With the Nasdaq up 2% today on healthy volume, MarketSmith received a number of calls from investors looking for confirmation about the Follow-Through Day (FTD) we have been discussing in recent blogs. For those who don’t know, the Follow-Through Day concept was developed by my father, William O’Neil, to validate the sustainability of a new rally attempt, after a market corrective phase. No bull market rally has ever started without one. While today’s action is positive and represents accumulation—something we haven’t seen in a while—it is not an FTD, and certainly not a signal to begin plowing back into the market.

The current market correction has lasted a little more than two months, and this rally attempt began only three days ago. As discussed in last month’s webinar , an FTD occurs four to seven days after a new rally begins. The reason we wait at least four days before calling an FTD is because we are looking for proof the rally is real. One or two days does not make a trend. But if after four days or more we can see that money is still flowing into the move, and institutions are not using this rally attempt as an opportunity to dump shares, we begin moving back into the market. Specifically, we are looking for significant, new demand on one of the major indices: a day where price is up over 1.4% and volume is higher than the previous day.

Take a look at the NASDAQ from 8/8/2007 (above) for an example of why we wait four to seven days for confirmation. The rally began on 8/6/2007. We got convincing price and volume action on day #3, but ultimately the rally was overwhelmed by institutional selling, and it failed.

So the earliest we could see an FTD would be tomorrow (day 4). But even if we do, I would apply extra scrutiny and begin wading into the market very slowly. In addition to the FTD market confirmation, we also look to leading stocks to signal it is safe to begin buying. While there are a few stocks with tempting breakouts today, most of the prior leaders (AAPL, PCLN) are moving up off their lows and are still pretty far from breaking out of a recognizable chart pattern. Several leaders like NTES and UA have met resistance and reversed at new highs multiple times over the last few months, as they tried to break out, despite the market correction. Who’s to say the same behavior doesn’t continue until we get solid confirmation from the indices? Most other leaders have not even fared that well. TSCO and RAX are two examples of prior leaders that are breaking down and no longer look healthy.

For these reasons, a cautious approach still seems appropriate at this point. You can protect yourself from the market volatility by moving in and out of the market incrementally, that is by making each decision prove correct, before getting carried away and making more decisions. Remember that moving back into the market is a methodical process that requires the market to prove its strength before we invest more in it.

Finally, and most importantly, I have been focusing on weekly charts to evaluate chart patterns forming on leading stocks and to assess the trend of the overall market. Keeping my eye on the weekly view has kept me from being tempted by some of the action we have been seeing on daily charts. It is pretty obvious from a longer-term time frame that most leading stocks—and the indices—still have work to do before setting up properly for another profitable rally.

Best Returns,

Scott O'Neil

President, MarketSmith Incorporated

Follow Scott O'Neil at Twitter.com/WScottOneil