THE ADVANCE/DECLINE (A/D) LINE GIVES THE TRUE MARKET PICTURE

Throughout our last several Swing Trader issues I've brought you an educational series on how to read the signals given off by the overall market. Last week I discussed new highs and new lows, a powerful indicator that can anticipate the turn from bull to bear market and vice versa. A similar, and equally potent, indicator is the advance/decline, or A/D, line.

Swing traders should use advance/decline data in two distinct ways. On a daily basis, traders should monitor the ratio of advancing issues (those closing up on the day) against that of declining issues (those closing down on the day). In most cases, the advances and declines will be in rough agreement with the price of a major average such as the S&P 500 or NYSE (New York Stock Exchange Average). On Thursday, April 15th, for example, the NYSE was up 18 points, or less than +0.3%. The number of advancing stocks came in at 1689 versus 1607 declining issues; the net difference was +82, a figure that reflects the flat market.

In some cases though, you'll find a divergence between the number of advancing/declining issues and the price of a major average. For example, let's take a look at the figures from Wednesday, April 14th. On that day, the NYSE fell 32 points, or just -0.5%. Advancing issues, however, came in at 735 compared to 2617 declining issues. The net figure was a whopping -1882. This number was far, far weaker when considered alongside the relatively small change in price.

This situation portrays a much weaker market than can be gleaned by just looking at the surface price action. Advances/Declines are a "breadth" indicator. On Wednesday, the market clearly had a dismal day based on this indicator. When I see a divergence between price and breadth, I always trust breadth. Not surprisingly, the market struggled to rally the next day and sold off sharply in intraday trading.

The second way swing traders should use the advance/decline information is by analyzing the A/D line. Many technicians consider the A/D line the single best indicator of market strength and direction--more accurate than any price-based average, such as the S&P 500, at describing the true market picture.

When observing the A/D line, the key question to ask is whether it is confirming or diverging from the market's underlying price action. As with new highs and new lows, which we discussed last week, confirmation occurs when price and breadth are moving to new highs (or lows) in tandem. Meanwhile, bearish divergence occurs when the price of an index, such as the NYSE, hits a new high, yet the advance/decline line tops at a lower peak. Bullish divergence is the opposite.

This divergence can last for very long periods of time. For example, although the A/D line on the NYSE peaked in April 1998, the NYSE Index itself didn't peak until September 2000. The divergence lasted a full 30 months! While A/D divergence is not a timing tool, it does often indicate that the market's direction is "suspect." As such, it should put the swing trader on alert to the possibility that the Primary market trend may reverse.

The advance/decline line can also be analyzed with trendlines and support and resistance levels. The steeper the A/D's slope, the stronger the trend. The longer the trend has been in force, the more valid it is.

Below you will find a six-month chart of the NYSE, daily net advances and declines and the A/D line. There are several important observations. First, examine the dramatic acceleration of large red bars (declining issues) since February 2004. The market has been unusually weak recently based on breadth. This weakness is confirmed by the number of new lows, which strongly exceeded the number of new highs on Wednesday, April 14th for the first time in over a year.

Second, note that the uptrend in the A/D line, which lasted from late November to early March, is now over. In its place, a downtrend has emerged in the A/D line. I have drawn a support line under the February low. If that level is broken, then the A/D line will have created an important top. If that happens, it provide us with yet another signal that the underlying health of the current bull market is suspect.

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