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There is a lot more to the stock market than just the popular averages everybody is talking about. You see, when the averages move you can’t tell how many stocks participated, so you don’t know how broad that move was.
That’s why you have to dig a bit deeper to get a real picture of the health of a market trend …
Fortunately there are some technical tools proven to help uncover what is beneath the surface of the major indices, to measure what technical analysts call “market breadth.”
And one of the best known tools is the advance-decline (A/D) line …
The A/D line is a measure of how many stocks are taking part in a rally or sell-off, telling you how broad the move is.
To calculate this important indicator you simply subtract the number of declining stocks from the number of advancing stocks. Then add the result to the previous day’s total.
A/D line = (# of advancing stocks − # of declining stocks)
+ yesterday’s A/D line value
This will give you an ongoing, daily indicator. And if you incorporate the daily volume numbers into the calculation, you’ll arrive at the advance-decline volume line.
Advance-Decline Line Is a Very Helpful
Predictor of Stock Market Trouble
As a rule, healthy cyclical bull markets are accompanied by rising advance-decline lines. In other words, as long as the index and the advance-decline line are climbing to new cyclical highs, the market’s breadth is healthy. And an abrupt end of the bull market is highly unlikely.
If however the stock market index is rising to a new high while the advance-decline line stays below its former high, a negative divergence has taken place. This divergence is a warning sign that the cyclical bull market is in jeopardy, and a bear market is in the offing.
The chart below shows an important example of this relationship …
In October 2007 the NYSE Composite and most other broad-based stock market indexes rose to new cyclical highs — that is, higher than in July. But the advance-decline line clearly stayed below its July high!
Source: www.decisionpoint.com
This negative divergence was a surefire warning sign that the cyclical bull market was coming to an end. Why most Wall Street analysts — even technical oriented analysts — didn’t follow this signal is another story. Fact is, the signal was there for everybody to see.
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| Despite all the lousy economic fundamentals, the market hasn’t finished its run up. |
Advance-Decline Line Sends
Medium-Term Bullish Message
Now compare the current status of the advance-decline line with the one of October 2007. As you can see in the above chart, it reached new cyclical highs during the past several days.
In doing so it is showing a healthy stock market breadth. And most importantly it is signaling a continuation of the medium-term uptrend that started in March 2009.
Of course I’m fully aware of the major fundamental problems the world economy is facing. And I fully expect a second act in the ongoing mortgage debt drama, accompanied and aggravated by sovereign debt problems. I also know that the stock market’s valuation is very high, thus assuring a disappointing long-term performance. And yes … I expect another recession rather soon, probably a very severe one.
But here and now the advance-decline line is telling us loud and unmistakably: Not yet. This stock market has still more room to go.
Best wishes,
Claus
About Money and Markets
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