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                                       | How to use the JSE Advance/Decline Line |

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                                       | Detecting AD Divergence with the Disparity Indexes |

One of the most powerful momentum indicators we use in mechanical investing gauges the strength of the market according to the number of shares that advance and decline in the previous trading day. It is sometimes referred to as the "breadth" of the market, depicted by three indicators:

-The Advance/Decline  ratio is the ratio of advancing shares to declining shares.
-The Decline/Advance ratio is the ratio of declining shares to advancing shares.
-The Net Advances is the number of advances subtract the number of declines.

Advance/Decline data for the JSE, although mentioned on some news broadcasts at the end of the day, for the day, is almost impossible to come by in charted (plotted) historical or updated indexed form, even lacking in sophisticated charting packages, which is very frustrating for us mechanical investors, since every great investor we follow uses this data in their strategies.

So here at PowerStocks Research we went and computed this data for the JSE for the last 11 years ( a very onerous task that took us a week to complete) and present it below. Not only is this data important for short term trading and timing but we will need it for some of the more sophisticated indicators and strategies we use later on as well as to identify "special situations" about 6-12 times a year that can lead to very profitable trades.

We will track Advance/Decline data for the JSE on a weekly basis for our subscribers under the Weekly JSE Pulse (WJP) section. Special situations get posted there as well.

The NET ADVANCES Index Line for the JSE
There are 420 shares on the JSE. If the JSE goes up, there is no way to know if it went up because of large gains in a few big-cap shares or if the whole market benefited from underlying strong sentiment. Similarly for declines. That's where the Net Advances Index Line for the JSE comes in. It is a very simple measure of how many shares are partaking in a rally or sell-off.

Above you can see the NET Advances Line, a "Summation Index" that we started in January 1998 at 4,210 (an arbitrary number to ensure the line is always above zero). It is created by taking the previous days reading and adding to it the net advances (advances minus declines) for the day. The index is ratio adjusted to cater for the growth in number of shares on the JSE over the years, to allow for meaningful historical comparative data (otherwise it would have had wider and wider net advances as the number of shares on the JSE grew).

The line pretty much should follow the ALSH index, but on occasion there is DIVERGENCE and this hints at weakness or strength in the market. For example, look at the 2007 to 2008 market peaks before the great 2008 crash. As the market advanced, fell and then advanced again, the Net Advances Index was in a decline, suggesting a WEAKENED underlying market. Growth was being attributed to fewer and fewer shares and this is your first warning sign to GET OUT THE MARKET. On 10th October 2007, the Net Advances line failed to make a new high with the new ALSH highs and that was our signal that a massive change was imminent.

Divergence can also occur when the Index is rising but the market declining, hinting at a turn in a down-trend to a bull market. In the last 12 years there have been 6 occurrences of this bearish divergence that gave early warning of a major JSE correction/crash. Not every correction is led by a diverging AD line, but when it DOES start diverging you know there is only trouble ahead.

For full details on how to detect and interpret AD-Line divergence to limit losses and even boost profits go and read Detecting AD Divergence with the PowerStocks Disparity Index". For more details on the A/D line and particularly for a historical chart of A/D Line divergences since 1996, go to How to use the JSE A/D Line.

The Advance/Decline Ratio for the JSE
The ratio of advances to declines are charted below for 11 years on a daily basis. We see that advances outnumbering declines 4-to-1 are rare events (use the left scale for the ratio). Also we see that AD ratios above 3 after a crash/correction seem to mark the start of new bull markets. As this ratio oscillates very rapidly, we use a 20 day moving average (the thin black line) to smooth it out.

Martin Zweig believes strongly that a few days of high advances to declines launch new bull markets. We put this to the test and recorded all occurrences since 1998 when the A/D ratio reached a certain point or higher and measured subsequent 20 day growth in the ALSH index.

