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In September 2014, the cumulative advance-decline (A/D) line for the S&P hit a new high. A month later, the stock index was down 10%.
Twice in December 2014 and again in February 2015, the cumulative A/D line hit new highs and within two weeks the stock indices lost 5% (twice) and 4%.
Among the ways of measuring market health, this is one of the consistently least useful. There are two big problems with it.
The first is conceptual. Cumulative A/D takes the number of stocks moving up on a day and subtracts the number of stocks moving down. That sum is then added to yesterday's total.
If a lot of small stocks move up by one penny on low volume but slightly fewer large companies move down a dollar on high volume, the cumulative A/D line moves higher. Or, if a large number of defensive stocks move up while "risk-on" cyclical stocks move down, the cumulative A/D line moves higher. Neither one of these is a healthy sign.
The second problem is empirical. Every fall of 5% or more since the 2009 low has started from a new high in cumulative A/D. This includes several 10% declines and the 20% decline in 2011. It's hard to be enthusiastic about a measure of stock market health that gives no warning before a 20% fall in equities. These instances are shown below below (cumulative A/D in top panel and the S&P in the lower panel; the zig zag is set for declines greater than 5%).
The S&P's 20% fall in 2011 is shown below. Remarkably, even as price made a lower high in July, cumulative A/D made a higher high (green line).
In it's defense, a drop in cumulative A/D did lead the 2007 top in the S&P by four months. But if that seems useful, bear in mind that cumulative A/D lead the 2000 top by 15 months, during which the index rose more than 20%. In real time, using this information with strong conviction is next to impossible.
In the examples above, we have used the A/D data for the S&P alone. It's also possible to use common stock-only A/D for the NYSE as well as the full NYSE. The latter is problematic as it includes a growing number of funds as well as preferred shares.
Cumulative A/D is one of the most popular ways to measure market health using breadth data. But cumulative A/D has given no warning before any drop in equities of 5% or more since the 2009 low, including the 20% drop in 2011. That cumulative A/D made a new high last week is not confirmation that the underlying market is healthy.
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