What You May Be Missing When Evaluating Market Breadth

When it comes to market analysis there’s a plethora of tools available. So many in fact that we can cover a chart in indicators, cycle studies, and rabbit reproduction lines to the point where the underlying price practically disappears. We also have other tools at our disposal that dive into the pool of market breadth which attempts to provide insight into the level of (or lack thereof) participation of individual stocks within the trend of the market. Breadth can be extremely useful, but also extremely misunderstood. Some of the examples of breadth include the number of stocks hitting new 52-week highs or 52-week lows, number of stocks above their respective 50-day or 200-day Moving Average, and the granddaddy of them all: The Cumulative Advance-Decline Line, which will be my focus today.

First off…
This is my personal opinion on the advantages and disadvantages of the Advance-Decline Line, I’m not the preeminent expert in breadth but it is a tool I’ve spent a great deal of time studying and use it regularly.

The genesis of this post comes from the recent lambasting of some traders for pointing out the decline in participation of individual stocks recently. As I said above, there are many ways to evaluate breadth, but in the summer of 2018 there seems to now be a pecking order for these tools, 52-week highs are passé  and only the Cumulative A-D Line matters. Why? Because one (the former) is declining and the other is rising. This is where I think people go astray in their use of breadth indicators.

Usefulness of Breadth
The broad usefulness of breadth indicators is when they diverge from price. This means for example, if the index is rising and making higher highs and the breadth indicator was declining and making lower highs, we could conclude that less stocks are participating in the up trend of the underlying index. This can be extracted from less stocks hitting 52-week highs, fewer stocks above their 200-day Moving Average, or a decline in the net number stocks advancing as shown by the A-D Line. Traders take this one step further in thinking that if a divergence isn’t present then the opposite must also be true, confirmation of higher highs in breadth along with price must be a good thing. And they’d be right, but not without a major caveat.  And that caveat presents itself in the construction of how some of these breadth indicators are calculated.

When The A-D Line is and Isn’t Insightful
I believe the Advance-Decline Line has its place in being used for divergences but is less effective as a tool in trend confirmation. While there are plenty of examples that can be pointed to of the A-D Line confirming an up trend, I think it can provide a false sense of what’s taking place in the underlying market of stocks and potentially not reflecting a weakening level of stock participation.

How The A-D Line is Calculated
Like I said, my focus today is on the Cumulative Advance-Decline Line, so let’s dive into how it’s created. Stockcharts.com sums it up well, “The Advance-Decline Line (AD Line) is a breadth indicator based on Net Advances, which is the number of advancing stocks less the number of declining stocks. Net Advances is positive when advances exceed declines and negative when declines exceed advances. The AD Line is a cumulative measure of Net Advances. It rises when Net Advances is positive and falls when Net Advances is negative.”

So when calculating the A-D Line, each day the total number of stocks of the underlying index, whether it be the S&P 500, NYSE, NASDAQ, etc., that went higher (regardless of the degree of the move) are added while the number of declining stocks (again, regardless of the degree of the move) are subtracted. The net number is then added (or subtracted if negative) to the prior day’s total, creating a running (cumulative) total of advancing minus declining stocks. Ideally in a bull market this gauge will steady rise with more stocks ticking higher on more days than not.

Sound good right? Well not so fast!

What’s Missing
What’s missing here is the Advance-Decline Line doesn’t care how much a stock moved. Remember when Facebook dropped approx. 20% post-earnings not too long ago? Setting a new record for the most value lost by a stock in a single day? All the A-D Line saw that day from Facebook was one notch in the ‘decline’ column, giving it the same weight as if another stock that dropped 0.01% that day.

How about an illustration? Below is an example of a stock that I made up that started at $100 and steadily declined to $92, losing 8% of its value. Can we agree that this stock is in a down trend? It’s making lower highs and lower lows, and from the time period shown, it’s trending lower, yes? Okay good, let’s move on.

Here is the same chart as above but with the contribution this stock made to the Advance-Decline Line as shown by the red line. During this period of time, while the stock lost 8% and was in a down trend it gave a positive contribution of 10 points to the A-D Line.

But wait, I thought this stock was in a down trend, how did it give a positive breadth reading?! It all comes down to the difference in the daily change in price and the number of positive and negative days that occur. The stock in this example saw more positive than negative days but the stock moved more on those down days, which led to the overall positive breadth contribution of a stock that was in a down trend.

This is why the Advance-Decline Line can be misconceived, just because a stock provides a positive contribution to the indicator doesn’t mean that it’s in a healthy up trend as one may believe based on the reading the breadth gauge is showing. Which means the Cumulative A-D Line can appear to be confirming a new high in an index but there could still be a narrowing of trend participation by individuals stocks that’s not being reflected in the A-D Line.

Real World Examples
Now let’s look at some ‘real world’ examples. We’ve had several corrections since the 2009 low, two of the largest in terms of time and price have been 2011 and 2015, so let’s take a look at those.

2011
Below is chart of the S&P 500 in 2011 with the S&P 500 Advance-Decline Line and the NYSE Stock-Only Advance-Decline Line in the top two panels. When the $SPX was making its peak in April, both the S&P and NYSE A-D Lines were “confirming” the trend, setting new highs themselves. In fact, they both made higher-highs in July when the equity index made a lower high, many analysts pointed to this positive divergence as a great sign of the underlying strength in equities, similar to today. What soon followed was a roughly 20% decline in stock prices.

2014
Before looking at 2015 lets sidetrack to 2014 when we did see a small divergence in these two A-D Lines. In September ’14 both the S&P and NYSE breadth gauges made lower highs while the S&P 500 made a higher high, which was followed by a quick 7.5% loss in the $SPX, this is what we look for in participation indicators, bearish divergences.

2015
We then moved into 2015 when the S&P 500 did basically nothing, setting a few higher highs with the breadth gauges sitting practically flat and slightly declining in July. I discussed the narrowing of breadth as well as other market tools in my July 30th, 2015 post, The Greatest Risk of A Market Peak Since 2007 where I laid out my bearish argument for stocks which ultimately was proven correct as stocks entered what many classify as a bear market, declining with lower lows for the next eight months.

2007
Finally, it wouldn’t be fair to write a post about breadth divergences without everyone’s favorite: 2007. The stock market peak in late ’07 provided a near-picture perfect example of a breadth divergence with the S&P 500 making a clear higher high as both S&P and NYSE A-D Lines made lower highs, signaling a narrowing of up trend participation by individual stocks – marking what we can now look back on as a major market top.

My Point
What’s my point? Based on how the Advance-Decline Line is calculated, which does not take into account the magnitude of daily changes in price of the underlying stocks, a lack of a bearish divergence in a single indicator is not necessarily reflective of a positive confirmation of an up trend. As my illustration showed, a stock can be in a down trend while still positively contributing to market breadth, blunting the usefulness of a perceived breadth confirmation by the A-D Line. This is why I personally feel divergences in the A-D Line are much more useful than confirmations of an underlying trend.

It’s my belief that the use of multiple pieces of data is important in applying analysis to a market and specifically the evaluation of trend participation. We can be much more confident if multiple breadth gauges are pointing to the same conclusion such as a rising A-D Line, an up trend in new 52-week highs, more stocks rising above their 50-day and/or 200-day Moving Averages, etc. It’s important to understand the strengths and weaknesses of the tools we have at our disposal.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.