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Advance-Decline Line
The Smart Profits Report: Issue #474
Friday, November 16, 2007
The Advance-Decline Line: This Technical Analysis Indicator Will Show You Where The Market Is Headed Next
By Jim Stanton
Quantitative & Technical Analyst, Mt. Vernon Research
I got a phone call the other day from a friend of mine. Knowing that I’ve been in the finance and investment business for over 30 years, he turned to me to give him some answers.
His question was very simple - and he’s certainly not the only investor asking it these days: "What’s the deal with the market, man?"
Quite a task, considering how volatile and unpredictable it’s been over the past few weeks! But thanks to my many years of research and experience, plus my cutting-edge analytical system, I was able to give him some clues. And now I’m going to give you some, too. And we’re going to do it using one of the most powerful, reliable technical analysis indicators in the business, the Advance-Decline line…
Don’t Let Technicals Terrify You… Here’s One The Simplest, Most Revealing Market Indicators
When a bull market is in full swing, most ordinary investors don’t realize that in order for the run to continue, it needs a number of technical indicators to sustain its momentum. Some of the most common include:
- Increased trading volume
- Stocks making higher highs and higher lows
- Continued price action above important moving averages
- Holding support on market pullbacks
- Participation in the rally by all the indexes
But there’s another very important market indicator - and you don’t get many simpler ones than this. It’s called the Advance-Decline line. Simply put, this is a cumulative calculation, where the number of advancing (or declining) stocks is added (or subtracted) to the previous day’s total.
Typically, the Advance-Decline line should increase over time during a bull market or rally, and decline during a bear market or pullback.
Let me give you a real-life example of this indicator at work…
Giddy Investors Got Burned - Smart Investors Were Clued In
On October 31, the Nasdaq 100 index bolted to a new high for the year. Happy Halloween, right? Not so fast. Just as giddy investors prepared to ride the rally all the way to the end of the year, I spotted something that should have truly spooked them. The Nasdaq Advance-Decline was vastly underperforming the main index. A significant red flag.
Below is a chart of the cumulative Advance-Decline line for the Nasdaq exchange from mid June to the present date.
As the chart shows, the Advance-Decline reading was very high throughout June and the first part of July, as all the major indexes set new highs for the year. But just look at the way the line totally fell off the cliff in mid July. That coincided with the brutal market correction that bottomed out in mid August.
The indexes then rallied strongly off those August lows and went on to make new highs for the year on October 11. However, the Nasdaq 100, which was performing stronger than the other indexes, rebounded more strongly off the August lows. It actually continued to climb until the end of October, while the Dow and S&P 500 did not. (When looking for potential market weakness, it’s always better to take the readings from the index that has led the way).
But here’s where the Advance-Decline reading can really tip you off…
Look At What The Herd Is Doing With The Advance-Decline Line
As you can see, despite the August-October 11 rally, the Advance-Decline line didn’t make much headway. This was the first warning sign - but it got worse from there. Even though the Nasdaq 100 continued to move higher and set new 2007 highs at the end of October, not only did the Advance-Decline line lose ground, it was trading below the August lows.
Okay, so what does this mean? Simply put, this tells us that the Nasdaq rally from mid August was very narrow and was moving higher on fewer rising stocks. In this case, mammoth tech companies like Google (Nasdaq: GOOG), Apple (Nasdaq: AAPL), and Research in Motion (Nasdaq: RIMM) were supporting the Nasdaq.
This type of technical weakness in the Advance-Decline line is usually a key sign that the rally is running out of steam and that a reversal is becoming more likely.
On November 2, just two days after the Nasdaq 100 set a new 2007 high, I sent out a market update to my ESP Profit System subscribers. In it, I highlighted the vast underperformance of the Nasdaq Advance-Decline line.
And one look at the stock market’s brutal performance this month shows you that this weakness turned out to be a very accurate warning sign. Just 10 days later (November 12), the Nasdaq 100 had slumped 11.5%, from its 52-week high of 2,239 on October 31 to 1,980 - its lowest level since September 17.
Who Cares About Bulls Or Bears? The Advance-Decline Line Satisfies Both
The example above shows you how the Advance-Decline line is an invaluable indicator during rising markets. But you can also use it when the market is declining.
If an index is falling and approaching a support area, we’d be looking for relative strength in the Advance-Decline line for signs of a potential reversal. If that’s the case, it means the selling is occurring in fewer and fewer stocks and a reversal to the upside becomes more likely.
Although a divergence in the Advance-Decline line is not required for a market reversal, when it does occur, we want to be sure to wait for the index’s price action to confirm the move. The above example demonstrates this well: Although the Advance-Decline line began falling sharply on October 12, the Nasdaq indexes continued to rally and did not signal a breakdown until the first week of November.
You can find Advance-Decline statistics for the NYSE, Nasdaq and AMEX here.
Good investing,
Jim Stanton
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Today’s Smart Profits Action Center
- Jim Stanton is the Investment Director of the ESP Profit System (ESP), a cutting-edge, computerized trading platform that nails down the movement of stocks and indexes with pinpoint accuracy. Not only will you learn what’s going to happen, you’ll also find out when it will occur, and how much the asset could move, so you know exactly what action to take.
For three decades as a stockbroker, bond broker and commodity trader, Jim has used this powerful blend of technical analysis, chart pattern recognition, and quantitative data to make money for private investors, institutions and hedge funds. Over two years, he amassed audited gains of over 400% on S&P futures and scored more than two-dozen double-digit winners. He’s a winner of the U.S. Trading Championship (options division), with a return of more than 300% in just three months. For more information, please click here, or call our VIP Trading Services Team at: 888.570.9830 or: 410.454.0498. - The Commerce Department’s latest Consumer Price inflation report made grim reading this morning. Fueled by the biggest spike in energy costs in five month, the overall inflation number rose by 0.3% in October. It was the second straight month that consumer inflation rose by that amount. Through the first 10 months of the year, consumer prices have climbed at an annualized rate of 3.6%. That’s 1.1% higher than the rise for all of 2006.
- With a 1.4% rise in October, energy prices are soaring at an annualized rate of 12.3% this year, compared with a 2.9% increase for all of 2006. Americans are starting to endure the impact of oil prices in the $90s, with gasoline costs up 1.4% in October - the biggest rise since a 10.5% spike in May. The national average price per gallon is $3.11, just 12 cents away from the all-time record in May.
- The inflation news deflated investors again today on concerns that consumers will cut back on their spending during the crucial holiday season period and deliver a blow to the economy. The Dow Industrials dropped 120.96 points (0.9%) to 13,110.05, the Nasdaq shed 25.81 points (1%) to 2,618.51, while the S&P 500 lost 19.43 points (1.3%) to 1,451.15. The price advance-decline readings were brutal. Just 21% of stocks on the NYSE rose today, versus 77% that lost ground, while only 27% of stocks on the Nasdaq advanced against 69% that saw a drop.
Related Articles:
- The Stock Markets: Using ESP To Chart The Next Move As The Indexes Race To All-Time Highs
- Technical Analysis: Two Simple Tools for Spotting a Technical Trend
- Stock Market Volatility: Three Ways to Combat Volatility’s "Radical" Shift
