Suppose that all you knew was that the NYSE's daily cumulative A-D Line was at a new all-time high, or even a 3-year high. What would that tell you?
Generally speaking, the A-D Line does well when liquidity is strong. To get a majority of stocks to be advancing takes plentiful liquidity, and that is why the A-D Line is so useful as an indicator of the health of the liquidity stream. Problems arise when major price indices are making higher highs but the A-D Line is not keeping up. We saw that condition in 2007 in a big way, and it correctly warned us of the trouble which was to come.
To create this week's chart, I built formulas to detect whether any given trading day saw the NYSE's A-D Line at a new 3-year high. For those dates, I then calculated the 3-month forward drawdown for the SP500. The idea is to examine what is the worst case over the next 3 months if we know that today sees a new A-D Line high.
Over most of the history of the A-D data (dating back to 1926), the answer is that the damage is usually limited to about a 10% max drawdown within the 3 months after a new A-D Line high. That's a useful piece of information, and it is also useful to note that most of the time it is not even that bad.
[Read: The Bears Are Seeing Red in a Sea of Green]
The chart above also shows us that the Bernanke era of Fed intervention brought a new answer to that question. At the market top in April 2010, there was no A-D Line divergence, but the end of the Fed's first round of "quantitative easing" (QE1) nevertheless led to the May 6-7 "Flash Crash" and an ensuing drawdown of 16% in the SP500. That market response told the Fed that they had pulled away too soon, and so QE2 was brought out later in the summer of 2010.
QE2 was a great success in resuscitating the stock market, and pushed prices higher all the way until QE2 was abruptly ended in June 2011. At that time, the A-D Line was still reflecting the strong liquidity that the Fed had been supplying right up until they turned off the spigot. But just one month later, in July-August 2011, we saw a 19% drawdown in the SP500.
This goes against the historic "rule" that a new A-D Line high provides immunity from anything worse than about a 10% drawdown. But it also helps to highlight just how much the stock market has become dependent on the Fed acting as the agent of marginal liquidity, as opposed to the liquidity for an advance being generated from the economy itself.
Fed officials seem to realize this, which is why for the current round of QE, the FOMC has decided to "taper" back very slowly instead of trying to quit cold turkey. When we eventually get to the end of QE, it will be a fascinating question as to whether the market can survive without another sharp selloff like the ones we saw in 2010 and 2011. For now, though, the Fed is still pouring money in, and we still have the A-D Line making higher highs to say that liquidity is plentiful enough to lift the majority of issues.
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