When the NYSE’s A-D Line hits a new high, it conveys a clear message that liquidity is plentiful. The market might encounter other types of problems, such as investors’ emotions suddenly swinging, or a big news event rocking the market. But if liquidity is strong, the market can more easily recover from such problems.
The DJIA has been in a concerted uptrend since making a final corrective low in February 2016. The DJIA’s upward progress has been in fits and starts, while the NYSE’s A-D Line has made a more steady uptrend. At several times, there were disagreements between the A-D Line making higher highs while the DJIA made lower highs, and in each case the A-D Line turned out to be right about where both were going.
Trouble has historically come when there is a bearish divergence between the A-D Line and the DJIA. Here are some notable examples:
So the fact that we have just recently seen a new A-D Line high says that we are not in one of these extreme bear market risk conditions. The market may still be subject to ordinary garden-variety corrections, but not the really big sorts of drawdowns.
I wrote about this point here in 2014, noting that during the 3 months following a new 3-year high in the A-D Line, drawdowns are typically limited to 10% or less. Here is an updated version of the chart from that earlier story.
This chart also makes the point that when the Federal Reserve puts its thumb on the scale, then “normal” market relationships can be bent or broken. There were drawdowns of greater than 10% after the end of both QE1 and QE2. Each time, the A-D Line was correctly stating that liquidity was plentiful, thanks to all of the money that the Fed was pumping into the banking system. But then forcing the market to quit its addiction to that free money cold turkey had bad effects.
Eventually the “experts” at the Fed learned their lesson, and so when they ended QE3 in late 2014, they did not stop it all at once. Instead, they “tapered” the injections down to progressively smaller amounts.
I liken this to hydroponic versus organic gardening. In hydroponic gardening, all of the nutrients that the plants need are artificially provided, and the results can be impressive. But you cannot switch a plant from hydroponic conditions to growing in real soil with natural nutrients, and not expect the plant’s health to suffer. 2015 saw the market chop sideways as it worked to find more organic sources of liquidity, without the Fed’s meddling, and it appears to have done that.
I am expecting that we are going to see a brief market correction this spring, as I have been detailing in our twice monthly McClellan Market Report and our Daily Edition. But the message from the strong A-D Line is that the risks of a big price drawdown during this upcoming corrective period are pretty minimal.
The McClellan Market Report