A Potential Head-and-Shoulders Top for the Nasdaq A/D Line

06/22/2010 12:01 am EST

Focus: TRADING

The Nasdaq’s advance/decline (A/D) line is the difference between the number of advancing and declining issues that make up the Nasdaq composite ($COMPQ). If more issues are advancing than declining, the A/D reading for that day would reflect a positive number. In contrast, if declining issues are outpacing advancing ones, the reading would be negative for that day. The information, either positive or negative, is then added to the cumulative total, which we refer to as the A/D line. If advancers are consistently outpacing decliners, the A/D line will trend higher, but if declining issues prevail, the A/D line will decline and trend lower.

The A/D line is the most widely watched market breadth indicator because of its usefulness in determining market direction. A market breadth indicator predicts the strength of the market based on the number of issues that are advancing or declining.

The Nasdaq 's A/D line has been in an uptrend since March of 2009, but in May of 2010 that trend broke. Further, the Nasdaq pierced through its long-term trend line in agreement with the A/D line. After penetrating through their trend lines, both the Nasdaq and the A/D line drifted down to test the February lows. In doing so, a head-and-shoulders top is carving out on both indexes (see graphic below).


Click to Enlarge

The recent selloff from the April 26 high has completed the head formation on the daily charts of both the Nasdaq and the A/D line. Should the rally continue, a right shoulder could etch out and complete the patterns. Once a lower high is clearly established on the Nasdaq and a pivot reversal transpires, taking prices back down to the neckline just above 2,100, then the pattern will be completed. Should prices collapse through the neckline of support, it will confirm the bearish pattern and change the long-term trend.

By penetrating through the neckline, we will have a confirmed lower high and lower low. It is a series of lower highs and lower lows that define a downtrend. A break to a new low would be quite bearish for the Nasdaq. So far, the Nasdaq A/D line has moved in tandem with the Nasdaq, but if a right shoulder forms on the Nasdaq, we’ll want to see one form on the A/D line. If the A/D line breaches its neckline in unison with the Nasdaq, it will validate the head-and-shoulders pattern.

In addition to this very bearish pattern looming over both the Nasdaq and the A/D line, the moving averages are showing weakness. Both indexes saw their 20-day exponential moving average‘s (EMAs) cross below their 50-day EMAs after the trend break. Shortly after the Nasdaq and A/D line bottomed out in March of 2009, the 20-day EMA crossed above the 50-day EMA. During the entire advance it remained above it. But during the last correction, both indexes got a bearish cross, suggesting that the advance has now run it course. The 20-day EMA briefly crossed below the 50-day EMA on the Nasdaq during the correction in February, but the Nasdaq 's A/D line never confirmed that crossover. This is the first time during the advance that the moving averages got a bearish crossover simultaneously (see graphic). This is very bearish and may hint a strong possibility that the right shoulders can form and do further damage to the tech-heavy Nasdaq.

By Ron Walker of TheChartPatternTrader.com

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