Sign of the Bear?

We frequently write in our newsletter about indicators we follow to give us some clue as to where the market may be going. The Advance/Decline ratio is another such indicator, and measures the strength of the stock market. It’s been behaving rather badly lately.

The A/D indicator is simply the number of stocks going up in price divided by the number of stocks going down in price on a particular day. When the number of stocks going up is larger than the number going down, breadth is said to be positive, and when declining stocks outnumber advancing stocks, breadth is negative.

An A/D ratio above 1 indicates that advancing stocks outnumber declining stocks, and a ratio of .5 means that decliners outnumber advancers by 2:1. Recently, breadth has been unusually negative. For the week of June 8, the ratio was .59, with 1121 stocks advancing and 1907 declining. In fact, the trend since the 2nd week in April has been negative, signaling general weakness in the market.

In the May 4th issue of Barron’s, Peter Eliades writes about his study, “Sign of the Bear”, and develops some interesting data using the A/D ratio. He found that when the market experiences at least 21, but no more than 27 consecutive days, with the A/D ratio between .65 and 1.95, the market may be headed for a downturn. In fact, in over 70 years of data there have been only 6 times when the A/D ratio did this; the last one occurring on April 6th. After each of the five signals preceding April 6th the market has topped, and then declined significantly. We combined Elizdes’ study with another study done by Cherney of Standard & Poors, and developed the following information:

 

Time after Signal to:
Subsequent decline in Dow Jones Industrial
Average (to bottom)
Signal Date Market Top % Gain to Top
7/19/29 7 Weeks 10.42% -9.5%
12/8/61 1 Week .92% -29.1%
1/25/66 2 Weeks .35% -26.5%
10/17/68 7 Weeks 2.74% -36.9%
12/6/72 5 Weeks 2.35% -46.5%
4/6/98 5 Weeks?? 2%?? -6.30%??

You can see that the market tops ranged from the very first week after the signal to as much as the 7th week after the signal. As of this writing we are 10 weeks after the 4/6/98 signal.

The market high since the latest signal was 9211.84, which was reached on 5/13, in the 5th the market (Dow) has declined 583 points, or 6.3% (as of 6/15/98). Thus, unlike so many other historical measures of market tops which have been broken, the accuracy of this indicator seems, so far, to be intact.

However, we should also note that 5 of the 6 signals were closely associated with Federal Reserve action to increase short term interest rates, which almost always has a negative effect on stocks. And based on Alan Greenspan´┐Żs recent report to Congress, it looks like the Fed will not be taking any action for a while. That makes us feel pretty good.

While we continue to be bullish over the longer term, we do expect increasing price volatility in the financial markets. Of most concern in this regard is the potential for rising labor costs, which would deepen the wound in corporate profits and spur action by the Fed to raise rates. Specifically, we will be watching the labor strike at GM as an indication of what may be coming. If labor is successful in increasing its share of profits and we see rising labor costs spreading, we would be inclined to take some profits and move some funds out of the market.

On a more positive note, we like the federal budget surplus and continuing inflows of money into the markets. We think these are good reasons to maintain our current investment posture.