Stock market “breadth” or participation has always been an extremely valuable tool at market tops. As stocks reach overpriced levels, it’s common to see investors become more selective in their stock purchases, especially if inflation fears appear and/or interest rates begin to rise.
The Advance-Decline (A-D) Line (cumulative total of daily advancing issues minus declining issues) is the most prevalent tool in monitoring breadth. However, there are two inherent limitations to this tool. First, one must visually compare the line’s divergence with the graph of a market index such as the S&P 500, and accurate measurement can be difficult. Second, the A-D Line became upwardly biased following the implementation of a decimalized pricing system in 2000 (minimum price increments of 0.01 instead of 1/16). As a result, many measures of market breadth that had historically provided early warning, including the A-D Line, now appear to offer less of an advanced signal than in the past.
One tool that solves for both problems mentioned above is our proprietary A/D Divergence Index. This tool measures what the S&P 500 Index should hypothetically be trading for given the trend in breadth, versus where the Index is actually trading (adjusting for the effects of decimalization). As a result, when this tool is moving sideways, it’s an indication that price and breadth are moving proportionately, which is a positive confirmation for the bull market. However, when this indicator is in steep decline, it shows that breadth is not supportive of S&P 500 performance and is a warning that the market is more vulnerable to a downturn. When this downward trend reaches a historically meaningful level in conjunction with other breadth measures, it becomes an excellent warning of an impending bear market or major correction.