Articles

By: Chris Rowe — August 21, 2019

How to Be the First to Spot Changing Trends

Today I want to talk about one of the best indicators for measuring the breadth of a stock market advance or decline.

CHRIS

It's called the Advance Decline (A/D) Line and it tracks the net difference between advancing and declining issues on any given major index.

It should be compared to the other market indices like the S&P 500, or the NYSE Composite Index (as opposed to the Dow-30.)

It is cumulative and normally plots a line similar to the chart of an index.  When there are more stocks advancing than declining, the A/D line moves up and vice versa.

The actual level that the A/D line is at is not what’s important.  What we’re interested in is the direction of the line relative to the index that you are comparing it to (NYSE A/D line, S&P500 A/D line etc.).

When higher highs in the major indices are confirmed by peaks in the A/D line, it's considered a bullish sign.  It’s also bullish when the major indices decline, but the A/D line is in a positive trend or neutral trend.

Divergences

This indicator is best used to find a divergence from a stock market index.  The A/D line will clearly show you if the market is in a rising or falling trend, or if a trend is still intact.

Historically, when a divergence develops between a major index like the NYSE index and the A/D Line, the NYSE has then corrected and followed the direction of the A/D Line.

In the (historical) chart below I’ve highlighted three positive divergences on the left side (where the NYSE Composite Index moved lower, but the advance decline line moved higher)...

And I’ve highlighted two negative divergences on the right.

As you can see in September of 2005, the NYSE made two highs while the A/D line moved lower. This meant that while the index moved higher, the majority of stocks on the NYSE were moving lower.

(Click any image to enlarge)

AD Chart 1

Again, this indicator tracks the net difference between advancing and declining issues.  It is usually compared to a market index to spot a divergence from that index, thus giving us an early indication of a possible trend reversal.

The Generals and the Troops

There are a heck of a lot more smaller companies than larger companies in the major indices (excluding the Dow-30).  So breadth indicators actually give greater weight to the “smaller GROUP”.

If all are stocks are treated equally, and the majority of “all stocks” are smaller companies, then the stocks in the “small company” camp will affect the breadth indicators more.

So it will reflect the smaller companies – as a group – on the NYSE, or on the NASDAQ or whatever the BPI or A/D line is.

Think of it this way...

The A/D line tells us if the troops are keeping up with the generals, or if the troops have decided to take another course of action.  It's like the old adage: “Trouble looms when the generals lead and the troops refuse to follow.”

The A/D line has historically peaked out ahead of the market averages, which is why this indicator is so popular.  Tops are generally much harder to call than bottoms, and the breadth of the market is one of the clearest indications we have that major indices could be running out of steam.

Let’s look at one more historical example:

AD Chart 2

As you can see, the NASDAQ, which is the darker line, is showing peaks that are not confirmed by the A/D line.  This is a bearish divergence, which, as we’ve discussed, occurs when the price of an index hits a new high, but the advance/decline line tops at a lower peak.

AD Chart 3

It's important to remember that divergences can last a very long time.

For example, the A/D line on the NYSE peaked in April 1998.  But the NYSE Index itself didn't peak until September 2000.  That divergence lasted over two years!

So remember that the A/D divergence is not a timing tool, even though it does often indicate that you should be suspicious of the market's direction.

AD Chart 4

You can see the negative divergence in the A/D line which preceded a correction, and you can see the same sort of thing happening (in the red shaded area).

Also, look back to the sharp increase in the A/D line in the beginning (stock market recovery) of 2003. The steeper the A/D's slope, the stronger the trend.

Notice that the slopes in the A/D line weaken over time, until finally they're not even moving up.

Now you can see why we call it the "True Market".  While everyone else is thinking that "the market" is heading up...

We can see what's really going on beneath the surface.

That's the beauty (and the power) of breadth indicators.

See you soon,

Chris

CHRIS

Archives

FREE e-Letter Sign Up