This Indicator Warned Us Before Every Market Crash

Stocks are selling off. Is this the beginning of a bear market, or just a long overdue pullback?

Traders try to forecast market action with indicators. Some indicators are elaborate. Others are simple. Over time, the simple ones tend to be more useful. This might be surprising.

Many of us think Wall Street is using sophisticated tools to make money. It is. As individuals, we can’t compete with its sophisticated techniques. That’s why day traders tend to lose money. Wall Street firms are trading in nanoseconds, and our data feeds can’t process information that quickly.

But big Wall Street firms also use simple tools to make money. Many long-term trend-following strategies use simple ideas. And we can use these same tools to ride big trends in the stock market.

The Advance-Decline Line

One tool many large firms use is the advance-decline line. The advance-decline line indicator subtracts the number of stocks that closed down every day (declines) from the number that closed up (advances). The A-D line is the blue line in the charts below. The S&P 500 Index is the black line.

One tool many large firms use is the advance-decline line indicator. This tool helps to gauge whether or not we are headed for a bear market.

These four charts show the market action before significant declines. In each case, the A-D line (the blue line) was in a downtrend before the S&P 500 turned lower. This happened before bear markets that led to losses of 50% or more in 1972, 1999 and 2007. It also happened before the 1987 crash.

The A-D line simply counts how many stocks are going up. In a bull market, we expect most stocks to be going up. In a bear market, the majority of stocks should be going down. That is a simple idea, but, as the charts show, it’s an important indicator to follow.

Near market tops, we see fewer stocks going up. The index is moving up because just a few large stocks are producing gains.

In 2007, housing stocks and financials were still moving up after most stocks peaked.

In 1999, internet stocks were the market leaders while most stocks were in downtrends.

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