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The Most Important Gauge of Stock Market Health: Technical Analysis 101: The Advance/Decline Line

Technical Analysis 101: The Advance/Decline Line

Professional portfolio managers and financial advisors use a variety of analytical tools. Many of these tools are also available to individuals seeking to save for retirement, college education, and other common investment goals. Advanced technology provides a wealth of different ways to determine when individual stocks, sectors, and even the market as a whole should be bought and sold to help manage portfolio risk and reward.

But you don’t need specialty software to help determine investing trends. There are many aspects of simple technical analysis that have become increasingly popular among those who want to keep track of their investments in mutual funds, exchange-traded funds (ETFs) and other vehicles.

Differences Between Fundamental Analysis and Technical Analysis

Many investors use a combination of fundamental analysis and technical analysis to make investment decisions. Fundamental analysis involves analyzing a company’s financial statements to determine the fair value of a business, while technical analysis assumes that a security’s price already reflects all publicly available information and instead focuses on the statistical analysis of price movements.

More specifically, technical analysis attempts to understand the market sentiment behind price trends by looking for patterns and trends rather than analyzing the specific fundamentals of a security.

Generally speaking, fundamental analysis requires specialized knowledge of how to read the financial statements of publicly traded companies, all of which are required by law to be made available online. Technical analysis, however, can be performed with the use of online tools that identify such widely used trends as 50- and 200-day moving averages and market volume over time.

For those seeking an elementary analytical tool that has stood the test of time, a good way to start is by becoming familiar with the Advance/Decline (A/D) Line and how it’s used.

A Brief History

A/D data was first calculated and analyzed back in 1926 by Colonel Leonard Ayres, an economist and market analyst at the Cleveland Trust Company. Shortly thereafter, James Hughes pioneered what became known as Market Breadth Statistics. In 1931, Barron's started to publish A/D numbers, which can still be found in its printed publication every week. A/D data came into prominence in the early 1960s when prominent investment newsletter publishers began to use it as part of their market analysis.

Simply put, the A/D Line is perhaps the best way to gauge the market’s overall health. It’s typically used for an entire index, like the NYSE, Dow Jones Industrial Average, S&P 500, and NASDAQ.

In fact, some notable investors say the weekly A/D information is the first data point they look for to help gauge market sentiment.

A Closer Look

The A/D Line is a market breadth indicator that analyzes the number of stocks advancing minus those that are declining. Positive market breadth occurs when more stocks are advancing than are declining, suggesting that the bulls are in control of the market’s momentum. A bearish momentum would result when there are more declining stocks.

It’s important to note that A/D data is best used when it includes all stocks in a specific index. Many times, the performance of a handful of companies can belie the health of the overall market one way or another.

The A/D Line is most commonly used to plot the difference between the number of advancing and declining stocks on a daily, and sometimes weekly, basis. When calculating the A/D Line, the total number of stocks of the underlying index that went higher are added each day while the number of declining stocks are subtracted. The net number is then added to the prior day’s total, creating a running total of advancing minus declining stocks.

The A/D Line is used to determine market sentiment, as it tells investors whether the majority of stocks in an index are rising or falling. It is used to confirm price trends in major indexes and can also warn of reversals when divergence occurs.

For example, if the S&P 500 is rising and the A/D Line is falling, it indicates the current uptrend may be losing its momentum. But if the S&P 500 is falling and the A/D Line is rising, it suggests that the market’s move lower may be about to reverse and begin moving up.

Detecting Divergences

Divergence is the disagreement between the stock market index and the A/D Line, and can result in significant implications for investment management. If the index moves up while the A/D Line moves down, the index may be misleading about the true direction of the overall market.

Such negative divergence has occurred at major market turning points such as the end of the Roaring ‘20s bull market and during 1972 at the height of the Nifty Fifty market.

However, the most notable was just prior to the 2008 bear market.

Technical Analysis 101: The Advance/Decline Line

Identifying a divergence can help the investors recognize and react appropriately to a change in price action. It tells us something is changing and investors must decide, if they want to take some risk off the table. Seeing divergence increases the profitability of protecting your investment gains.

Limitations

Technical analysis tools should never be used in isolation because they all have their limitations and the AD line is no different.

