Understanding Distribution Days

If you are a believer in watching for distribution days in the averages, indicating professional selling, to determine whether a market is topping is there a particular number of distribution days you use to tell you whether the market is beginning to get into trouble?

The number of distribution days that signals a probable top has changed over the years. This is due to the markets being so much larger than before. Institutions are managing a lot more money these days. It used to be three, four, or five distribution days would occur before a top was signaled. Today it can be up to six distribution days. What most investors don’t realize is that a market will undergo distribution as it is advancing.

Following an advance in the MA’s ignore the first two days of distribution, but begin to get concerned on the third distribution day. On the fourth distribution day begin to sell some of positions. On the fifth day, sell more, and on the sixth day sell more. The distribution day concept does not say how far down the market will go or how long the decline will last. It could be two days, two months, or two years. It is supply and demand that determines prices and how far a decline might go.

There are also different definitions of what constitutes a distribution day. The definition used here since ’99 is that price must decline by at least 0.30% on volume that is at least 3% greater than that of the prior day. This is a bit confusing when you read, get out a paper and pencil and write it down, once you do, you will see that it is easy to understand and to track. Subsequent to a market advance, a distribution day can also occur in a session in which price stalls, or churns, on higher volume, without actually falling in price.

The below chart of the NASDAQ shows the accumulation-distribution score as 0 to 3 over the past four weeks. This is a rough picture, and thus it is not worth spending time debating the merits of this or that day being a d-day or not.

What is known is that the NASDAQ is five days off its peak for the move, and has dropped 3.3% from that peak. Whether this progresses to a full-blown correction is not known. Given that its 19.1% advance post-Dec. 19 was a unidirectional affair, it is certainly entitled to one, and this would be normal, and perhaps expected.

The two best indications that the market is ready to move higher would be

1) a reversal of the recent trend of heavier volume coming on declining days, such that higher activity occurs on advancing sessions, and

2) leading stocks with a high degree of institutional sponsorship showing accumulation, i.e. up days on higher volume.

Otherwise, the risk is more drama from the eurozone and a Mideast war. If the latter was being taken seriously by the market, prices would not sit where they are. Obviously, if a war breaks out, the risk-on trade is done.

After the initial round of base breakouts by individual leaders, chart patterns have become extended above their most recent bases, or areas of price consolidation.

This is certainly the case now. The leaders need time to form new bases that can offer fresh entry points that have technical support areas beneath. These support areas can help to mitigate the risk of the general market weakening right after purchase.

For the speculator who has been on the sidelines watching the market go higher, entering now would represent too high of a risk, at least in most leaders with sound fundamental growth prospects.