What The New High In The Advance-Decline Line Means For Stocks

Summary:  The cumulative advance-decline (A-D) line for both the NYSE and SPX made a new all-time high (ATH) last week. That's good news for stocks, as they most often move higher in the following weeks/months, also to new highs.

This is probably the best way to use the A-D line in equity research. Other common uses of A-D line are fraught with issues.

For example, while it's true that the A-D line has often weakened before stocks have encountered a major decline, you'll need hindsight to make use of this information. For every time a weakening A-D line has signaled a major fall it has signaled nothing special at least twice as often. "Negative divergences" happen all the time.  In real-time, it is impossible to know when a divergence is worth paying attention to.

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Last week, the cumulative advance-decline (A-D) line for both the NYSE and SPX made a new all-time high (ATH). The A-D line sums the net number of stocks moving up on the day added to yesterday's total.  The idea is that when the A-D line is rising, more stocks are moving higher and breadth is considered healthy. In other words, it's a bullish sign for stocks.

Let's start with the good news.

The charts below show every "breakout" in the NYSE A-D line to a new high (top panel) and what happened next to SPX (lower panel) in the past 30 years. What we find is that in every case, SPX has moved higher in the weeks/months ahead. Enlarge any chart by clicking on it.

The Top 5 Stocks Are Big. And They're Outperforming. This Is Normal

Summary:  The 5 largest stocks comprise about 16% of the S&P 500. That's normal. In fact, the importance of the top 5 stocks was far greater in the 1970s than anytime in the past 5 years.

It's true that today's top 5 stocks - known by the acronym FAAMG - have largely outperformed most other stocks. That's how they became today's top 5. Over time, stock indices have typically been driven higher by a small number of stocks. And over time, those leaders have continually changed. This is the story of the stock market. Only one of today's top 5 was also in the top 5 in 2013. At the height of the tech bubble in 2000, the top 5 were companies like GE, Exxon, Pfizer, Citigroup and Cisco.

Right now, most stocks are doing fine: an index in which non-FAAMG stocks have a 99% weighting closed at the second highest level in its history today. It's on pace for a 10% gain in 2018.

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The 5 biggest stocks in the S&P 500 - known by the acronym FAAMG - are equal to the smallest 282 stocks.  Enlarge any chart by clicking on it (from Michael Batnick).

New Highs In The A-D Line and the Small Cap Index Are Not Necessarily Bullish

Summary:  The conventional wisdom is that "healthy breadth" is necessarily bullish. This sounds  intuitively correct: a broader foundation - where more stocks are ticking higher - should equal a more solid market, but it is empirically false. Equities can continue to move higher when breadth is healthy, but new highs in the advance-decline line or in the small cap index have also preceded drops of 10, 20 or even 50% in the equity market.

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The conventional wisdom is that "healthy breadth" leads to higher equity prices. This sounds intuitively correct: a broader foundation - where more stocks are ticking higher - should equal a more solid market. Conversely, a narrowing market should be a warning of a likely market top.

But it is empirically false. Consider some recent research into this issue.

The Russell small cap index (RUT) has been making new highs even as the large cap indices have not. Because there are four times as many stocks in RUT as in SPX, many infer that breadth is broadening and that this must be bullish for all equities. "When the troops lead, the generals will follow."

Yet, as Mark Hulbert points out, small caps have peaked after the major stock indices in more than half of the 29 bull markets since 1926. If the conventional wisdom was correct, small caps should lead by peaking before the major indices, but this happened only a third of the time (Mark's article is here).

Weekly Market Summary

Summary:  Equities are 2-5% higher so far in May, trying to add to their small gains from April and put behind a rough winter. This week, small caps closed at a new all-time high (ATH) and NDX broke to a 7 week high near its March ATH. This is constructive for the broader market. But new uptrends are defined by persistent strength; it's time for large caps to reveal the true character of this market.

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US equities fell slightly last week. SPX and DJIA lost about 0.5%. But May, so far, is tracking positive. Large caps are up 2.5%, tech stocks are up 4% and small caps are up more than 5%. The volatility index, Vix, has been crushed. Enlarge any chart by clicking on it.

