July 26, 2018
Technical analysis offers a wide range of options to analyze the strength of a market trend. Many use price action and indicators, but when it comes to analyzing the strength of an index, it is helpful to look at the breadth underlying that index. This will help analyze how the stocks within the index are performing. It is particularly valuable at a potential market top, since many of the smaller companies in an index may start struggling before the larger companies. However, since the larger companies hold more weight in the index, its price can still show an uptrend.
The Advance/Decline line is one of the indicators that can help identify whether the majority of stocks in an index are rising or falling. This study takes the difference between the number of advancing and declining issues trading within an index and adds or subtracts that value from the previous day’s number. What we are looking for here is a divergence between the price of the index and the Advance/Decline line. If we see higher highs and higher lows on price but see lower highs and lower lows on the Advance/Decline line, that might tell us that the breadth of that index is losing strength, therefore increasing the likelihood that price will follow the indicator and form a top.
The chart below is a one year look at the NYSE Composite Index (NYA) along with its Advance/Decline line. You can see that the Advance Decline line is continuing to set record highs even though the Index hasn’t yet recovered all of the losses it experienced in early 2018. This depicts strength as it’s signaling that the majority of stocks in the NYA are still rising. Even at the price trough in late March, the Advance/Decline line registered a higher low, a sign of strength.
Source — thinkpipes Platform
Watching this indicator may help identify turning points in a broad market, as it can turn down 6 to 12 months before the price of the index follows suit. In this case, we still haven’t experienced the first turn, so it appears that this bull market still has legs.
This example uses NYA, but most trading platforms offer several indices to choose from in your analysis. The NASDAQ Composite Index can be an important one to analyze this way, considering the vast difference between the sizes of the largest and smallest stocks within it. Today, the Advance/Decline line for NASDAQ is hitting new highs, along with the price of the index itself.
Although 2018 has produced significantly more market volatility than 2017, the broad strength in the U.S. stock market is still intact. Using technical analysis indicators like the Advance/Decline line can potentially help identify this strength and offer a possible warning when changes may be coming.
While this article discusses technical analysis, other approaches, including fundamental analysis, may assert very different views.
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