STRATEGIES

Traders can use divergence analysis and proven indicators like the Advance/Decline Line to identify critical market turning points—like the one that seems to be unfolding this week.

For most veteran analysts, technical analysis is part science and part art, as the indicator patterns require some subjective analysis. In timing the stock market, there are a series of tools that I use to determine whether or not the market is healthy. As we approach the summer months, which is often a difficult period for stocks (think “Sell in May and go away”), I like to keep an even closer eye on the market’s health.

I have been using divergence analysis for over 25 years and determined early on that relying on divergences in just one time period was dangerous. On the other hand, significant turning points often coincided with weekly divergences that were then confirmed by the daily analysis.

This is rarely pointed out in the current trading world, as some analysts have concluded that divergence analysis doesn’t work based on their analysis of only the daily data. Others who do believe in divergence analysis can often come to the wrong conclusions when they look at divergences in only one time frame.

One of the most powerful tools for market timing is the divergences that occur between the Advance/Decline, or A/D line, and the major stock market averages. Let’s first look at the weekly NYSE A/D line.

Figure 1

chart
Click to Enlarge

In the above chart, I have combined the weekly NYSE Composite A/D line and that of the Spyder Trust (SPY), which is more familiar to most traders than the NYSE Composite. I am continuously monitoring the relationship of both averages to the A/D indicators, but over the years, I have found the signals to be essentially identical.

At the late-April 2010 highs, the weekly A/D line failed to make new highs with SPY, therefore forming a negative divergence, line c. The following week, the A/D line violated its uptrend, line d, confirming that a trading top had been completed. Though the daily A/D line will generally form a divergence at the same time, it did not form such a divergence at the April 2010 highs.

The weekly A/D line declined for the next five weeks, bottoming in early June (point 1) while the SPY made its low five weeks later at point 2. The higher low in the weekly A/D line (point 2) was a bullish divergence that was confirmed when the downtrend in the A/D line was overcome (line c).

The A/D line broke out to new highs during the first week of September, as it was acting much stronger than prices. This was a very bullish development. Several days later, the daily A/D line also broke out to new highs. (See “Advance/Decline Line Hits New High.”)

The A/D line’s major uptrend from the lows, line e, is still intact. The weekly A/D line only had a minor pullback in mid-March when global markets reacted to the disaster in Japan. This was a sign of strength and helped convince me at the time that the decline would not last long.

Earlier this month, the A/D line made another new high, but it turned lower last week. Since the weekly A/D line has confirmed the most recent highs, there are no signs yet of a top, but one could still form before the end of the month if the A/D numbers do not keep pace with prices.

NEXT: Analyze Latest Chart Action for S&P 500

Tickers Mentioned: SPY, QQQ, IWM