to increase, the market may be churning or topping. I will immediately turn to the NH-NL ratio to gage the strength of the individual leaders to give me a glace 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. When red flags appear, such as moving average violations, support levels sliced 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.

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. Is it currently up-trending, moving sideways or down-trending? When you understand this last question, your trading results will improve dramatically. You could be the best stock selector in the world but that doesn’t mean anything if you buy and sell during the wrong time 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.

Piranha