What This Indicator Is Telling Me About The Market Rally

When we see a strong selloff, like with the recent Covid-19-fueled rout, it tends to make investors worried. And rightly so.

But when a rally begins, they can become hesitant and anxious. That feeling only increases as the market continues to surge higher and higher.

It’s like we’re waiting for the other shoe to drop. And it makes sense… after all, in just three months the S&P 500 is up more than 23%.

How much higher can it go?

One way to check the strength of this market rally is to check in on the Advance/Decline Line (AD Line).

If you’ve been with us for a bit, then you may remember where I’ve talked about this breadth indicator numerous times in the past. In fact, back in May 2019, I cited it as a reason for why the market could continue to rally. (The S&P 500 rallied another 18% or so before reaching its peak.)

And in the early days of the coronavirus crisis, back in February, I cited this metric as the key indicator I would be watching. Specifically, I told readers I would watch it to confirm whether the ensuing rally is healthy or not.

How To Gauge Market Breadth

For a quick refresher, the AD Line tells us how many stocks are rising versus falling. If a market is rallying, we want to know if this rally is because of only a handful of stocks. Ideally, we want to see strong market participation. This means a lot of stocks are pushing the market higher and that the rally is strong and healthy.

But if the market reaches new highs, while the breadth indicator doesn’t, that’s called a bearish divergence. This has historically led to a market pullback.

For example, in the fall of 2018 we had a bearish divergence:

As you can see, when the market reached new highs in September 2018, the AD Line didn’t confirm that new high. Over the ensuing three months, the market tumbled by nearly 20%.

Again, when the market rallies we want strong participation from a lot of stocks to confirm that it’s a healthy rally.

While the S&P 500 hasn’t hit a new high (yet) the rebound off its March low has been strong. Here’s what the AD Line looks like today:

As you can see, the AD Line hit a new high on June 5. That means the rally is broad and healthy and a bust isn’t imminent.

Action To Take

Long story short, as of right now, this indicator is giving us the green light. Of course, we will still likely see wild swings in the market. And this is just one indicator. But it’s one of my favorites, as it has proven to be reliable in the past.

A word of caution, though. It is worth noting that this indicator won’t help us if we have a black swan event like the coronavirus pandemic, which was a sudden and swift event that ended our historic bull market.

This indicator is better at revealing what’s lurking beneath the surface of the market and economy. It has an impressive record of letting us know when a bear market (or large pullback) is looming.

But right now, it’s telling us that another bear market isn’t imminent.

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