Fighting The Stock Market Rally? – Don’t Ignore This Indicator

Both the stock market bulls and bears were lined up on either side of last week’s CPI report. Those who were convinced that the stock market rally from the June lows was just a pause in the bear market expected a much worse than expected CPI report. Instead, the report came in better than expected as stocks exploded to the upside.

A weekend Bloomberg article began with “Stock bears are suddenly getting crushed”. They further commented that “sharp market reversals are baffling real-money veterans, retail speculators and quants alike”. So what did they miss?

The ability of the S&P 500 to overcome the 4200 level likely triggered even more short covering but that should not have been surprising as I felt this was likely at the end of July. My expectations for short covering were based on the strong technical readings at the time and the June reports that the dollar amount of hedge fund shorts reached levels last seen in 2008.

The uninterrupted S&P futures rally Friday afternoon did not provide any pullbacks for traders to cover their short positions. I would expect next week’s Commitment of Traders report to show a significant decline in the short positions for the S&P futures.

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There were plus signs across the board led by a 5% gain in the iShares Russell 2000 which was up 5%, followed by a 3.7% rise in the Dow Jones Transportation Average. For a change, the S&P 500 ($SPX) outpaced the Nasdaq 100 ($NDX) by a margin of 3.3% to 2.7% for the more growth-dominated $NDX.

The Dow Jones Industrials had a solid gain of 2.9% just a bit better than the 2.7% rise in the Dow Jones Utility Average. The SPDR Gold Shares had the smallest gain of just 1.6%. It is also significant now that only the $SPX and $NDX are showing double-digit losses year-to-date (YTD). The NYSE market internals were as impressive as the price gains with 2695 issues advancing and just 788 declining.

But why is this important? In my view, the technical indicator based on this data is the most important measure, other than price to determine the stock market’s trend. The advance/decline line is a cumulative reading of the net advances minus declines. I developed my unique A/D line analysis in the 1980s and have been using it ever since.

The NYSE Composite has stocks, bond funds and ADRs which is why the data is referred to as issues not stocks. All of these issues are used in the NYSE All Advance/Decline line. There is also the NYSE Stocks Only A/D line which is based on just the stocks that are traded on the NYSE.

In addition, I follow four other advance/decline lines; the S&P 500 A/D, Nasdaq 100 A/D, the Russell 2000 A/D line and Dow Jones Industrial A/D line. I have found that often one or more of the A/D lines but not all will indicate a change in trend so that is why I monitor all of them regularly.

It was my analysis of the weekly Nasdaq 100 Advance/Decline line on the week ending June 24th that a more important low could be in place as I pointed out in “Don’t Count On Another Rally Failure”. The focus then was the fact that when the Nasdaq 100 and Invesco QQQ QQQ Trust (QQQ) made new lows the week ending June 17th, the Nasdaq 100 A/D line did not, line c.

The next week, line d, the A/D line moved above its WMA that added weight to the bullish divergence. Over the next four weeks, the A/D line moved above resistance, line b, and it has risen strongly over the past month. Similar action was evident after what turned out to be the important market lows in February 2016 and December 2018.

The close last week was above the downtrend, line a. The weekly chart shows the move above the 38.2% Fibonacci resistance from November 2021 high with the next target at $339, the 50% level. The more important 61.8% resistance is at $355.45. Typically a close above the 61.8% Fibonacci resistance confirms that the major uptrend has resumed.

At the mid-March low, the S&P 500, the NYSE Stocks Only A/D and NYSE All A/D lines moved above their EMAs, turning positive as highlighted by the green squares. By early April they had all turned negative again and none of the weekly A/D lines showed any positive signals during this period.

The positive signals from the daily A/D lines at the mid-May lows (purple squares) did not last as long as the market averages, like the Spyder Trust (SPY PY SPY ), was hit with another wave of selling as it dropped to new correction lows. During both of these periods, the daily A/D lines formed lower lows with prices and did not form any positive divergences.

That changed on July 14th when the NYSE Composite had a new intra-day low that was not observed in other indicators like the SPY or QQQ. This was significant as the NYSE All A/D line did not make a new low forming a daily positive divergence, line f. The move in the NYSE All A/D line above its EMA and then the resistance at line e, was a positive development.

In the past week, all of these A/D lines have overcome their major downtrends, lines a, c and d which is a bullish sign from an intermediate standpoint. It is also a good sign that the EMAs of the A/D lines are rising strongly and trending higher.

In my experience using the moving average and trendline analysis on the A/D lines is the most reliable way to identify corrections lows. One does not always have to observe divergences at the highs or lows but when they do occur the signals can often be stronger. In A Survivor’s Guide To Market Corrections I discuss several other significant market corrections that can help you better use my A/D line analysis.

The four straight weeks of solid gains it would not be surprising to see a 1-2% pullback that could coincide with option expiration this Friday. This should provide another good buying opportunity.

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