From a market technician’s aspect there is only one thing that matters and that is price as it reflects all known information. Most newcomers to the market can find interpreting price movement ethereal and as such attach mystical significance to indicators because they come with better “instructions”, provide simple buy-sell signals and, in general, require a lot less experience to manage. Sadly though, the Holy Grail of indicators does not exist. That being said indicators are extremely helpful and can provide additional depth to market analysis than just price provides. I find one without the other is like peanut butter without jelly, bananas, or chocolate.
One of my favorite indicators when looking at the health of the overall market is the Advanced-Decline line, or AD line for short. The AD line measures market breadth or simply the sum of the number of advancing stocks minus the number declining in the NYSE index. It’s such a clean and simple concept because for a market to move higher the number of stocks moving up has to be more than the number moving down over time. The AD line is a leading indicator meaning it moves ahead of market price. For example when the market is moving up and a correction is coming, the AD line makes the first move down as more and more stocks begin to fall. The market won’t actually begin its fall until the number of stocks going down eventually overwhelm the number increasing. Market strength is undermined when fewer stock participate in an advance.
Don’t let all this talk about the AD line and market falling leave you the impression the AD line is only good for warning of potential declines, it is in fact an equal opportunity indicator working equally well warning of potential rises or declines.
Let’s take a look at the current AD line and see what the health of today’s market. In the 80-month chart below I have plotted the AD line in the top pane and a US stock market proxy (SP500) in the bottom. You can see the AD line began moving down in January of this year while SP500 price continued to move up during the same period. This reflects fewer stocks moving up but because the total falling have not yet overtaken the number increasing, stock market prices push higher. This (negative) divergence is a warning flag. To provide some historical references and why I find this indicator so persuasive, I have highlighted all prior negative divergences with blue vertical bands to help illustrate what happened subsequently.
While not reflected in this chart, there are times when the AD line warned of a change but the market never followed along. Contained within this back-tested period the AD line does a good job warning of potential market reversals but the exact timing and magnitude are unfortunately left undefined. Regrettably there is no perfect indicator and the AD line is no exception but when used to confirm price it can do wonders to keep investors on the right side of market trends.