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Home > Opinion > Vanessa Drucker

Indicator points to dispirited US market

An advance decline (AD) line can reveal that a stockmarket is about to make a turn

By Vanessa Drucker | Published Jul 16, 2012 | Investments | comments

Imagine an army arrayed for battle. The generals lead the vanguard, resplendent in their smart uniforms. Suppose they charge, but the lower ranks behind them panic and disperse. If the infantry are routed, even the bravest of generals will be forced to retreat.

An advance decline (AD) line provides a similar test for financial assets in a broad market. It is straightforward to calculate: one can net out the advancers from the decliners, treating every stock equally, to measure the buying or selling pressure during any given session. An AD ratio of more than two shows significant force, although markets can in fact reach four or five on extreme days. “During periods of intense volatility, like in August 2011, we sometimes saw a ten to one AD ratio,” says Arthur Hill, senior technical analyst at Stockcharts.com.

The main value of the AD line as a technical tool is that it provides an aggregate measure of how a broad market is working internally. Mr Hill likens it to taking the blood pressure or the temperature of a patient, or looking under the bonnet of a car, “to see all the different components and how they are functioning.”

The AD really comes into its own, though, when plotted as a cumulative line, in conjunction with an index. A quick glance at any divergences between the AD line and the chosen composite gives a clue as to overall strength or weakness, frequently six to nine months ahead of a definitive market turn.

Remember the adage, “three steps and a stumble”? In other words, after the central bank has hiked rates three times, the market has a tendency to turn tail. Accordingly, the well tested AD line rule of thumb operates best in a rising interest rate cycle, explains Louise Yamada, who publishes TechPoints, a monthly newsletter. As she described in the recent July issue, the logic behind that historical pattern is that some deterioration in a large number of interest rate sensitive issues would often show up initially, as rates backed up. Ms Yamada prefers to use an Operating Company Only (OCO) line, encompassing all common stocks, to filter out these factors.

The key point is that all sectors do not degenerate at once, but tend to falter at different speeds, stage by stage. For example, in 2007, US equities stumbled in batches, first tumbling in the housing sector, and then exhibiting weakness among financial issues. Some groups, like railroads, even remained buoyant up until the final market peak. Ms Yamada was particularly vocal in 2007, when she noted that toppy homebuilders and financials were already giving out warnings. By October 2007, the New York Stock Exchange index had reached a new high, but ominously, the AD line was not confirming it.

Both positive and negative divergences deserve attention. During the dark days of 2002, the NYSE and the AD lines were each breaking new lows. By March 2003, however, the NYSE was still trailing along its bottom, but the AD line suggested a glimmer of hope, as it traced out a higher low.

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