On Tuesday the Dow fell more than 400 points, its fifth straight down day. People are nervous. Last year analysts told us to "buy the next pullback," but some are now turning bearish. This mood shift is common on Wall Street. So, has the bull market ended? Did we enter a bear market?
The single best indicator for predicting major market tops is the Advance-Decline Line. This market-breadth indicator compares the number of advancing stocks on the NYSE to the number of declining stocks. When the Advance-Decline Line is stronger than the S&P 500 index, there is broad market participation. In effect, the troops are leading the generals.
When the S&P 500 is stronger, however, market breadth is poor, which serves as a warning flag that the risk is increasing. This is a popular indicator and is found in most financial publications, such as Barron's and Investor's Business Daily. Unfortunately, the indicator found in financial publications does not always represent what is actually happening to the underlying market. That is because nearly half of the NYSE issues are preferred issues, closed-end funds, stock funds, ADRs, and warrants.
Therefore, while the advancing and declining figures are technically correct, they are misleading because half of the issues represent "irregular" securities. To correct that, I calculate an Advance-Decline Line from the price activity of the 1,500 common stocks that comprise the S&P 1500 index.
Lowry Research Corporation (www.lowryresearch.com) published a thorough report that found the most common characteristic at major market tops was a negative divergence in the Advance-Decline Line. That is, the Dow and S&P 500 reached new highs while the Advance Decline Line was moving lower for an extended period.
An extreme signal of a market top came amid the internet stock bubble top in 2000. The Advance-Decline Line fell for two years even as the market reached new highs! So what is this indicator saying now? It's good news. Our stocks-only Advance-Decline Line reached an all-time high on March 12 and again on April 18. That implies that most stocks are stronger than the Dow and S&P 500.
We also can see this divergence by comparing market indexes. The Dow and S&P 500 (i.e. large-cap stocks) have year-to-date losses while broader-market small-cap indexes like the Russell 2000 have gains. To benefit from strength in small-cap stocks, consider the iShares Russell 2000 ETF (IWM).
Bottom line: Far from showing a negative divergence that would signal a major market top, the Advance-Decline Line is pointing to higher prices ahead. The market is not topping out.
David Vomund is an Incline Village-based, fee-only money manager. Information is found at http://www.VomundInvestments.com or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial advisor before purchasing any security.