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Advance Decline Line Brings Good News and Bad

Posted By Barry Ritholtz On April 30, 2004 @ 9:33 am In Finance | Comments Disabled

There have been a few reports [1] recently suggesting that the Bull move is over. Based upon deteriorating market breadth, these authors are predicting the end of the rally. Under specific circumstances, we’d be inclined to agree with that perspective. Typically speaking, a narrowing advance-declines line that diverges from a rallying market is cause for grave concern. Under those conditions, the A/D line would be an early signal of an imminent collapse.

That rule doesn’t apply to periods like now.

Why? We are in a rising rate environment. One should expect to see the NYSE experience a marked weakening in the number of advancing versus declining issues. The NYSE is home to a broad variety of interest rate sensitive issues. As the weakening NYSE A/D [2] reveals, these are selling off in response to rising rates. Many of these issues have taken tumbles of 15% or greater. REITs, closed end bond funds, and other similar non-operating companies are doing exactly what they are supposed to do in this environment.

But that doesn’t mean the present A/D decline weakness is anything more than a concurrent – and not a leading – indicator. It is merely tracking a softening market, which is distracted by geopolitics, a rallying dollar, and valuation concerns. That situation is a far cry from times when the A/D line diverges from a strongly rallying market. Recall that divergence occurred in late 1999 and early 2000.

So the A/D line is falling with the market: That’s the good news. The bad news is that none of our favorite indicators have reached the point where we feel we must start getting long again. The one notable exception: The NYSE McClennan Oscillator [3] has reached moderately oversold levels. Some practitioners use this Oscillator to provide a short term snapshot of when the market is getting oversold. But since it is essentially a breadth derived signal, I prefer to see it much more oversold, in light of the previously mentioned trading in interest rate sensitive REITs and Funds, before getting too excited.

Investors still remain quite optimistic, by most recent sentiment measures. Measures such as the AAII Bull Bear Ratio, the Volatility Index (VIX), and the Put/Call Ratio are still relatively strong (see nearby chart [4]). On Wall Street, Pessimists are your potential buyers, while Optimists are potential sellers.

We continue to suggest trading smaller and less frequently until we see contrary extremes in these measures.


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URL to article: http://www.ritholtz.com/blog/2004/04/advance-decline-line-brings-good-news-and-bad/

URLs in this post:

[1] reports: http://online.wsj.com/barrons/article/0,,SB108317550181796147,00.html

[2] NYSE A/D: http://stockcharts.com/gallery?$NYAD

[3] NYSE McClennan Oscillator: http://www.equis.com/Education/TAAZ/?page=68

[4] chart: http://bigpicture.typepad.com/comments/2004/04/chart_of_the_we_6.html

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