Mar 28, 2014

How To Spot a Market Peak




How to spot market peaks using Advance/Decline ratio (ADR)?

ADR is a market breath indicator showing the number of stocks closing higher vs the number of stocks closing lower over certain period of time.The interpretation of this ratio is quite simple - the higher it is, the more advancing stocks there are, the more overvalued the market is. However the timing here is important as its peaks not always coincide with the market ones. In some cases higher ADR actually supports the market, especially if it is after severe correction. That sound logical. After sharp drop there is large number of shares bouncing.

Back to the question how to spot the market peaks. The answer is simple:
First, look for divergence between the market and the indicator. Rising market index accompanied with declining number of advancing stocks means upcoming drop. Second, look for high readings of the ADR. Values above 3.5-4x to be considered as significant. (Note: analysis is based on 25 period ADR).

I've done some back testing, which showed pretty interesting results. Here hey are:
  • It is most likely to see ADR higher than 3 during first quarter of the year. Usually that is February or March as it happened in 2010, 2012 and as it seems in the current 2014.
  • After the peak in ADR with values > 3.5 the bull market continues 40-70 more days before correction occurs (see 2010, 2012).
Advancers vs decliners and S&P 2010-2012
Advancers vs decliners and S&P 2010-2012

The case of 2007. It is interesting how the indicator behaved just before the previous bull market peak. In 2007 ADR reading above 3.5 was registered in May. Since then the index started falling while overall market continued climbing, although on sideways. Still the market trend was positive for some 72 days after the ADR max. After that followed sharp decline erasing the year gains.

Advancers vs decliners and S&P 2007
Advancers vs decliners and S&P 2007

Back to present as of 12th of March ADR was 3.16x i.e. the advancers were 3.16 times more than decliners. That does not seem supportive for the market trend because ADR is not extreme (above 3.5) but within the range 2.5-3.5. In that case the market mildly pulls back with the ADR line as it happened in 11 Oct 2011 and 23 May 2013.

For the moment according to ADR analysis there is no reason to believe that major correction is on the way. However if we see steady decline of the ADR index with still rising market that is clear signal that strong correction could evolve in the next 40-70 days.

Advancers vs decliners and S&P 2012-2014
Advancers vs decliners and S&P 2012-2014
By Detelin Y.
More on Markets and Forecasting

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