IBD follow through days

So IBD changed their interpretation of follow through day. Irrespective of what IBD does on this particular instance, let us look at the logic behind the IBD follow through method for confirming new rally start and see if it makes sense and is it logical. The fundamental hypothesis behind the IBD overall market direction is based on the logic that large investors like mutual funds, pension funds and hedge fund drive the market because of their large size. It uses a price and volume action as a proxy to figure out what these institutions are doing. So when a market is in rally mode, it looks for a possible top when there is a cluster of 5-6 high volume selling days. It calls those days distribution days. It defines distribution day as a day where the market was down and volume was up. When such distribution days are clustered in a short time frame it indicates that the large funds are selling or distributing stocks. So after 5 distribution days it says you should be preferably in cash. Besides that it uses list of market leaders (stocks which had outperformed the market in price and earnings term ) to see the health of the market. If majority of stocks in that list are going down below 50 day MA it describes the market as risky .

Now once a market goes in to correction mode as signaled by number of distribution days , then the next logical step is to see when to get back in to market. For that it uses again a proxy of large speculators buying to confirm possible start of a new rally. How does it do it, by looking at rally attempts. So in a downtrend it looks for a positive day. Once there is a positive day, it looks for second positive day on high volume. The second day should come in between 4 th and 7 th day of the rally attempt otherwise the rally attempt is considered a failure and you start all over again. It has tested the system on last several years of market data and it calls a turn in 80% of the time correctly.

The more important question which is not really been asked is should you follow it and do you have a better system. The IBD system has a context which is most important to understand and that in IBD model of CANSLIM, it buys stocks with primarily two main characteristics 1) those with earnings momentum and 2) price momentum. One of the primary characteristics of such stocks is that they outperform during market rallies and significantly under perform during corrections. So they will double quickly but give up 50% or more of their price gains when the market turns. While high growth is sexy there is a corresponding high risk associated with it. So by staying in cash during the correction phase , you significantly narrow the risk. If you are not trading those kind of stocks, it does not matter and you should not follow it.