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.
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 (NYSEMKT: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.
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.
The A/D line remained very positive until February 2007, when negative news on the Chinese market caused a sharp selloff in the US. This took the A/D line below its weighted moving average for the first time since July. The A/D line did hold up better than prices and formed a slight positive divergence before turning higher.
The market high in 2007 was a textbook example of A/D line analysis. After the February drop (see Figure 2), the A/D line rebounded sharply, and by March 20 (line 1), it had already moved above the previous high, line a.
The A/D line was again leading prices higher, as the sharp rally continued into early June when the A/D line made its bull market high at point 2.
The A/D line developed support in June and July, line c, but when SPY made a new high on July 17, the A/D line failed to make a new high (point 3). This bearish divergence is illustrated by line b.
The A/D line dropped sharply into the August lows and moved well below its weighted moving average. (The wide gap between the A/D line and its WMA was indicative of an oversold market.)
By early September, the A/D line was again in an uptrend (higher highs and higher lows), and on October 11, 2007, SPY hit a high of $157.52, but the A/D line was much lower (point 4). The A/D line had just rallied back to its downtrend, line b, and the former support (now resistance) at line c.
Just to illustrate that this type of A/D line analysis has worked for many years, this chart covers the NYSE Composite from May 1972 through April 1973. This is the market top that was followed by the massive bear market of 1973-1974.
Prior to our recent financial crisis, this was the worst bear market since the Depression. (Though I was not trading the market at the time, by the late 1970s, I had studied this period in detail using historical charts!)
Click to Enlarge
The NYSE A/D line peaked on May 26, 1972 with the close in the NYSE Composite at 648.66. The market stayed in a broad range until the latter part of October, as the A/D line was forming lower lows. The A/D line moved above its weighted moving average on October 26 and the NYSE Composite rallied over 11% by early December, point 2. On this high, the A/D line was much lower, line b.
The NYSE Composite made another new high on January 11, but the A/D line was not able to move above its declining weighted moving average and formed a much lower high, point 3.
This second bearish divergence signaled that the market was internally weak. The drop below the A/D line support just two weeks later (line c) completed the top. By the final low in October 1974, the NYSE Composite had lost over half its value.
As for more recent history, the market bottom in March 2009 came at a time when many investors had already given up on the stock market. The selling into the November 2008 lows took the stock market, as well as the A/D line, to dramatic new lows. Stocks finally rebounded into early 2009 and stabilized before another wave of selling hit in February 2009.
As the major averages headed back to test their lows, the market internals had improved and the A/D line started to act stronger. This was evident in a chart that was posted on February 25, 2009.
If the market was actually bottoming, then finding the strongest sector was obviously quite important. After running my relative performance, or RS analysis, on the key sectors, there was one sector that stood out, which I noted on March 4 (see "Tech Sector Breaks Out.")
The positive view of the RS analysis was consistent with the analysis of Tradestation's Advance/Decline data on different market averages which includes the S&P 500, Dow Industrials, Amex Index, Russell 2000, and Nasdaq 100.
In the above chart, I have plotted the PowerShares QQQ Trust (QQQ), the ETF that tracks the Nasdaq 100, versus the Nasdaq 100 A/D line. The A/D line made sharp new lows in November, as did QQQ before it rebounded back to the $31.63 level in both December and January (line d). The March 9 lows in QQQ at $25.63 were just above the November 2008 lows at $25.06.
Though it is tough to tell on the chart, the Nasdaq 100 A/D line did make slightly lower lows in March. It had tested its downtrend from the June 2008 highs in February (see circle) but failed to move through it. The A/D line rose sharply from the lows and broke its downtrend on March 23.
By early April (line 1), the A/D line was in a new uptrend, as tests of its weighted moving average were well supported. Further resistance for QQQ at $33.85 was overcome by the end of April, which was confirmed by the A/D line.
Both QQQ and the A/D line formed corrective flag patterns in July before both again moved sharply higher. The A/D line stayed positive and held support (line e) and by April 2010, QQQ had moved above the $50 level.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.