The hot debate here at MarketSmith is on base counts and whether this past bear market was severe enough to reset the base counts on all stocks.

 

Counting bases on stock charts enables an investor to discern whether a stock is early in its move, or whether you are late to the party. Buying a stock out of a first stage base puts you in the position to ride that stock for a major move. Buying in late stage bases (third or forth) is generally a riskier proposition, given the stock has already had a huge run and may be closer to its ultimate peak. The later the stage, the more obvious the stock is, and obvious seldom works in the stock market.

 

If you pull up a MarketSmith chart, you can clearly see how many bases a stock has formed during its most recent move. If the price of a stock drops and undercuts the low of a previous base, the base properties displayed in our Pattern Recognition program (scheduled to launch soon) will indicate that the stage count has been reset to one. The idea is that the gains from the previous run have been consolidated; profit-taking has occurred, and enough weak holders have been shaken out. After a stock has reset its base count, it is in a better position to begin a new price run. For example, take a look at the following stocks that have recently undercut and reset their base counts: Deckers Outdoor Corporation (DECK), Tractor Supply Company (TSCO), and Whole Foods Market, Inc. (WFM).

 

Most of the time, base counting is pretty straightforward. Our current debate stems from the rule that a “bear market” resets all base counts. During most bear markets, stocks are beaten down enough to justify the resetting of all base counts. However, this latest market correction has not been so obvious. The NASDAQ and S&P 500 slumped 20.4% and 21.6% (peak to trough) respectively, just meeting the 20% minimum requirement to be labeled a bear market. We can’t say with certainty that this latest correction was severe enough to consolidate all of the gains made since the bull market began in March of 2009.

 

There are two reasons why a bear market better positions stocks for future price advancement. First, there is the sheer magnitude of the decline which shakes out weak investors. Second, the longer a bear market lasts the more it discourages and repels remaining investors. As the saying goes, if it doesn’t scare you out, it will wear you out. Although the percent decline from the market’s highs surely scared out some investors, it may not have been severe enough. Also, I don’t think enough time has passed to wear out the hard core holdouts that would need to be shaken out before a new, sustainable cycle can begin.

 

Interpreting the resetting of bases is not black and white. Numerous environmental factors go into this analysis, and there is no formula for figuring out how many weak holders are left. I think breaking hard and undercutting significant support levels leads to a stronger, more sustainable rally the next time around. But that is my opinion and that doesn’t mean shorter rallies can be ruled out in the interim. Look at the charts: assess the market, the prior moves of leading stocks, and current bases, then decide for yourself. Feel free to join the debate and tell us what you are seeing.

 

Best Returns,

 

Scott O'Neil

President, MarketSmith Incorporated

Follow Scott O'Neil at Twitter.com/WScottOneil