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…Many of us think Wall Street is using sophisticated tools to make money. It is…but big Wall Street firms also use simple tools to make money…One tool many large firms use is the advance-decline line.
The original article by Matt Badiali has been edited here for length (…) and clarity ([ ]) by munKNEE.com to provide a fast & easy read.
The Advance-Decline Line
…The advance-decline line indicator subtracts the number of stocks that closed down every day (declines) from the number that closed up (advances). The A-D line is the blue line in the charts below. The S&P 500 Index is the black line.
The above four charts show the market action before significant declines. In each case, the A-D line (the blue line) was in a downtrend before the S&P 500 turned lower. This happened before bear markets that led to losses of 50% or more in 1972, 1999 and 2007. It also happened before the 1987 crash.
The A-D line simply counts how many stocks are going up. In a bull market, we expect most stocks to be going up. In a bear market, the majority of stocks should be going down. That is a simple idea, but, as the charts show, it’s an important indicator to follow.
Near market tops, we see fewer stocks going up. The index is moving up because just a few large stocks are producing gains.
- In 2007, housing stocks and financials were still moving up after most stocks peaked.
- In 1999, internet stocks were the market leaders while most stocks were in downtrends.
- In 1987, traders were buying just the largest stocks for a strategy called portfolio insurance. That insurance failed spectacularly in October.
- In 1972, the Nifty Fifty became popular, and investment managers bought just the 50 largest companies.
Narrow buying always leads to a sell-off. That means we should watch the A-D line for an advance warning signal of the next bear market.
The next chart shows the indicator right now.
Conclusion
The S&P 500 and the Advance-Decline line are in synch. As long as they remain in synch, a bear market is unlikely. We might see a pullback, which is a decline of 5% to 10% but that will be a chance to buy more stocks and prepare for the next upturn.
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