“Watch the market leaders, the stocks that have led the charge upward in a bull market. That is where the action is and where the money is to be made. As the leaders go, so goes the entire market. If you cannot make money in the leaders, you are not going to make money in the stock market. Watching the leaders keeps your universe of stocks limited, focused, and more easily controlled.” – Jesse Livermore

What is a Market Leader?

Market leaders are the strongest stocks in the stock market at a given time. When the market goes up, they go up more. And when the market goes down, they go down less. They’re the first to turn up following a bear market, and the last to crack at the end of a bull market.

In this way, they can be like leading indicators for what the broad stock market will do. But more than that, they’re the most rewarding stocks to own if you can buy them at the right points. 

They can range across different industries but they tend to be in the more cyclical sectors which offer the most growth like technology, healthcare, and consumer discretionary. These sectors tend to offer the most growth opportunities because they’re tied to rapid economic growth.

When the economy is booming, investors are willing to fund radical new healthcare innovations like CRISPR, disruptive but risky ideas like Tesla, or even fad-like consumer products like Peloton.

On the other hand, when things slow down, investors shy away from risky opportunities with higher growth potential in favor of stable, dividend-paying stocks like defense companies, government power utilities, or consumer staples like Procter & Gamble who make everyday items like diapers and shampoo that people buy even in a recession. 

As you can see, the ‘defensive’ stocks often benefit from monopoly-like lack of competition and rigidity from economic downturns, but the opportunities for growth are limited. For this reason, they’re rarely market leaders. 

So following the market leaders is best done in a bull market. Although traders of market leaders like William O’Neil have strategies for trading market leaders in bear markets, most modern traders use a more dynamic approach tailored to the market environment. In general, owning highly cyclical growth stocks into a bear market is a losing game.

Past examples of market leaders are Starbucks, Yahoo, and Apple Computer. Both Starbucks and Apple have graduated and become blue chips and no longer lead the market, while Yahoo was acquired by Verizon after a series of mismanaged opportunities. 

Investors getting married to the market leaders of yesterday is a recurring problem

Characteristics of Market Leaders

Market leaders jump off the screen at you. They’re the best performers in the market. They steep rallies with shallow pullbacks, they outperform the Wall Street darlings you hear about on CNBC, and they’re positioned in the fastest growing industries. 

Most of the time, they have a new product or service and sometimes they’re disrupting their entire industry. Peloton (PTON) and Zoom Video (ZM) are two perfect examples of market leaders that emerged out of the brief bear market of March 2020. 

Both companies had new products that were perfectly fit for the current landscape. Zoom had scalable video calling enabling work-from-home and remote learning, while Peloton made a gamified at-home fitness product that was actually fun to use.

All during a global pandemic where people were locked inside. Notice they were also positioned in cyclical industries: technology and consumer discretionary.

Relative Price Strength

One of the most important aspects of a market leader is relative price strength. The idea is simple but still works excellently to this day. 

Note that relative price strength is not to be confused with the popular technical indicator Relative Strength Index (RSI). 

Relative strength refers to how well a stock’s price is performing relative to its underlying index, typically the S&P 500 for mid-caps and large-caps, and the Russell 2000 for small-caps. If we wanted to measure the relative strength for Apple (AAPL), we would compare its price performance to the S&P 500.

Market leaders tend to be in the 90th percentile of relative strength among all stocks. 

There are several ways to calculate this:

• Technical indicator
• Formula used in a scanner
• Ratio chart 

The first is a technical indicator that utilizes relative price strength, which you should be able to find either built-in or custom made by somebody online for most modern charting platforms.

For example, I’m using TradingView, and there’s a community-built script for Relative Price Strength called Relative Strength made by modhelius. 

A value above zero indicates that it’s outperforming the S&P 500 over a rolling 50-day period, and a rising line indicates that it’s building strength. Typically, the market leaders will be in the top 10% of stocks on relative strength accompanied by a rising RS line. 

The problem with using a technical indicator like this one is that it’s not scalable. You can’t screen across an entire universe of stocks to find those with the highest RS rating. This is why I prefer to go the screener route. 

Of course, the most efficient way is to create a formula for your scanner/screener to search for high RS/rising RS stocks, or simply find a screener that has this function built in. If your scanner allows custom formulas, it probably won’t be too difficult after some time figuring out the nuances of their pseudocode to write the relative price strength formula. 

When it comes to screening for high relative strength stocks, the important thing is to contextualize numbers by making them percentiles. This way you can rank every stock, regardless of its price. 

One option would be to subscribe to Investor’s Business Daily, who publishes their IBD 200 (and other) lists each Thursday. However, screeners are more flexible. A few screeners, like ChartMill can do pretty much the same exact thing that IBD does. It’s also not hard to figure out the formula and create a screen in a flexible screener like TradeStation or Fintel. 

Finally, the last way to gauge relative strength is through the use of ratio or spread charts. This involves simply dividing your stock of choice by your index of choice, like so: AAPL/SPY. 

When this chart goes up, that means Apple is gaining relative strength and vice versa. This is definitely the most brute force and slow way of doing things, but it’s a good tool to go back and analyze different periods of volatility to see how a market leader reacted compared to the index. These breadcrumbs can reveal clues about a stock’s true strength in market corrections. 

Ratio charts in general can be a very powerful tool that will reveal patterns you can’t see on a simple price chart. It’s one of the main tools that pairs traders use for trade selection. 

Clean and Orderly Price Trend

If you’re familiar with the 80/20 rule, you know how it applies to almost every facet of the financial markets, shockingly. 20% of traders make 80% of profits, 20% of companies get 80% of market cap, 20% of trading days account for 80% of volatility, and so on. The exact numbers aren’t what’s important, it’s the skewed distribution of significance. 

