Headaches, coughs and sneezes can tell you when you're going from healthy to getting knocked by a severe cold. Yet not everyone knows about a similar indicator in stock investing: the technique of identifying clear distribution days.
XThey help you identify major stock market tops.
And that's the best time to quickly raise cash, lock in profits in at least some of your best winners, and to cut losses in your under-achievers fast.
Stock Market Tops: The Definition Of Professional Selling
A distribution day is a significant decline in the Nasdaq or S&P 500 in higher volume than was seen in the previous session. IBD defines a "significant decline" as a drop of more than 0.2%, with no rounding up.
A distribution day indicates unusually heavy selling by institutional investors, the heavyweights who largely set a market's direction.
Four or five distribution days over several weeks nearly always signal that stocks have topped and are heading for a downturn. That's similar to how persistent headaches, coughs and sneezes suggest that you ought to call in sick and break out the chicken soup.
By May 4, 2010, distribution days had piled up, with four such days for the Nasdaq in the preceding few weeks.
That helped change the market's outlook to "correction," as explained in The Big Picture column, published daily after every market close.
How Distribution Marks Stock Market Tops
Those four distribution days for the Nasdaq were on May 4 (1), April 27 (2), April 16 (3) and April 7 (4). On each of those days, the tech-heavy index fell more than 0.2% in faster trade than in the prior session.
The other three major indexes — the Dow, the NYSE and the S&P 500 — all had more than four distribution days by May 4, adding to the bearish mood.
So what's an easy way to keep track of distribution days? The daily Big Picture and its accompanying graphic, the Market Pulse, make it simple to watch the count. During each day of a rally, the Market Pulse lists the number of distribution days, with the Big Picture offering an interpretation of the market's latest action.
But don't expect a tally of distribution days during a correction. At that point, the market has already topped. Investors should be looking for a follow-through day, which indicates that a new uptrend is likely underway.
When Distribution Fades Away
IBD's research has determined that investors shouldn't count distribution days after 25 trading days have passed. At that point, those days of liquidation have become irrelevant.
A distribution day also falls out of an index's count after the index climbs 5% above that distribution day's close. IBD has developed this rule on the premise that when an index rallies and extends itself from a distribution day, it's showing the strength to overcome high-volume selling.
Not All Distribution Days Are Equal
Keep in mind that some drops in higher volume don't carry as much weight.
Distribution days in this camp include those that come after a holiday, leading to an easy volume comparison. Plus, watch for those sessions on Wall Street where turnover is boosted by heavy options-expiration trading. Options-expiration days fall on the third Friday of every month. If that Friday is a holiday, expirations move to Thursday.
It's still a distribution day even if turnover comparisons are distorted by a holiday or expirations. But such a day isn't as significant as a sharp drop in higher trade without any distortions. The Big Picture column will note these nuances.
A version of this column was originally ran in the Aug. 10, 2010, edition of IBD. Please follow Chung on Twitter at @SaitoChung and @IBD_DChung for more on growth stocks, buy points, breakouts, chart analysis and stock market analysis.
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