Why you need to carefully monitor stock gains, losses

Opinion and Analysis

 

Maritime workers at an event in Mombasa last year to mark the World Maritime Day. PHOTO | FIL

By RUFUS MWANYASI

There is an old saying that seems to always apply to the investment world, “hindsight is 20/20”.

When looking one, three or six months into the past, we can easily tell what the market did and why
it happened so. But if you are looking to discover the trends of the market today, where do you look? 

We will go over the advance-decline line (A-D), a technical analysis tool used by traders to gauge the strength of the market. The indicator calculates the difference between the advancing stocks and declining ones.

If the markets are up but there are more declining stocks than advancing ones, it is usually a sign that they are losing their breadth or momentum. If the number of advancing shares is dominating the declining issues, the market is said to be healthy.

Arguably, the indicator is considered to be the best “liquidometer” (a way of finding out the state of the liquidity available to the stock market). 

From the chart below, it is obvious the general trend of the market has been upwards (although the NSE 20 Share Index has shed roughly four per cent of its value since last February) in the last several months.

Prices have been trading way above vital support lines. But so far, the markets A-D line has not followed suit. Maybe it will catch up in the days ahead, but for now we have a bearish divergence showing.

That is a way of saying that the elevated price highs for the index are being made with dwindling participation, and that is not good news.

Is this is a sign that the market is going through a topping phase? Should investors be worried about the situation? Well, not entirely.

This is because the price index may continue making higher highs in spite of the bearish divergence, which could possibly influence the market to undergo a sudden improvement eventually taking away the divergence that is evident now.

Investors should not just take notice of this divergence and act on that basis alone. If the market continues to push higher say past its February highs (at 5,491 points) while the divergence is still in effect, this conveys a more dangerous message about what lies ahead. If this becomes a reality, then at this point investors will be best advised to start pruning their positions.

For investors to better appreciate this tool, they need to realise that financial markets can suffer from many different types of problems, but liquidity problems are the toughest to get over.

And in periods when liquidity is plentiful, as evidenced by a strong A-D line, then the other types of problems are easier to get over.

Plentiful liquidity means that even the least deserving stocks can garner some of it, and participate in the advance. But when liquidity begins to get tight (as displayed by the chart), the big and popular stocks which dominate the index start to enjoy much activity while the rest of the market tumbles.

Investors are therefore best served tracking the A-D line to keep track of the markets momentum.