A Look Under the Market Hood

May 17, 2008: 10:17 AM CST

The market has been strong since its March 2008 lows, but let’s take a peek under the hood at the Market’s Internals to see if there’s underlying strength or weakness.

First, the the recent NYSE Advance/Decline Line:

The important fact to note about this chart is that the line made a new high for 2008 and rose steadily in line with the market from the March lows.  This could be a sign of strength in the market

Now the weekly AD Line:

The Weekly AD Line broke out of a downward trend line and again made new highs for 2008.

Notice how the AD Line led the market top, in that the high on this chart was formed in June 2007 yet the Market peaked near October, when the AD Line was clearly beneath that earlier peak.  Now we are seeing a break of the down trend (lower lows and lower highs) which could be an early sign of strength.

StockCharts says the Advance/Decline Line is “One of the most widely used indicators to measure the breadth of a stock market advance or decline. The AD line tracks the net difference between advancing and declining issues. It is usually compared to a market average where divergence from that average would be an early indication of a possible trend reversal.”

In the weekly “New High – New Low” Index ($NYHL), we see only a minimal recovery, as few stocks have been able to surmount the losses they took earlier this year.  While the line has turned positive, it has done so only slightly.  Many stocks including the US Market Indexes fell over 20% from the October peak and it will take strong strength and sustained buying to stage a broad-based recovery to advance this line significantly.

Notice also that this indicator peaked in July 2007 and by the time the actual market peaked in October, the indicator clearly was showing weakness at that time with fewer stocks making new highs.

Looking under the hood, we see some strength, but keep in mind that the indexes appear to be at critical resistance levels via their ‘line in the sand’ average (200 day moving average).  I would like to see the indexes clearly break that level before getting super bullish, but if I had to make a bet, I would say the price would experience a short-term reversal at these levels and test some lower prices – that’s a common expectation.

Should price defy expectations, it could knock a lot of traders off balance and higher prices could result as the market defied the odds yet again and caused more and more shorts to cover their positions.

Check out Dr. Steenbarger’s Wednesday post entitled “Gauging Market Strength after a Move to New Highs” for further information on recent market internals.

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