Most stock investors spend a lot of time using technical or fundamental analysis to pick the best stock, ETF, or fund to buy. Less time is spent on doing equally rigorous analysis of the market's trend, and too often their conclusions are based on a fundamental opinion of the economy. The majority of technical analysts, of course, will tell you that the fundamental data badly lags the price action.
In March 2009, it was almost impossible to have a positive fundamental view of the economy. As I will show you later, there were clear technical signs at the time that the stock market was indeed bottoming. In this article, I will focus on the one indicator that is often ignored by many, but that should be followed closely by all stock investors.
While there are always some stocks that will rise when the major averages are declining, going against the major trend is generally never a good idea. By determining the market's internal strength or weakness, you will be able to make a more reasoned decision to buy or sell, and this should make your investing more successful.
The best way to measure the market's health is through the Advance/Decline line, or A/D line. The most important A/D line is based on the NYSE Composite. It is calculated daily by determining the number of stocks that are up (advancing) and the number of stocks that are down (declining). The A/D line is a then-cumulative total of the number of advancing minus the number of declining stocks.
In many years of study, I have found that the A/D line is the most effective tool for identifying market bottoms. In this article, I will show you how I use support, resistance, trend line analysis, and moving averages to determine the market's trend using the A/D line. Of course, these patterns are rarely exactly the same, but through these examples, you should be well-prepared for most future scenarios.
Figure 1
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This chart, courtesy of Tradestation.com, covers the period from November 2004 through November 2005 and is a ideal example of how the A/D line can identify a market low. On the bottom of the chart in blue is the A/D line with a 34-period exponential moving average (EMA) of the A/D line in pink.
From the NYSE Composite's March high of 7453, the market retreated sharply and violated four-month support, line a, in April. This created significant overhead resistance, as anyone who bought since November was now at a loss.
The NYSE made lower lows in April and May (line b), consistent with a weak market. The NYSE A/D line was giving a different picture, as it formed higher lows, line c. A bullish or positive divergence is not always seen at market lows, but when it is, that signal is highly reliable.
As I have mentioned previously, once a divergence is spotted, I wait for confirmation before I am confident that a turning point has been identified.
On May 15, 2005 (line 1), the A/D line moved above the key resistance at line d, which confirmed the positive divergence.
It is important to note that the A/D line was acting stronger than prices, and while the NYSE was at 7124 and still well below the April high at 7222 (line e), the A/D line was higher.
The NYSE Composite did not overcome its resistance until 17 trading days after the A/D line. Though this may seem rather surprising, this is a rather common occurrence with the A/D line.
Over the next three months, the A/D line was rising steadily, but on August 12, it failed to make a new high with prices (point 2). This was the first warning signal.
The NYSE Composite made further new highs on September 9 at 7665 (point 3), but the A/D line failed to make new highs, forming a negative divergence, line f. This divergence was completed on September 20 when support at line g was broken. This was 11 days before the important chart support at line h was broken.
Figure 2
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With the popularity and liquidity of ETFs like the Spyder Trust (SPY), I started to combine it with the NYSE A/D line and found the signals to be quite reliable. SPY peaked in May 2006, which made the followers of the "Sell in May…" philosophy happy for a while.
The ensuing decline in SPY took it 7.5% lower, as it bottomed at $122.34 on June 14, but the NYSE A/D line only declined by 2.4%. This was a sign that the market was showing internal strength. The A/D line tested long-term support at line a, but no divergences were formed. On July 26, SPY closed at $126.83 and the downtrend in the A/D line was broken (line 1).
By early August, the A/D line was well above its rising weighted moving average (WMA) and on August 29 (line 2), the A/D line moved above the May highs with SPY closing at $130.58. It was almost a month later before the SPY surpassed its May highs.
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