Want To Know If A Market Rally Is Healthy And Strong? Here’s How…

Market breadth indicators are designed to help traders gauge the relative health of a given market or index. It is based on the number of stocks going up or down. The Advance-Decline (A/D) Line is the simplest way to measure breadth.

Every day, the major exchanges report the number of stocks that closed higher (advancing issues, or AI) and lower (declining issues, or DI). The A/D Line can also be found for any group of stocks, like the Dow Jones Industrial Average, by tracking the direction of the close for the stocks in that group. The A/D Line is found by subtracting the number of declining issues from the number of advancing issues (AI – DI).

Positive breadth means that the number of advancing issues is greater than the number of declining issues. This indicates the majority of stocks are moving higher.

Negative breadth is when the number of declining issues is greater than the number of advancing issues. This indicates the majority of stocks are moving lower.

How Traders Use Advance-Decline (A/D) Line

In a strong price trend, the A/D Line will move in the same direction as the price. If the majority of stocks are advancing while prices are moving higher, as measured by a major index like the S&P 500, then breadth is confirming price. In a downtrend, prices should fall while the A/D Line declines. Divergences between price and breadth are usually signs of a potential trend reversal.

For example, in 2007, the market indexes pushed to new highs while breadth was falling. This is shown in the chart of the NYSE Composite below.

A/D Line

Following breadth may lead to a number of false signals, a problem that is common with other indicators. For example, the recovery in the A/D Line of the S&P 500 late in 2000 did not lead to an upward trend in the indexes. The gain in the A/D Line was most likely due to individual investors trying to find bargains in the aftermath of the dot-com crash.

Why It Matters To Traders…

Gauging breadth helps traders confirm price trends. If a market is rallying with broad participation from components of the index, then it’s considered healthy and bullish. If breadth reverses, then it may be time to sell.

If an index is rising to new highs, but the A/D Line doesn’t confirm (meaning it isn’t keeping pace or hitting new highs), then it is means only a few components are leading the charge higher. This is considered a bearish divergence, and a potential sign the index is about to decline.

On the flip side, if an index is declining and the A/D line confirms, then means there is broad participation in the decline. This is a bearish sign, signaling a particularly weak market.

If the index is declining and the A/D line does not reach new lows, then this means that fewer stocks are leading the charge lower. This is called a bullish divergence — a sign that the declines may be near an end.

Divergences tend to be very important at significant market tops. Because many individual investors buy more stocks when markets are falling, the A/D Line may be less useful in declines.

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