STRATEGIES

These past case studies show that the Advance/Decline (A/D) line is the most effective tool for stock investors to use when looking to identify key trends and market bottoms.

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

chart
Click to Enlarge

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.