For example, the A/D Line does not weigh the exact percentage a stock moved, only that it is an advance or decline. Therefore, a stock could set a record for the most value lost by a stock in a single day, but the A/D line would only see that day as a decline, giving it the same weight as if another stocked dropped by only one basis point, or 0.01%.

The A/D line is all relative; it all comes down to the difference in the daily change in price and the number of positive and negative days that occur. A stock may see more positive than negative days, but the stock could move more on the down days, which would lead to an overall positive breadth contribution of the stock that was in a downtrend.

Critics of the A/D Line, as it applies to the New York Stock Exchange (NYSE), argue that today’s version of the index is tainted. A large part of the index is now composed of bond related closed-end funds that have a positive bias. But I don’t believe that argument is valid. Sometimes, the bond closed-end funds can prove to be a better indicator of stock market direction than the stocks themselves. You want a tool that gives you a different answer from what the “price” is saying, otherwise the entire exercise is pointless.

This is why the A/D Line can be misperceived. Just because a stock provides a positive contribution to the indicator doesn’t mean that it’s in a healthy uptrend as one may believe based on the reading the breadth gauge is showing.

How Potomac uses the AD Line?

The concept of an A/D Line and evaluating market breadth is built into just about everything we do in terms of applying technical analysis.

Our technical indicators use a combination of index price movements and their relation to market internals such as the A/D line. This concept is known as “inter-market” analysis and was coined by John Murphy, which essentially states that that markets do not move in isolation.

In order to properly extract value from market trends, one must study the relationships between what would seem like unrelated markets and or data points. A great example of that is our Intermediate Momentum System that tracks five underlying data points.

Technical Analysis 101: The Advance/Decline Line

We look for divergences between an index and its underlying components. Typically, a healthy market will display broad participation when the majority of an index’s constituents are participating. By comparison, an unhealthy market is where a handful of stocks are driving index prices higher while many of the index’s other constituents are declining in price.

This isn’t a buy-and-sell indicator. It serves as one gauge of the overall market environment.

Think of it as taking your blood pressure or your cholesterol level. Neither is indicative of imminent death. But if ignored over time, both can have grave consequences.

A Complementary Tool

The A/D Line can tell you a lot about the state of a specific market or a particular industry. For example, when an index is ascending even as it’s A/D Line is descending, it’s likely that relatively few stocks are contributing to that growth, which could be a sign that that market is vulnerable to a correction. That was certainly the case with the New York Stock Exchange (NYSE) composite index in the months leading up to the 2008 bear market.

Even if the two lines were to diverge dramatically, investors would be wise to avoid decisions based on the A/D Line alone. When an A/D Line starts to fade, I view it as an opportunity to be more cautious. You might cut back on your exposure to stocks a bit, but don’t use it as the sole argument for exiting the market altogether.

Parting Thoughts

Investors who are constantly on the search for the holy grail of investing indicators or get rich quick trading systems will always be left disappointed. Why? Because it simply doesn’t exist.

However, you can use technical tools such as the A/D line to give you a general sense of the current market environment.

Often times, the A/D Line is typically plotted over the top or below the security's price and is commonly used with a histogram of advances and declines below it. Using these two indicators, investors can see whether a trend is gaining or losing momentum.

Since the A/D Line does not take into account the magnitude of daily changes in price of the underlying stocks, a lack of a bearish divergence in a single indicator is not necessarily reflective of a positive confirmation of an uptrend. A stock can be in a downtrend while still positively contributing to market breadth, blunting the usefulness of a perceived breadth confirmation by the A/D Line. This is why I personally feel divergences in the A/D Line are much more useful than confirmations of an underlying trend.

It’s my belief that the use of multiple pieces of data is important in applying analysis to a market and specifically to the evaluation of trend participation. We can be much more confident if multiple breadth gauges are pointing to the same conclusion such as a rising A/D Line, an uptrend in new 52-week highs, more stocks rising above their long-term moving averages, etc.

The bottom line: An index’s A/D Line can help you gauge the overall health of a market or an industry, but it shouldn’t be the only metric you consider.


Disclosure: This information is prepared for general information only and should not be considered as individual investment advice nor as a solicitation to buy or offer to sell any securities. This material does not constitute any representation as to the suitability or appropriateness of any investment advisory program or security. Please visit our FULL DISCLOSURE page.