The same is true of market trends. Most stocks stay in a sloppy trading range without a definitive trend roughly 80% of the time (of course there is always upward market drift, but we’re talking about a trend as defined as a series of higher highs and higher lows), while trending only 20% of the time. 

Market leaders are different. They trend far more often, and cleanly. When they do start lagging for months at a time, that might tell you something about either the stock or the broad market. When several market leaders can’t get up off the canvas but the market is still rising, that can be a very powerful contrarian indicator. 

Market leaders exhibit a smooth pattern of steep upswings and shallow downswings. Kind of like the classic ABCD trading pattern:

While not a market leader, the recent smooth price action in NexTier Oilfield Solutions (NEX), which came up on my screens this week exhibits exactly what I’m referring to: 

Fundamentals

Rapidly growing sales and earnings is one of the factors that distinguishes hyped up ‘flavor of the week’ stocks from true market leaders. The market gets excited about consumer fads like Beyond Meat (BYND), but after repeatedly disappointing sales numbers, the novelty wears off. 

Typically, market leaders have been growing both their sales and earnings at annual rates north of 20%. 

How To Find Market Leaders?

Finding market leaders is a bit more complicated than simply looking at the best performers over the last several months or years. Like anything worth doing, it takes more than a few calculations to find the diamonds in the rough. Don’t worry, though, true market leaders stick out like a sore thumb after just a little bit of digging. 

Screening for market leaders is the easy part. You can use simple factors like Relative Price Strength, 52-week highs, and growing earnings/sales and get a nice list of potential winners.

Here’s a sample screen from ChartMill applying these factors: 

However, in a bull market, that isn’t likely to narrow down your list too small. You need to actually research these companies and figure out their deal. If you come from the value investing world or simply don’t have much experience researching individual companies, a great framework that was basically made for this is William O’Neil’s CANSLIM methodology.

• Current quarterly earnings showing significant YoY % growth
• Annual earnings growth over the trailing five years in excess of 20%
• New products, new management, new price highs. There should be a catalyst of some sort to get the market interested
• You’re looking for low floats, with insiders and institutions controlling a large portion of the float.
• Leading it’s industry group.
• Institutional sponsorship.
• Market direction.
  

Trading Market Leaders

If you’re a technical trader, you have your own setups and methods. We’ll go over specific setups a bit, but we need to nail down one primary concept. 

You trade market leaders (and by extension, all growth stocks) using a momentum trading approach. You do not buy massive dips in these stocks, because by their nature, they love to trend.

So regardless of what you think of these specific setups, you need to understand that a momentum approach when trading market leaders is paramount. Mean reversion is best left to defensive blue chips like Berkshire Hathaway (BRK.B). Your mileage may vary, and that’s what makes a market.

The Trend Pullback or Bull Flag

The flag setup is a textbook technical trend trading pattern. The goal is to buy short-term weakness within a strong and healthy uptrend. It plays on a structural pattern in equity markets, which is that they tend to move in 2-3 day cycles up and down. They mean revert in the very short-term. 

This pattern is one of the psychologically easiest for novices to trade because it allows you to participate in a trend “on the cheap.” Your stop loss will be relatively tight and the price level at which a trade is deemed “failed” is easy to ascertain. 

Here’s an example of what a bull flag would ideally look like: 

In reality, bull flags in the real stock market are sloppier. Here’s an example in Allstate (ALL), which was a pretty active stock last year:

We have an entire article on the trend pullback pattern here if you’re interested.

The Breakout Pattern

Breakouts are the most popular among novice traders and probably the most ill-advised for them to start off with. It’s a low-probability, high-reward pattern with a fair bit of nuances that influence its probability of success. And sometimes market regimes just aren’t favorable to breakout trading, which can kill a novice’s confidence. 

With that said, breakout patterns are the most popular way to trade market leaders.

At its core, the breakout is simple. A market builds a long tight base (or range) and traders forget about it. The weak hands are pushed out until a catalyst occurs that pushes everyone into buying at once causing a frenzy of volatility.

I liken the base to the day before Black Friday at Walmart, and the breakout being when Walmart opens on Black Friday and everyone rushes in. 

Here’s an example of an idealized breakout pattern:

However, like every pattern, real breakouts are far more tricky. Stocks can build up long-term, wide ranges from which they breakout from aggressively, like the situation here in W&T Offshore (NYSE:WTI): 

Breakout formations can also setup following a upward momentum thrust, where the bars following the momentum bar form a sort of tight “coiling” pattern, as we see here in the US Energy Equity ETF (XLE):

Here’s another example of another uptrend breakout coil pattern in McDonald’s (MCD) in March 2021: 

Bottom Line

The Chat With Traders podcast recently had on a legendary proprietary day trader, Lance Breitstein, formerly of Trillium Trading. One of the things he said stuck out to me with regard to stock selection, especially in reference to market leaders: 

“If you take two traders, one trader sits in the seat during market hours and during the course of the week they put in 50 hours. You can have another trader putting in 50 hours, but it’s not just about the hours. Who’s the person that’s sitting brainless typing up tickers all day, looking at charts but not doing any deep reflection? That’s gonna be way different than the trader spending the same hours, but is going to the right stock selection, and writing them up in-depth. And those couple of great plays per day, you really need to systemize them.” 

While it might seem obvious, it can escape us that the simple factor of which stocks we’re looking at can have a massive impact on our results.

You can have the best trading methodology and a great process but if you’re trading the laggards that aren’t in play, your results will be mediocre at best.

Sometimes an uncomplicated shift in how we create our watchlists for the week will have a massive influence on our trading results. 

As we mentioned before, almost everything in finance comes back to the 80/20 rule. Stock selection, and specifically, narrowing down the market leaders will have a disproportionate effect on our success for the effort put in.