Can the Advance-Decline Line Predict a Market Top?

The meteoric rise of the so-called FANG stocks (Facebook, Amazon, Netflix and Google) has some pundits worried that the current bull market is being propelled by just a few behemoths.

Large companies have always had an outsize influence on the S&P 500® and other stock indexes that weight securities according to their market capitalization. But such indexes don’t always indicate overall market health, particularly when a few big names are driving most of the gains.

Enter the advance-decline (AD) line, a technical-analysis tool that charts the number of advancing stocks minus the number of declining stocks each trading day over time. The AD line rises when advances exceed declines, and it falls when declines exceed advances.

The results can tell you a lot about the state of a specific market or a particular industry, says Lee Bohl, a senior manager of trader education at Schwab Trading Services. “For example, when an index is ascendant even as its AD line is descendant, it’s likely that relatively few stocks are contributing to that growth—which could be a sign that that market is vulnerable to a correction,” he says. That was certainly the case with the New York Stock Exchange (NYSE) composite index in the months leading up to the Great Recession (see “Mixed signals,” below).

Mixed signals

From July through October 2007, the New York Stock Exchange’s composite index climbed to new heights—even as its advance-decline line trended lower—signaling all was not well with the market.

Source: Stockcharts.com. Date from 01/03/2007 through 12/31/2007. Past performance is no guarantee of future results.

In the past several years, however, the NYSE’s composite index and AD line have been moving in tandem, which suggests that, contrary to fears, a breadth of companies are driving the market.

Even if the two lines were to diverge dramatically, Lee says, investors would be wise to avoid decisions based on the AD line alone. “When an AD line starts to fade, I view it as an opportunity to be more cautious,” he says. “You might cut back on your exposure to stocks a bit, but don’t use it as an argument for exiting the market entirely.”

The bottom line: An index’s advance-decline line can help you gauge the overall health of a market or an industry but shouldn’t be the only metric you consider.