Use this 5 Step Analysis to Understand how you can use the Power of the Advance-Decline Line & Market Breadth to make better investing decisions.
What is Market Breadth?
Market breadth is a way of measuring the moves of the stock market in general by comparing the number of stocks that rise compared to those that fall or comparing stocks making new highs to those making new lows.
The Advance Decline Line (AD Line) is a useful indicator that measures if the broader market is advancing or declining.
This enables you to see not just if the Dow Jones Industrials components are moving up but if all the stocks in the NYSE are increasing. The reasoning behind this is that if all stocks are increasing in a synchronized manner with the bigger indexes all is well.
If most stocks are beginning to move downward and the Dow Jones Industrials or the S&P500 are still increasing this could be a sign of a significant change in market direction. The Battlefield analogy often used is “Are the Troops (smaller capitalization stocks) following the generals (DJ-30 / SP-500).
How Does the Advance-Decline Line Work?
This line is plotted by taking the difference between the number of stocks advancing and those declining. If more stocks increase in price on a given day than those that decrease in price then the result is positive. If more decrease on a given day than increase the number is negative. This is then plotted cumulatively on the AD line.
I find the AD Line is most useful at major market bottoms. Here we have a chart of the DJ-30 and the AD Line. It produces some very interesting results that are useful to you during times of market turbulence.
Advance Decline Line versus DJ-30
Notes on the chart:
- From July to October 2007 the Dow Jones Industrials made 2 peaks which we now know to be the top of the Bull Market
- The AD Line made a negative divergence with the Dow indicating all was not well in the broader market and signaling a change in direction.
- Here at the bottom of the of the 2007 – 2009 bear market the Dow was still moving down to its ultimate bottom in March 2009.
- The AD Line was signaling a positive divergence, meaning that the smaller capitalization stocks were starting to slowly increase in price.
- In February 2010 we can see that the decline in the Major Indices is also reflected in the majority of stocks on the NYSE, so no divergence from this move down is yet visible indicating that the market decline we are currently seeing is confirmed by the broader market.
You can use this method on the year 2000 DotCom bust and previous major market turning points to find similar divergences. If you feel the market is heading into a serious correction or trend change take a look at the breadth and specifically the AD line.
This brief section should enable you to become accustomed to what breadth is and how to use it. You can use many of the other breadth indicators in the same way as the Advance-Decline Line.
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