Using Breadth To Anticipate Market Inflection Points

Summary:  When equity indices move higher, you will often hear commentators suggest the rise is suspect because leadership is narrow. "Breadth is lagging," "small caps are lagging," "breadth is diverging" or "the indices are lying because the average stock is underperforming" are common warnings.

It's conventional wisdom that new highs in the stock market should be confirmed by "healthy breadth." In other words, you want to see a large number of stocks in uptrends as the index price moves higher. Similarly, small cap stocks should outperform the relatively fewer number of large cap stocks as breadth broadens.

All of this sounds intuitively correct: a broader foundation should equal a more solid market. Conversely, a narrowing market should be a warning of a likely market top. This is how most pundits use breadth to anticipate market inflection points.

But there are two problems with this view on breadth.

Most importantly, the conventional wisdom about "healthy breadth" being critical for future stock market returns is empirically false. Indices have typically been driven higher based on a small number of stocks contributing disproportionately large gains. Over the past 20 years, just 4% of stocks have typically accounted for almost 70% of annual gains in the SPX.

Moreover, most market drops over the past 15 years, including those with declines of more than 10% or 20%, have started when 80-90% of stocks have been in an uptrend. In fact, over the past 5 years, the SPX has gained more than 3 times as much over the following month when breadth was weak compared to when breadth was "healthy." Risk/reward has been more than twice as favorable when breadth has been weak as when it was healthy. The conventional wisdom on breadth and future market returns has been exactly wrong.

The second problem is that stock pundits' views on breadth conflict with their views on investor sentiment.  Important market tops are defined by excessive investor bullishness: "everyone" is a bull by the end of a bull market. But think about what this means for breadth: if investors are bullish, they should be less selective about which stocks they own. They should seek to own the riskiest, highest beta stocks in the market. This means that market tops should be defined by broad, not narrow, breadth. By the time breadth is "healthy", investors are overwhelmingly bullish and the market tops.

No single indicator is sufficient in assessing market inflection points. Using breadth has serious drawbacks.  But this post suggests a far more logical and useful methodology for using breadth to anticipate market inflection points than "lagging breadth," "breadth divergences, " or outperformance by small caps stocks.

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It's conventional wisdom that new highs in the stock market should be confirmed by "healthy breadth." In other words, you want to see a large number of stocks in an uptrend, trading above their moving averages, as the index price moves higher.

Yet, consider the following:

At the October 2007 peak in the stock market, almost 85% of stocks were above their 50-dma. The index dropped 10% in the next month and 50% in the next year. 

In April 2010, almost 95% of stocks were above their 50-dma and 200-dma. The index dropped 15% in the next two months. 

In May 2011, 80% of stocks were above their 50-dma and more than 90% above their 200-dma. Just three months later, the index was 20% lower and feared to be in a new bear market. 

These are not isolated examples where breadth was considered "healthy" and the index was near a significant top. Others are highlighted below. In the past 15 years, almost every significant market drop was preceded by an overwhelming majority of stocks in the SPX being in an uptrend. An exception was the initial 10% fall in August 2015. Enlarge any chart by clicking on it.

The Similarities (and Key Differences) Between 2017 and 2013 So Far

Summary: 2017 is off to a remarkably similar start to 2013. No two years are ever exactly the same, so there's no reason to suggest that 2017 will repeat the 30% gains achieved in 2013. But many of the technical and fundamental similarities between these years suggest that 2017 may continue to be a good year.

There are two watch outs, however, that make 2017 much higher risk than 2013. It's also worth recalling that equities fell 3-8% at six different points in 2013. Expecting 2017 to continue to ride smoothly higher will probably prove to be a mistake.

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2017 is off to a remarkably similar start to 2013. Is it set to be a repeat of that year? It's an important question as stocks gained about 30% in 2013.

Consider some of the following:

2017, like 2013, is the first year in a new Presidential term.

