Just to review, the warning signs consisted of 1) leading stocks breaking down 2) an increasing number of distribution days 3) very high bullish sentiment and 4) too many breakout failures.

Since my last post, we have observed even more distribution days (which is defined as heavy volume selling by the institutions). If you look at a NASDAQ chart, you will notice big volume down days on 1/20, 1/21, 1/22, 1/26, 1/28 and 1/29. The worst part is that the selling accelerated in volume last week with Friday 1/29 being one of the heaviest volume down days in the past year!

I view this as obvious “dumping of shares” by the large institutions. I said this before and it’s worth repeating: “WHEN THE BIG BOYS ARE GETTING OUT OF THE MARKET, I DON’T WANT TO BE IN!” Why? Because you need institutional support to keep stocks in an uptrend. Right now, this support does not exist. In addition, “breakout failures” in leading stocks such as $PEGA $STX and $MTL confirms the unhealthy nature of this market.

Although we may see some low volume short covering rallies, my best advice is to simply stay out of this market. If you feel that it’s too late to sell and you want to “ride it out,” keep in mind that you will likely deal with more downside volatility over the near-term.

One of my favorite trading rules is: “Always protect your confidence.” By putting our clients in cash in mid-January, not only did we survive the past two weeks, but we will also be more confident when it comes time to re-enter the market. In other words, if the market corrects 10-15%, while everyone is struggling to get back to even on the year, we can start from a stronger position and trade with a higher level of confidence when the market becomes healthy again. Until then, sit out and wait patiently for a better environment. Who knows? It might not be that far away.

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The proprietary RS Rating measures the price performance of a given stock against the rest of the market for the past 52 weeks. Every stock in the market is assigned a rating from 1 to 99, with 99 being the best. An RS Rating of 99 means that the stock has outperformed 99% of all other companies in terms of price performance.

My personal cutoff when selecting a stock is a RS rating of 90. I almost never buy stocks with a rating below 90. My reasoning is this: Harvard University rarely accepts students who score in the 23rd percentile of the nation’s SAT scores. They take only the best. So when selecting stocks, why should you settle with laggards or weaker-performing stocks? In addition, the key is not to simply buy stocks with the highest ratings. According to William O’Neil, the key is to “buy stocks that are performing better than the general market just as they are beginning to emerge from sound base-building periods.”

I use RS in three ways: short-term, medium-term and long-term.

Short-term: Intra-day RS can be useful when looking for day-trade ideas. For example, if the NASDAQ is down 20 in the morning, and you think it might rally back up, pay attention to stocks that are “holding up” better than the market. I like to look for stocks that are green or barely down on my screen with the theory that if they survived a morning selloff, they will most likely go higher if the market recovers.

The opposite is also true. If you purchase a stock in the morning and it doesn’t move when the market rallies, chances are it will become even weaker if the market fizzles. This is also a good way to look for short ideas intra-day. Again, these concepts can be used for shorter-term or day trading.

Medium-term: The best way to explain how near-term RS can be helpful is to use a real-time example. From 9/23/09 thru 10/2/09, the NASDAQ corrected approximately -5%. If you were looking to enter the market or add to positions near the NASDAQ’s 50-day moving average, the best trading ideas were the stocks that “held up” well during this pullback. For example, if you look at charts of $AAPL $BIDU $FIRE $CDE $EJ you will see how these stocks barely corrected when the market did. As soon as the selling pressure was lifted off the market, these stocks resumed their uptrend towards new highs.

Long-term: When the market emerges from a Bear Market, look for stocks that held up well during the big correction. For example, in the summer of 1998, the NASDAQ corrected approximately -32% during the LTCM collapse and the Russian financial crisis. When the market bottomed in October 1998, stocks such as YHOO CSCO MSFT AOL AMZN and EBAY were trading near their highs. In other words, the correction was like a “spring” holding down or compressing these stocks. As soon as the tension was released…BOOM! These stocks not only exploded to new highs, but also continued to be huge winners through 1999.

