The shares are selling. Is this the start of a bear market or just a long overdue pullback?
Traders try to forecast market action with indicators. Some indicators are developed. Others are simple. Over time, the simpler ones tend to be more useful.
It can be surprising. Many of us think that Wall Street uses sophisticated tools to make money. It is.
As individuals, we cannot compete with his sophisticated techniques. This is why day traders tend to lose money. Wall Street companies trade in nanoseconds, and our data streams can’t process information as quickly.
But the big companies on Wall Street also use simple tools to make money. Many long-term trend following strategies use simple ideas. And we can use those same tools to track major stock market trends.
The Advance-Decline line
One tool used by many large companies is the anticipated decline line. The lead-down line indicator subtracts the number of stocks that closed each day (declines) from the number that closed (advances).
If you look at the market action before significant declines, in each case the AD line was in a downtrend before the S&P 500 fell. This happened before the bear markets which resulted in losses of 50% or more in 1972, 1999 and 2007. It also happened before the crash of 1987.
The AD line simply counts the number of shares on the rise. In a bull market, we would expect most stocks to rise. In a bear market, the majority of stocks should fall. It’s a simple idea, but, as the charts show, it’s an important indicator to follow.
Near market highs, we are seeing less bullish stocks. The index is advancing because only a few large stocks are producing gains.
In 2007, real estate stocks and financials were still up after most stocks peaked.
In 1999, Internet stocks were the market leaders while most stocks were down.
In 1987, traders bought only the most important stocks for a strategy called portfolio insurance. This insurance failed dramatically in October.
In 1972, the Nifty Fifty became popular, and investment managers only bought the top 50 companies.
A restricted buy always leads to a sale. This means that we should be watching the AD line for an early warning signal of the next bear market.
The S&P 500 and the Advance-Decline line are synchronized. As long as they stay in sync, a bear market is unlikely. We could see a pullback, a drop of 5% to 10%. But it will be an opportunity to buy more stocks and prepare for the next rally.