Both years got off to a fast start. By March, SPX had gained 8% in both 2013 and 2017.

Both years started by making a string of new all-time highs (ATHs). By the end of February, the Dow Industrials had closed at a new ATH 12 days in a row. A similarly rare streak of 10 days took place by March 2013.

SPX is often weak in February. But the index gained in both January and February in 2013 and 2017. In the other instances that this has happened since 1945, SPX closed up for the full year every time by an average of 24% (more on this here).

Both 2013 and 2017 came on the heels of long, volatile periods. SPX dropped 20% in 2011 and started 2013 only  2% higher than 18 months earlier. Similarly, SPX dropped 16% in 2016 and started 2017 only 5% higher than 18 months earlier. In both years, a dip at the election in November caused the market to be oversold; in both years, the market was significantly overbought by March (top panel).

McClellan Oscillator Hits 91

The McClellan Oscillator (NYMO) closed at 91 today. This is the first spike over 80 in NYMO since last October.

NYMO is a momentum indicator for breadth. When NYMO is positive and gaining, breadth momentum is increasing. This is generally good for the indices.

But breadth momentum can reach an extreme, and when it does, indices can fall in the next few days. That is the current situation.

The charts below look at all NYMO readings over 80 since 2009. Some conclusions:

Indices were generally weak in the following days. In most cases, indices traded at least 1% lower. In several cases, indices lost more than 3%. 

If the indices continued higher in the next day or two, it was by less than 1%, followed by a drop below the date of the high NYMO. 

The first spike higher in NYMO in several months (like now) didn't end the rally. The longest span before a "higher high" was one month (in September 2013).  

Let's review each case. In the charts below, SPY is shown in the upper panel and NYMO in the lower panel.

In November 2014, NYMO closed over 80. SPY fell 1% intraday the next two days, although the close on the second day was only 0.3% lower.

In October 2015, NYMO closed over 90. SPY gained 0.2% in the next two days before closing down 1% in the next two days.

New Highs In Cumulative A/D Is Not Confirmation Of A Healthy Market

Summary: Cumulative advance-decline (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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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%).

Tuesday's Sell Off Low Likely To Be Retested

Summary: Yesterday, stocks fell more than 1% on intense selling pressure. Trin spiked over 2 for the first time since early March. Declining volume was more than 8 times more than advancing volume. It would be very unusual for that level of selling pressure to dissipate immediately. More likely, Tuesday's low will be retested in the days ahead.

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On Tuesday, US equities sold off hard. The S&P dropped more than 1%. Of significance, selling pressure was intense: declining volume on the NYSE was more than 8 times greater than advancing volume, the highest since late January.

Moreover, Trin (also called the Arms Index) closed above 2.0 yesterday. Trin is a breadth indicator. It is derived by dividing the advance-decline ratio for issues by that for volume. A close over 2 means that down-volume was twice down-issues; in other words, stocks fell on relatively high volume.

A spike higher in Trin like yesterday's can often be near a low in the equities market. That is especially true if the market has been selling off for a week or more. In this case, a high in Trin marks capitulation. A relevant post on this indicator is here.

This makes today's action noteworthy. The S&P gapped up overnight and then rose nearly 1%; the Nasdaq rose 1.6%. Yesterday's low was not retested.

It would be unusual if Tuesday's low remains uncontested in the days ahead. Down momentum like yesterday's almost always takes more than one day to dissipate.

Let's look at recent examples.

The first chart looks at the past year: the S&P is in the top panel, Trin is in the middle panel and declining volume relative to advancing volume is in the lowest panel. Every instance of a Trin spike higher involves at least one lower low in the S&P, even if it came after a strong bounce like today's (note September 2014 and January 2015).

Breadth Divergences: More Noise Than Useful Signal Of A Market Top

It's conventional wisdom that new highs in indices should be confirmed by an expansion in breadth. In other words, you want to see the number of stocks trading above their moving averages expand as the index price moves higher.

