What My Market Health Indicator Is Telling Us In The New Year…

I’ve lost faith in the “Santa Claus” rally. Yes, I realize that Christmas is over. But historically the Santa Claus rally would run into January, providing a nice jump start on the New Year.

While the S&P 500 did hit new highs to close out the year, and even into the first couple of trading days of January, we didn’t get the overall signs of strength that I’d expect to see.

To put it more specifically, I’m talking about market breadth…

When the S&P 500 closed at a new high last week, 334 companies trading on the New York Stock Exchange hit a 52-week low. That’s more than double the amount of those hitting 52-week highs.

The last two times that happened were just prior to the tech bubble collapse over twenty years ago.

To understand this better, I want to turn to one of my favorite indicators — the AD Line (Advance/Decline Line).

I touched on this indicator repeatedly last year, most notably here, here, and here. In those cases, it helped us forecast the market weakness heading into the holidays last year. And while that weakness was relatively minor, it has a pretty good history of steering us clear of much worse.

For a quick recap, the AD Line is a breadth indicator that measures how many stocks are rising compared to falling.

In a healthy bull market, we tend to see a lot of stocks participating in the rally. This is a good sign that the rally is being driven by real economic factors and the investor enthusiasm that should accompany it. In short, it confirms the bullish trend. However, if the AD Line fails to keep pace with the underlying index, this is a sign of weakness.

When a major index hits new highs and the AD Line doesn’t follow suit, this is known as a bearish divergence. This is a clear warning sign that there’s major weakness in the market.

Here’s what the AD Line is showing us as of last week…

What This Means For Us

As you can see, the AD Line didn’t even come close to making a new high when the market did earlier this week.

A major thorn in the market’s side has been the high-growth tech stocks that have been leading the charge for the last few years. I’m talking about all the pandemic darlings that delivered outrageous returns in 2020 and 2021 — which we gladly profited from.

But when the tide turns, it’s best not to ride it out hoping it will bring you back in. In other words, don’t hold onto those once-big winners thinking they’ll quickly return to their old highs.

Of course, they certainly could rebound and return to their old highs (only time will tell). But they also could drift much lower. Remember, momentum works both ways. The trend is your friend. Don’t try and swim upstream. And it’s best to not try and catch a falling knife.

Okay, enough of the clichés… hopefully, you get the point.

This is why I’m such a fan of keeping your losses small. You may think that sounds nice, wouldn’t we all… But there are practical ways to do this — not the least of which is with stop-losses.

For example, over at my premium services, we had a few stocks that hit their trailing stop losses over the holidays. And just last week, we had a few more hit. In just about every single case, we either booked a significant profit or a small loss. And that’s how you win in the long-run.

Closing Thoughts

You might recall that, in this article, I talked about the need to keep our losses smaller. After all, one of Warren Buffett’s famous sayings is to “Never lose money.” I know Buffett is a long-term investor and not a trader, but the rule especially applies to traders like us.

To help reach that goal I will occasionally shore up my stop losses if our trades aren’t setting up how I like. I may also do this if I’m seeing weakness in the overall market or a particular sector — both of which happen to be the case this week with a rotation out of the tech sector as well as a bearish divergence in the AD Line.

Consider doing this in your own trading until we get a clear read on how this New Year is shaping up.

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