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<p>Stock market “breadth” or participation has always been an extremely valuable tool at market tops.&nbsp; 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.</p>
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<p>The Advance-Decline (A-D) Line (cumulative total of daily advancing issues minus declining issues) is the most prevalent tool in monitoring breadth.&nbsp; However, there are two inherent limitations to this tool.&nbsp; First, one must visually compare the line’s divergence with the graph of a market index such as the S&amp;P 500, and accurate measurement can be difficult.&nbsp; 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).&nbsp; 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.&nbsp;</p>
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<p>One tool that solves for both problems mentioned above is our proprietary A/D Divergence Index.&nbsp; This tool measures what the S&amp;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).&nbsp; 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.&nbsp; However, when this indicator is in steep decline, it shows that breadth is not supportive of S&amp;P 500 performance and is a warning that the market is more vulnerable to a downturn.&nbsp; 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.</p>
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