How strong is this market?

Trade wars have led one indicator to signal the rally may be losing short-term strength.

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Key takeaways

  • Average directional index (ADX) is a short-term technical indicator that can help you assess the strength of an investment.
  • ADX suggests the recent short-term volatility trend may have some strength.
  • Indicators like ADX should be used in combination with other indicators and fundamentals.

Days like August 5, when the S&P 500 lost 3% after news broke that China devalued its currency in response to US trade tariffs, can serve as a reminder that any market is susceptible to down days. Even markets like this one, where stocks are still close to all-time highs despite the recent volatility.

If you are an active investor, you may have found yourself asking how strong the momentum is behind the US market. One technical indicator that can help shed some light on this question is ADX. According to ADX, the market's long-term uptrend may lack strength over the short term, with some bearish signals suggesting additional caution as well. 

Why strength matters

There are many ways that you can incorporate technical analysis into your investing strategy. One way is to use indicators and other chart techniques to supplement your overall assessment of the fundamentals of the global economy, the business cycle, and other factors relevant to your analysis.

Whereas technical indicators like RSI, MACD, and stochastics can help you determine at what price to buy and sell a stock, ADX is used to help determine how strong a trend is. From an investing perspective, strength can be an important factor as it can help determine if there is momentum behind a market move.

To understand why, consider a hypothetical stock that is rising in price. Would you rather own this stock if the uptrend were strengthening or weakening? From a technical analysis perspective, a rising stock in a strong uptrend may suggest greater likelihood of continuing to rise than the same stock whose uptrend is showing signs of weakness.

ADX up close

ADX is simply the mean, or average, of the values of directional movement (DM) lines over a specified period. DM lines are calculated using current high and current low prices. Much like RSI and stochastics, ADX fluctuates between 0 and 100. The orange line in the bottom part of the chart below is an example of what the ADX indicator looks like.

Unlike other technical indicators, however, readings above 60 do not occur frequently for ADX. In practice, most chart analysts believe a reading above 25 typically indicates a strong trend and a reading below 20 usually suggests there is no trend. No clear signal exists between 25 and 20.

A rising ADX line generally means that an existing trend is strengthening. This is noteworthy because, if ADX suggests the trend is strong (i.e., ADX is rising), then trend-following systems—such as moving averages and channel breakouts—are expected to have more validity. Alternatively, if you see a falling ADX line, which indicates an existing trend is weak or there is no trend, you may not want to place as much value in the signals given by trend-following systems.

The chart above is a simplified version of the ADX indicator. There are actually 3 lines. The most important one, as seen above, is the ADX line. In addition, there are 2 other lines: a DMI plus line (sometimes shown on charts as DMI+ or DI+) and a DMI minus line (sometimes shown on charts as DMI- or DI-). DMI stands for directional movement indicator. Whereas the ADX line determines the strength of the trend, the 2 DMI lines complement the ADX line by helping determine the trend’s direction.

The direction of the trend is interpreted as positive when the DMI plus line is higher than the DMI minus line. Conversely, the direction of the trend is interpreted as negative when the DMI minus line is higher than the DMI plus line.

How strong are stocks now?

As the price chart of the S&P 500 below shows, stocks (top half of chart) have generally trended higher in 2019—with a few significant pullbacks interspersed, including the past week. Over the same period of time, ADX (bottom half of the chart) has ranged from confirming the strength of the market's uptrend, to more recently signaling there may be a reason to question the rally's strength. 

ADX has a reading of 27—indicating there may be strength behind the current direction of the short-term trend. However, it has also been moving mostly sideways for several weeks, which does not signal a confirmation of the short-term trend. Meanwhile, the DMI minus line is well above the DMI plus line, suggesting the trend is clearly negative, according to this indicator. These 2 signals taken together suggest the bearish trend of recent days may have some strength behind it.

If the DMI plus line were to close the gap with the DMI minus line, that would be a signal for a reversal to a bullish trend. Additionally, if stocks were to resume the rally, and the ADX line were to continue to rise above 25, that would be confirmation of a bullish trend.

Adding ADX to your toolkit

Of course, ADX's current reading does not necessarily mean that stocks could rapidly decline and that you should sell. ADX is simply a short-term indicator that can be used under any type of market conditions (e.g., bull or bear markets, high or low volatility, etc.), and can complement your understanding of what’s happening in the market. You might first use ADX to determine the strength and direction of a trend. If the trend is strengthening, then you might couple this interpretation with other trend-following indicators, such as moving averages or channels to determine when to buy or sell, depending on your strategy. Given ADX's current signals, investors that utilize this indicator and have short-term positions may want to have a cautious approach.

Next steps to consider

Find new investing ideas and get up-to-the-minute market data.

Learn what you need to know before trading the market.

Learn about more technical indicators and how they can help you trade.

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