The Trend's your friend!
P.O. Box 3362, Jersey City, N.J. 07303
We must learn to appreciate our friends while they are still alive. Then hangs up the
Gangster's comment when told of the murder of his associate, Gatsby
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The whole grab-bag of market averages does a great job of telling us what happened in the past, but are of little help in predicting the future. What happened, is of course necessary from an accounting standpoint. But what the future holds is the burning question for the investor.
For us that means how much longer does the Great Bull have to go? This monster has shrugged off the deficit, trade problems, gyrations of the dollar, collapse of the S & Ls, and the implosion of the junk bond market. Looking backwards we can see that "Black Monday" (October 19, 1987) and Saddam's invasion of Kuwait were barely hurdles for this golden calf. What were then seen as cataclysmic events, in retrospect, were really buying opportunities.
But only the very foolish (destined to be separated from their money) will think that the Great Bull is immortal. Like a horrendous storm, like the Caesars, like Napoleon, this market force is destined to sweep over the landscape only to pass away. The crowd of naysayers that, at many points, predicted the imminent end of the market's advance were wrong, but only with reference to timing. The timid investor, by paying heed to those voices of doom and gloom, has missed many chances to make money. But the halt and retreat will come. Only those that want to buy in at the top will not be concerned about when that day will come.
The advance-decline line is one of the most powerful tools in technical market analysis. The advance-decline line, used in comparison with the major market averages, signals when bull markets are in interim retreat or are about to end. The advance-decline line is used in conjunction with other market data, in particular broader market and OTC indexes. This will be treated at length in upcoming articles.
There are two ways of looking at the behavior of the any of the major market averages, of which the Dow Jones Industrial Average is the leader. The one view is that the major market averages, as a small sample of the world's most powerful companies, tells us NOTHING about either the trend or the behavior of the market as a whole. Let's give a meteorological illustration of this way of thinking. Make believe that we are trying to find out which direction the wind is blowing. We hoist up a flag, a weather vane, a light windsock - something that will easily respond to the air currents. You don't tie a rock or a boat anchor to the top of a pole! By the time this heavy object is moving in the wind, EVERYTHING else will have blown away!
Here we are assuming the same with stocks. When market forces have grown to gales so forceful that the globe's great concerns start to totter and heave, all the smaller companies will have already been knocked down a long time ago.
The other view, really not entirely in opposition to the first, is that major market averages do a great job of telling us what the trend was and what the trend is, but don't have any power to predict the future. The reasoning here is that with the very large companies, owing to their great mass, once in motion it's very difficult to slow down, stop, or reverse the direction of their stock market price movements. Simply stated, the blue chips are the last to stop going up in price. With the many lesser corporate entities, that just don't have it either in terms of resources or investor confidence, these stock prices will quickly react to any applied force. Let's take another wind example. We're looking at a flag and a massive windmill. Both are moving in a strong breeze. The wind dies. The flag will immediately go limp while the windmill, for a short time, will continue spinning.
Focusing on the indexes that are only made up of the big caps, to the exclusion of the market as an organic whole, leads to that great tragedy of the small investor - getting out at the bottom and buying in at the top!
This then is what we are trying to get from the advance-decline line - an indicator that will quickly signal imminent change in the market's underlying forces. The advance-decline, since it condenses all reasoning, all sentiment, and all expectation of the entire New York Stock Exchange into a single number is one of the best of these indicators - and one of the simplest. For a bull market to continue, the overwhelming majority of stocks must take part. As lesser companies start to fall by the wayside, to "lose steam," the future of the overall advance becomes suspect.
This chart is compared day by day with a chart of the DJIA. For the most part the two graphs will mirror each other. This is known as a market "in gear." Whatever the trend is, the reasonable expectation is for it to continue.
It's a buy signal when the advance-decline line is rising, while the major market is flat or falling. Historically, the advance-decline line has had very mixed results in predicting the end of bear markets and major corrections.
The advance-decline line is most useful in predicting an aging bull market. If the DJIA continues climbing while the advance-decline line sputters and falls, the ability of the market to sustain advances is extremely suspect. This scissor-effect disparity between the two curves is a strong sell signal.
A very easy way of doing this is to tabulate a ten day moving totals of advances. For ten days add the number of advances to a total. On day ten we have the first item in our series of ten day moving totals. On day eleven, subtract the first days advance number and add in day eleven's figure to the total. And so on. The ten day moving total is used to smooth out all the little inconsequential blips and bumps in the data.
Do the same for the number of declines.
Chart the two resulting lines on a single graph. Since the more issues advance, the less will there be to decline (the reverse also being true), for the most part, you will see a sinusoidal line and its inverse. In other words, you will have a series a waves that grow closer only to grow apart to a set length. This pattern will tend to repeat as long as the market is in a trading range. Where the two curves draw together is the price ceiling of the market, advances being at a peak, declines at a trough. As the two lines bellow apart, declines increasing while advances plummet, we can get a good idea of where the price floor of the market is located.
It's presumed that when a market is in equilibrium, when no force is present to further feed or to dampen and existing trend, stocks will tend to bounce away from the previous reaction. Let's assume the aftermath of a rally in a bull market. Short sellers will panic and rush to cover. Sell signals will be generated in program trading if the previous ceiling is penetrated. Traders will take profits. Individuals, hearing all the good news, will be tempted to sell in order to live it up a little (or just get rid of some bills).
This puts a lot of selling pressure into the market that will tend to drive down prices. As the market tests the new price floor, many investors will perceive a buying opportunity and react. Once buying starts the market will generally continue to rise, until the current price ceiling is again reached.
The trading range will repeat itself until some major event outside the market affects the trend.
There are many minute and major items that affect this. The day of the week used to be a minor item that had a major affect. Professional traders (speculators) would routinely cash out of the market on Friday and buy back in on Monday. This, of course, generated major selling pressure for the Weekend and buying pressure on Monday. The belief it was better to go liquid and lose a little money in the turnaround, than to take the chance of some disaster over the Weekend. This would crash the market with sell orders on Monday morning. The advent of a host of hedging strategies and round-the-clock trading through the world's exchanges, has sent this practice to the junkyard.
Seasonal factors are still to be reckoned with.
(To be continued)