The shares are selling. Is this the beginning of a bear market or just a pullback that should have been made a long time ago?
Traders try to forecast market action with indicators. Some indicators are elaborate. Others are simple. Over time, the simple ones tend to be more useful.
This can be surprising. Many of us think that Wall Street is using sophisticated tools to make money. It is.
As individuals, we cannot compete with your sophisticated techniques. This is why day traders tend to lose money. Wall Street companies are operating in nanoseconds, and our data sources cannot process information as quickly.
But the big Wall Street companies also use simple tools to make money. Many long-term trend following strategies use simple ideas. And we can use these same tools to take advantage of the big trends in the stock market.
The advance-decline line
One tool that many large companies use is the advance-decline line. The advance-decline line indicator subtracts the number of stocks that closed every day (declines) from the number that closed (advances).
If you watch the market action before significant dips, in each case the AD line was in a downtrend before the S&P 500 turned down. This happened before bear markets that led to losses of 50% or more in 1972, 1999, and 2007. It also happened before the 1987 crash.
The AD line simply counts how many stocks are going up. In a bull market, we expect most stocks to rise. In a bear market, most stocks should go down. That’s a simple idea, but, as the charts show, it’s an important indicator to watch.
Near market highs, we see fewer stocks rise. The index is rising because only a few large stocks are making a profit.
In 2007, real estate and financial values continued to climb after most stocks peaked.
In 1999, Internet stocks were the market leaders, while most stocks were in a downtrend.
In 1987, traders were buying only the largest stocks for a strategy called portfolio insurance. That insurance failed spectacularly in October.
In 1972, the Nifty Fifty became popular and investment managers bought only the 50 largest companies.
Restricted buying always leads to a sell-off. That means we should keep an eye on the AD line for an early warning sign of the next bear market.
The S&P 500 and the Advance-Decline line are in sync. As long as they stay in sync, a bear market is unlikely. We could see a pullback, which is a decrease of 5% to 10%. But that will be an opportunity to buy more stocks and prepare for the next rally.