Distribution Days: Do They Cause Market Corrections?

Posted On December 1, 2017 11:12 am

For the past year, essentially since the election, the stock market has been characterized by rotation, as investors shift from sector to sector.

Different sectors have all had their moments in the sun. These included financials that were expected to benefit from deregulation and higher rates, to cyclicals that were to profit from infrastructure spending, to small cap domestic companies that would reap the benefits of tax reform, and healthcare/pharma, which swing back and forth according to the latest repeal and replace vote.

But one constant behind the ebb and flow has been the broad and consistent strength in the tech sector.   Typically this type of rotation, or rolling corrections, is a sign of a healthy market and has allowed the broad indices to march steadily higher.

That is until the past few days, in which the Nasdaq (QQQ) has severely unperformed both the S&P 500 and the Russell 2000 by 1.2% and 3.1% respectively.

We’ve had other 1-2 day periods of such divergence, but the past few days were ones defined as “distribution,”  suggesting a wider and deeper correction might be coming.

Here Gavin McMaster defines distribution days and what it may mean for the days to come:

“There are a number of techniques that investors can use to determine the sentiment of a broader market or a financial security. Sentiment is a measure of investor confidence in a market.  Positive sentiment is associated with increasing prices where negative sentiment is correlated to decreasing prices.

The combination of price action and volume help measure sentiment. One of the most interesting ways to measure negative market sentiment is to define distribution periods.

Distribution days are a sign that the big players in the market are starting to take profits and unwind their positions. This can be measured by using a combination of price movements and volume. By measuring distribution,  a retail investor can avoid a situation where large players are selling stock to smaller players who are just entering the market. Once the big institutions start to leave the market, retail investors are left to direct price action.

According to Investor’s Business Daily, a distribution day is defined as “the loss of more than 0.2% by a major index (Nasdaq, the NYSE composite or the S&P 500) while volume ticks higher than the prior session’s total. Tracking the accumulated damage is crucial to gauging a market’s health. Institutions are the heavyweights that largely determine the market’s direction. They account for perhaps 75% of daily trading. In a nutshell, when they buy, or accumulate stocks, the market goes up. When they sell, the market falls.”

An investor can use distribution days to create an index, or follow distribution ratings such as the one put out by Investor’s Business Daily.  The IBD rating uses a formula to measure distribution from A-F, where F = heavy selling by institutions and an A = heavy buying by investors.  IBD uses their rating on stocks as well as major indices.

This article explains a little bit more about how IBD calculated distribution days.

When a market is edging higher while distribution is taking place a retail investor should be cognizant that the resistance taking place will likely turn into market liquidation when the last buyer has purchase a stock.

Investors can use distribution days to create an index that will give them a warning sign that a market is turning.  For example, when a security or index experiences 3 distribution days in a row an investor can determine that the security or index is experiencing negative momentum.  IBD counts distribution days but not in consecutive order.  They have determined that 6-7 over the course of a month reflect a warning sign to investors that a market is vulnerable.

Multiple distribution days do not necessarily mean a market is going to move lower.  According to IBD, there are a number of ways distribution day count can be terminated.

The first way a distribution day is terminated according to IBD is by the calendar. After 25 trading sessions, a distribution day expires. The count of distribution days reverts back to zero. A second way a distribution day count can terminate is for the index to rise 6%, on an intraday basis, from its close on the day the higher-volume loss appears. The third way is far more painful. A broad market correction makes the distribution day count a moot point. Often, a high distribution day count will foreshadow a correction.

Distribution is a sign of market sentiment and can be a useful tool to help an investor exit positions or hedge in light that an impending correction is imminent.”

 Related: Is the Retail Rebound Real? 

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Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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