That sounds intuitive. All else equal, having an increasing number of stocks above, say, their 50-dma as the index moves higher means that the index is supported by a growing number of stocks that are in an uptrend. Think of it as a wide foundation to support the index.

We find there is a practical problem with this, however. The index has better performance looking ahead when breadth is weak.

Let's take three situations: one where the percentage of SPX constituents above their 50-dma is 80% or more (strong breadth), one where it is less than 80% and one where it is less than 50% (weak breadth).

If greater breadth was a positive, then SPX should do best when 80% or more of its constituents are trading above their 50-dma. In fact, that is when the index does worst. SPX does best when breadth is weakest.

First Major Accumulation Day in 14 Months

The markets hit a large number of extremes at the end of last week (post). More were hit Tuesday (post). These, together with positive statements from the Fed today, created a major accumulation day (MAD). These are days when up volume on the NYSE is at least 9 times larger than down volume.

That is telling you that investors overwhelmingly see equities as attractive or oversold at current prices. It's a bullish sign and normally (but not always) initiates a move higher in price.

As an aside, 'tick' on the NYSE was also strongly positive today. We look especially for a cluster of ticks over 1000 after a strong period of selling. This means that many stocks are moving up on the ask, not the bid. The highest tick today was 1350, one of the 5 highest of 2014. Overall, the profile of tick is consistent with a MAD.

Today's MAD was 17:1. It was the first MAD since the October 2013 low in SPX. In the past two years, the only other MAD was January 2, 2013. Both of these initiated long moves higher in SPX.

RUT Has Reached An Important Juncture

It's an overused phrase, but this is an important juncture in the market.

Weakness in the small cap index, RUT, has reached the point where just 23% of the index's components are above their 50-dma. In the past 2 years, this has been the buy point for every rally; the only time this measure of breadth has been lower was November 14-15, 2012, right before a 60% rally. Before that, it was lower on June 1, 2012, right before a 20% rally (chart from Sentimentrader).

Buy SPX on the Death Cross in RUT

We discussed weakness in RUT over the weekend. Our conclusion was that relative strength or weakness in RUT in the past has been an inconsistent indicator for the broader market (post).

This is consistent with a prior post where we analyzed significant market corrections and found no reliable relationship between market tops and the relative performance of RUT and NDX (risk indices) versus the SPX and DJIA (large cap indices; post).

The chatter in the market now is that RUT is experiencing a "death cross", where its 50-dma is crossing below its 200-dma. The conventional wisdom is that this indicates weakness in trend and is therefore bearish. The contrarian point of view is that many "death crosses" coincide with good buying opportunities. So, which is it?

The evidence for the contrarians looks more compelling on first glance. The vertical lines are each death cross (lower panel) in the past 20 years. More often than not, RUT (top panel) moved higher in the months after a death cross.

If you look more closely, you will notice that RUT only moved lower after death crosses in 2000-02 and 2007. These were bear markets. In other words, buying the death cross in RUT worked because the broader market was in a bull market (1995-1999; 2004-06; 2010 and on).

A Short Term Watch Out For High RSI and Low Trin

In our weekend post (here), we specifically warned how a break back above the 50-dma for SPX has been a momentum kick off in the past. This has been when the long win-streaks have taken place (yellow). This remains the big picture view for SPX.

SPX has since risen 4 days in a row. There are two studies indicating that short-term (1-2 days) weakness is ahead, followed by at least one higher high.

A Sign of Possible Capitulation: Trin Closes Over 2.0

Trin (also called the Arms Index) closed above 2.0 today. This is usually a positive for equities, at least over the short-term.

Trin is a breadth indicator. It is derived by dividing the advance-decline ratio for issues by that for volume. A close over 2 means that down-volume was twice down-issues; in other words, stocks fell on relatively high volume.

At a minimum, stocks have very often been higher the next day and also higher 5 days later. This is particularly true when the spike higher in Trin has occurred after several days of selling, like now. In the chart below, the vertical lines are Trin spikes over 2 during the past 2 years.

