Money
& Investing 
How to Do a "Litmus Test" on the Market --
Look at the News and Then the Reaction
If history follows its normal course, the stock market will turn up while the economy is still struggling. The market and individual stocks tend to “discount news in advance”. So, a smart investor needs to be alert and not discouraged by bad news.
The key to getting a measure of what is truly going on is to do a “litmus test” on the market and individual stocks by “dipping them in the news for the day”.
A good saying to remember: “The news is not the news. The news is how the market or a stock reacts to the news.”
The classic method for a litmus test, first used in 1300 by chemists, was to dip litmus-type paper into a solution. If the blue paper turned red, it indicated the solution was acidic. If the red litmus paper turned blue, the solution was alkaline.
The same sort of approach can be used by investors. A simple guideline for some possible news-reaction scenarios would be:
1. Bullish News + Bullish Reaction = Affirmation of Bullish Trend
2. Bullish News + No Reaction = Concern for a Trend Change
3. Bullish News + Bearish Reaction = Likelihood of Trend Change
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4. Bearish News + Bearish Reaction = Affirmation of Bearish Trend
5. Bearish News + No Reaction = Concern for a Trend Change
6. Bearish News + Bullish Reaction = Likelihood of a Trend Change
To take a “litmus test” of the general stock market trend, one could use a chart and note key news items and how the market reacted to it. At this time, with the stock market in a down trend, the key would be to spot if the stock market can react in a bullish way when bearish news comes out.
By marking news sequences on a chart, one could well begin to pick up a pattern where the stock market is, as they say, “stronger than expected”. However, keep in mind that the response to the news by the market needs to be followed by a clear turn in the trend of the averages. Following the “news and then the reaction” is like an investor doing a “heads up”.
At this point (late February), the Dow Jones industrial average is in a clear down trend and is at 7,365. It recently undercut key support around 8,000. This technical breakdown took place even while the president and congress were announcing various plans to boost the economy. At this point, the bullish news was still bringing a bearish reaction to the stock market. So, one would have to say the bear market is still in effect.
Using the litmus test for individual stocks is extremely helpful. There is one important catch: Sometimes, the stock of certain companies will have a tendency to move well before the news. So, an investor needs to be alert to the “historical trading pattern of the stock in relation to its news”.
With earnings season coming, eSignal subscribers will need to be mindful of how stocks react to news. A useful tool in eSignal is the Headline Count in the select field of the quote page. This gives you the number of news headlines on each stock on the quote page. It is a great tool!
To put the litmus test to work, one could look at the stock of HMS Holdings Corp. (HMSY). The stock has been a top performer for the bulls despite the bear market (see following chart). The company, with revenues of 174 million dollars, provides health-care cost containment services.
HMS reported February 20 that fourth quarter net jumped 73 percent to 26 cents a share from 15 cents a year ago. That beat the consensus estimate of 24 cents and the highest estimate on The Street of 25 cents. That was a bullish report.
How did the stock react to the news?
Bullishly! HMS surged 3.26 to 34.68. Volume ballooned to 1.3 million shares -- four times its average daily volume of 349,000 shares. The big surge by HMS also came on a day when the Dow fell 100 points. So, one could surmise that HMS’s bullish stock pattern remains in effect. The stock has climbed from 20 to 34 the past five months.
The day before, on February 19, tech company Hewlett Packard Co. (HPQ), a Dow blue chip stock, came in with an 8 percent decline in net for the fiscal first quarter, which ended on January 31, to 77 cents a share from 83 cents a year ago. It also lowered its earnings outlook.
The HPQ news was bearish. The stock’s reaction: Bearish. HPQ fell 2.69 to 31.39. Volume swelled to 57 million shares -- more than double its normal daily turnover of 20 million shares. So, one would say that Hewlett Packard’s stock pattern remains bearish. It has fallen from 50 approximately a year ago to 31 (see following chart).
Because many stocks are in down trends and earnings projections are weak, one would expect the first quarter news to be bearish for many and their stock response bearish. However, this is where an alert investor needs to be watchful.
If a stock moves higher on bearish news, it could well mean the market has “discounted” the bad news and may be looking ahead to better prospects.
This scenario will show itself somewhere down the road in the general stock market averages. That most likely will be the early litmus test sign that a new bull market is about to begin.Mr. Fasciocco’s is publisher of Ticker Tape Digest at www.tickertapedigest.com. He is a contributing writer for several publications. Mr. Fasciocco can be reached at leo@tickertapedigest.com
