Most agree that the major ingredients required to herald a sharemarket crash are investor euphoria combined with an overvalued sharemarket; like a pressure cooker, as prices for stocks soar upwards, a market becomes overheated and the likelihood of a market crash is ever more present.
Last week we looked at the fundamental reasons for why investors can all of a sudden have a change of heart, offloading stocks at once and causing a market crash. We also compared the fundamentals of the Australian sharemarket today compared to the era of the Black Monday crash in 1987. It was reassuring to discover that the Australian sharemarket isn’t terribly overvalued, and doesn’t seem to hold the usual characteristics of a market on the verge of a crash. Neither unemployment, inflation, interest rates nor bond yields would lead us to the suspicion that a crash was on the cards.
Yet, when trying to predict the behaviour of investors en masse, the wildcard is always investor sentiment, or market psychology. The question is: on the continuum between greed and fear, where are investors’ currently sitting? Are they optimistic for the future and expect strong gains from their sharemarket investments, or are they starting to fear losing money to the market.
A popular gauge of market sentiment is the market breadth. As we briefly mentioned last week, the market breadth measures the strength of a market by comparing the number of stocks that advance on a particular trading day to the number of stocks that retreat.
An increase in bullish sentiment is noticeable when the number of stocks advancing up the charts is higher than stocks in retreat. Bearishness is present when the numbers of declining stocks is larger. A leading indicator of market breadth is the advance/decline line (A/D Line). The A/D line is calculated by taking the difference between the number of advancing stocks and the number of declining stocks at the end of each day, and adding this figure to the cumulative total. See below for a basic, hypothetical example.
Since the A/D line starts at zero, the actual figures offer little insight. What’s telling is the direction and slope of the A/D line when plotted on a chart.
Clearly, if there are more advancing stocks than declining stocks on a given day, the difference will be positive and the A/D line will go up by that amount. If more stocks fall than rise over a given day, or period, the AD line will slope downwards.
Therefore, a rising A/D line implies bullishness and a falling A/D line signifies bearishness.
So rather than using broad market averages encapsulated in the S&P/ASX 200 or All Ordinaries indices as a guide to the strength of the sharemarket, canny sharemarket punters often use the A/D line instead.
So let’s have a quick look at the A/D line for the Australian sharemarket over the past 12 months, as well as the New York Stock Exchange (NYSE), supplied by Colin Nicholson, using his Insight Trader charting software with data supplied by BeyondInvest.
As you can see in the first chart, the A/D line for the Australian sharemarket hit a peak in February, about the same time as the All Ordinaries broke the 6,000 mark for the first time. However, since then, it has been steadily trending down, with a pronounced drop in late July to mid-August – corresponding with a sell off in the market; the All Ordinaries hit a low of 5,670.30 on 17 August. It has only been of late, in September and October, that the A/D line has recovered some ground.
Australian (ASX) Advance Decline lines
Technical analysts compare the A/D line with the broader market indices for any divergence that may occur.
Below is a chart of the All Ordinaries over a similar period. As you can see the All Ordinaries hit a wobble in July and August, with a fairly pronounced sell-off in August. It has since continued to surge higher – peaking at 6,781.00 on 18 October.
Some sharemarket analysts use the market breadth as a gauge of investor sentiment. When sharemarket indices are up but the A/D line is sloping downwards, some punters get nervous. They argue that the market could be setting itself up for a reversal in trend.
Conversely, when the A/D line is up, and the markets are down, those who use the market breadth as a guide to market strength feel more optimistic. The most recent performance of the A/D line therefore suggests that positive sentiment could be creeping back into the market.
Others go so far as to say that stockmarket plunges in the past have been preceded by a divergence between the broader market indices and the A/D line. Unfortunately, we don’t have the data on hand to test this line of thinking.
The final graph depicts the A/D line for the New York Stock Exchange. In stark contrast to the Australian A/D line, the market breadth of the NYSE has been trending up from November to July, but suffered a similar dive to the All Ordinaries index in late July and August.
US (NYSE) Advance Decline Lines
So what does the market breadth have to do with the Hindenburg Omen, a technical indicator used by some to predict a forthcoming market crash (mentioned last week)? Well, similar to the A/D line – the Hindenburg Omen looks at divergences as a guide to the possibility of a market crash. However, rather than using A/D data, the Hindenburg Omen evaluates the number of stocks hitting new highs and new lows, and argues that when a substantial number of stocks hit both new highs and new lows, then the market is clearly out of wack. A healthy market, in contrast, occurs when there is some uniformity of direction – either up or down.
The Hindenburg Omen goes on to include other vital signals when crash-testing sharemarket conditions, which we won’t elaborate on today.
So in sum, when evaluating the likelihood of a market crash, it’s worth remembering that declining market depth in combination with the fundamental factors last week – are typical factors used to crash-test the market. However, rather than trying to forecast a large-scale market correction (which isn’t so easy) it’s more important to ensure that, should it occur, your financial health isn’t unduly affected. In the end that’s the key to long-term financial success.