Many of these Trin spikes, especially in the past year, have also come at important lows: September, February and April, for example. In June 2013, the Trin spike was 3 days before the low after the market had been falling for 4 weeks. In other words, a spike in Trin can mark capitulation.

The biggest failures in a Trin spike coinciding with a relative low in equities usually occur when the spike comes after stocks have been on the rise. In October and November 2012 and in February and June 2013, the spike in Trin occurred when SPX  was within a day of a 5 or 10-day high. It signaled a change in direction. That’s not the case here.

There are never guarantees, but we are likely to see SPX move higher in the next 1-5 days. That has been the pattern in the past. That doesn’t necessarily mean the end of the 2 week downtrend. The Trin spike in March this year was followed by higher prices but also preceded the eventual low a month later, in April.

Signs Of A Washout In Utilities

The utilities ETF, $XLU, is now off more than 10% from it’s high.  Among the nine SPX sectors, its performance in the past 2 months has been the worst.

The main part of the (initial) fall is likely to be over.

Zero companies in the XLU are now above their respective 50-dma. In the past 4 years, this level of ‘breadth’ has been very close to a low in the sector’s price (red circles). It's not always the exact low, but close. A scenario like that in 2010 - a bounce followed by a lower low - is possible over the medium term

Assessing Market Health Through Breadth

Breadth measures the number (or percentage) of stocks trending higher or lower. The conventional wisdom is that expanding breadth is bullish. Is this true? The short answer is no.

And what are breadth measures saying about the health of today's market? The short answer is to be cautious.

Let's start with NYSE advance-decline issues (NYAD) which measures advancing issues minus declining issues. It recently made new highs. The chart below looks at prior new highs in NYAD versus drops in NYSE of over 10%.

A Breadth Warning From NYSI and NYMO

2013 is the year breadth divergences appeared to be irrelevant. There have been seven major distribution days (90% down volume) and only one major accumulation day. The summation index declined from January until May without much impact on equities. And since May, the percentage of SPX stocks trading over their 200-dma has been in decline.

Today comes a new warning from the McClellan oscillators, NYSI and NYMO. NYMO measures the momentum in breadth and NYSI sums those values daily. A string of negative NYMO readings therefore causes NYSI to go negative. For more details, read here.

Aside from a few days, NYMO has been negative since October. As a result, Summation went negative at today's close.

Since 2000, NYSI (bottom panel) has been negative 20 separate times (yellow shading). Every time it has done so, SPX has not formed a durable bottom until NYMO (middle panel) has capitulated, meaning it closes at minus 75 or lower. The lowest close in NYMO so far has been minus 53. Today, it closed at minus 18.

Monday Was Not A Washout

There are a number of indicators that we track to determine whether sellers have capitulated and a durable bottom is in place. We look for at least a few (not all) of them to confirm a washout. When a high proportion are at an extreme, it's a Fat Pitch TM.

And by that measure, Monday was not a washout as only one reached an extreme.

NYMO: We have been tracking the McClellan oscillator closely. It is a very good indicator for a bounce long. On Monday it reached -100; that is an area from which the indices will normally advance higher for a few days, or longer. But note that many times a lower low will follow as the down momentum continues (red arrows).

Put/call: The options market has been subdued throughout the past two weeks (first chart) and especially during the last 4-day sell off. On Monday, calls outnumbered puts whereas fear is normally represented by a put/call ratio of 1.2 or higher (yellow shading; second chart).

SPX Is On Major Support With An Extreme Negative Breadth Reading

Today, $SPX returned to the bottom of its channel from December 2012. We noted at the close the defined risk in going long here as (1) the channel bottom, (2) the 50-dma, (3) the April high pivot and the May opening gap were all within 1%. Note also the positive RSI divergence. The clear support close by makes the risk-reward attractive.

The rise into mid May was driven by cyclicals. The cyclical index has also returned to its May break out level today. No harm, yet.

One indicator mentioned today that supports a near-term long is the McClellan, a breadth oscillator. It closed at an unusual low that has consistently been near a profitable bounce. The bounce may eventually fail, but there is normally upside within the week.