The chart above shows subsequent 20-day ALSH growth for all occurrences of an A/D ratio above a certain minimum point (the X-axis). Using the above graph we see that the best performing investment criteria was to set a target A/D ratio of 3.7 or higher and there would have been 20 such occurrences since 1998 averaging 3.98% 20-day growth with a 5.28% deviation, leading to a Sharpe of 0.75. It seems that A/D ratios above 4.7 lead to diminished returns (perhaps as the market rises of these events were too high to allow the small 20 day window to gain any appreciation) 

We see that the "sweet spot" (Sharpe above 0.6 demarcated by the blue box) seems to be a A/D ratio between 3.7 and 4.7 as anything outside this range suffers from too much deviation leading to impaired Sharpe ratios. If we set this range  as our investment criteria, there would have been 12 such occurrences averaging 4.73% growth and 4.03% deviation, with a Sharpe of 1.17. For each 20-day period you would have enjoyed an annual return rate of 56.7%

The above suggests that once a year, on average, a "special event" occurs when the Advances/Declines ratio is between 3.7 and 4.7 and you can make an investment on this occasion in a SATRIX40 ETF or TOPCAK geared warrant and be fairly certain of a 0.7% to 8.76% gain within 20 days.
(7%-80% for the warrant.)

The Decline/Advance Ratio for the JSE
The ratio of declines to advances (the inverse of the previous section) are charted below for 11 years on a daily basis. Note how high ratios ("spikes") are indicative of "final capitulation sell-off's" that are highly correlated to market bottoms. We have less of this "phenomenon" with the Advance/Decline ratio. Visually at least, it would appear from the below chart that the Decline/Advance ratio is excellent at picking troughs!

The chart below shows subsequent 20-day ALSH growth for all occurrences of an D/A ratio above a certain minimum point (the X-axis). We see that on only 6 occasions, declines outnumbered advances by more than 14 times and each time this occurred, the market advanced in 20 days an average 11.76% with only 8.1% deviation! If you played a TOPCAK warrant your gains would have been in excess of 20%-110% over that period!

So it looks like high Decline/Advance ratios also warrant being placed in our "special situations toolbox" together with high Advance/Decline ratios, in fact the decline ratio "special situation" seems to deliver double the returns of the advance ratio "special situations". This makes sense since high Decline/Advance ratios are indicative of "final capitulation" broad-based sell-off's meaning you are very near a bottom. On the way up though, the market is governed by greed as opposed to fear and hence you see much smaller Advance/Decline ratio extremes than Decline/Advance ratio extremes.

Using these two ratios in "special situations" would have led to 12+6=18 events that would have served us nicely over the last 10 years.

The Advance/Decline Index Line is useful to identify divergence between market movements and underlying strength. This divergence can predict turnaround's in the market. If no divergence is apparent it can be used to confirm underlying market strength in an advance.

Sell-off's and rallies can be confirmed with the Advance/Decline and Decline/advance ratios. For example if a rally is confirmed with a high Advance/Decline ratio or moving average we can be confident we have a sign of broad based market strength. On a market decline, we can confirm with the Decline/Advance ratio if it is a blip due to one or two large cap shares or sectors or something more broad based we need to be concerned about.

High A/D ratios following a crash or high D/A ratios mark turning points in the market.

Special situations occur with both advances outnumbering declines and declines outnumbering advances that can be used to generate healthy short term profits (20-40 days) on average 18 times every 10 years (1.8 times a year).

In particular, days with very high Decline/Advance ratios represent "final capitulation" sell-off's that provide strong clues as to market bottoms, which is excellent news for market timers.

To read how our subscribers doubled their money in 10 days using this indicator recently, go "Instant Money! But beware... "

To read more on how we use the NET Advance/Decline line to profitably time the market, go and read "The Incredible McClellan Oscillator"

SEE THIS IN USE WITH-->  | Up/Down Volume and Lowry's 90% Days | PowerStocks TroughFinder |
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