A more recent example is the March 2009 bottom. Stocks such as $GMCR $PEGA $EJ $PCLN and $NTES were all making new highs as the market was emerging from its Bear Market correction. These names went on to have significant gains in the ensuing six months.

So whether you’re a short-term trader or a long-term investor, you can see how relative strength can be used to help increase your success in the stock market.

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Although the NASDAQ Composite experienced heavier volume today, I don’t consider it a “distribution day” because the market showed incredible resilience and rallied back to nearly even. More importantly, plenty of stocks held up well and were actually positive when the Dow was down over 100 this morning. I also like how the NASDAQ found great support on its 20-day moving average (near 2090).

Here are some stock ideas and quick notes:

1) $GMCR – I mentioned this stock as a potential breakout candidate in my Market Notes (9/27/09). On Monday we saw a nice move from 69-75 on strong volume. I tweeted on Tuesday that the stock could pullback to retest its breakout area of 70-72. I like how it pulled back on Tuesday and Wednesday on lighter and lighter volume, and found support today right around 72. Look for a breakout above 75 soon as I am expecting more upside in the next day or two. The stock’s high short interest could fuel this upside.

2) China ideas – $BIDU is nicely consolidating it’s up move from the week of 9/13/09. I believe it will run to 420-440 soon. $PWRD and $NTES broke out on strong volume on 9/23, pulled back to retest their breakout areas on light volume and are setting up to go higher. I like $PWRD better because it has a higher Relative Strength rating and stronger earnings growth. $HMIN is looking strong and I reported huge earnings growth last quarter. $EJ is building a great base on a Weekly chart and has great support near 20, which is near its 10-week and 50-day moving average. The short interest in $EJ has tripled over the last month (click to view) probably because people expect China to tighten its lending practices soon, but I think rates will continue to be accommodative worldwide and the shorts will get punished.

3) Gold – Many gold stocks broke out on strong volume in early September and pulled back recently on light volume. You will notice this in the charts of $CDE $IAG $GOLD $AEM and $GLD (the Gold ETF). According to Marketwatch.com: “The Hulbert Gold Newsletter Sentiment Index (HGNSI) which reflects the average recommended gold market exposure was unchanged recently at 25.2%. This is important because the HGNSI is nowhere close its record high of 90% and…the HGNSI saw peaks of 64.3% and 60.9% at gold’s highs earlier this year.” (click for article)
Gold has made several attempts to break $1,000/ounce over the last two years. Its recent surge might be sustainable this time since the majority seems to be doubting or even ignoring the move. If we do see higher prices, the gold stocks mentioned above should benefit.

4) Big Caps – $AAPL $GS $PCLN $AMZN $GOOG $BIDU. I mentioned over the weekend how most of these stocks found support last week near their 10 and 20-day averages, a positive sign. I tweeted this morning how $AMZN was holding up well (up +0.20) while the Dow was down –130 and was worth buying if we rallied back on the day. It finished up +1.64. Great example of why (as a trader) watching intra-day relative strength is important.

5) Miscellaneous watch list – Internet Security – My 2 favorite ideas are $ARST (support at 21-22) and $FIRE (support at 20). Biotech – $DNDN (support 24-25) $HGSI (support 17-18) and $MNKD (support at 8-9, the company’s founder Alfred Mann has a history of building successful Biotech companies and selling them). $HITK $PEGA $SXCI (these companies all have very strong earnings and sales growth numbers). $WFMI and $ISRG (also on my watch list).

My best trading ideas for the remainder of this week include: $GMCR $PWRD $HMIN $CDE and $AMZN

Please keep in mind that the purpose of this blog is to help people with idea generation. If you trade some of these stocks, PLEASE, PLEASE, PLEASE use stops. In other words, if some of these stocks turn against you and the market doesn’t cooperate…protect your portfolio! Thank you. Good luck trading!

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