Looking Under the Hood with Market Internals (Part 1)

Key Takeaways
• The stock indices are weighted averages of an underlying basket of stocks. Since they’re a
‘weighted’ average, their price can be influenced by a few big stocks, even if the overall market
is not moving strongly in that direction. As such, we need to look “under the hood” of the index
to determine the true health of a given price move, and we do this by gauging what the
individual stocks that make up the index are doing. The indicators that allow us to do this are
called market internals, or breadth indicators.

• The Advance / Decline Line (A/D Line) measures how many stocks are up on the day versus
those that are down on the day (as compared to yesterday’s close). The formula is: Advancing
stocks - Declining stocks = Advance / Decline number. The A/D line shows how this number is
changing over time.

• The S&P 500 A/D Line ranges between +500 (all S&P 500 stocks are up on the day) to -500 (all
S&P 500 stocks are down on the day). The NYSE A/D line can range up to somewhere around
+3000 down to -3000. The exact number will change based on how many stocks are currently
listed on the NYSE.

• The A/D Line is helpful when it diverges with the price of the index. If the index is making new
price highs while the A/D Line can’t get to new highs, this could be a warning sign that the
index is being propped up by a few heavily weighted stocks and the overall market is not as
healthy as the index is making it seem. In the right context, this can be a good signal that we’re
about to head lower.

• If the A/D Line opens at an extreme (beyond +/- 400 on S&P Line or beyond +/- 2000 on NYSE
Line), and holds beyond the extreme, that’s the kind of behavior that tells us that we could
have a trend day. (Another scenario could be that the market had a very large gap and then
will balance all day without being able to reverse the gap). Even if the line drifts down while at
a positive extreme (or up while at a negative extreme), as long as it’s holding the general area,
that’s enough to get sustained directional price action in the indices.

• Other than the case of holding at an extreme, what matters is not the absolute number the line
is at, but rather its trend. If we open at -400 for instance but the line rises all day long, then we
can readily have an up-trend day off of the gap down.

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