If you are an active investor, you may have found yourself asking how strong the momentum is behind the US market's recent recapture of the all-time highs originally reached in January 2018. One technical indicator can help shed some light on this question: ADX. According to ADX, the market's short-term uptrend does not appear to have strength, and investors with short-term strategies may want to exercise caution.
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 (for more information on how to calculate these values here).
Much like RSI and stochastics, ADX fluctuates between 0 and 100. It is typically plotted below the price chart (see the orange line in the bottom part of the chart below).
Unlike those other 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, you can see that stocks (top half of chart) have generally trended high during the past year—with the late January/early February correction briefly interrupting the uptrend.
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 is not much momentum behind the market’s rally.
Digging deeper, ADX has registered a reading below 20 over the past couple months—indicating a lack of strength behind the uptrend that has pushed the US market to new all-time highs. While this doesn’t mean that stocks could rapidly decline, the lack of conviction behind the uptrend may warrant caution over the short term. If stocks and the ADX line were to rise simultaneously, that would be one signal of market strength, according to this indicator.
In terms of the direction of the trend, the DMI+ line has been higher than the DMI- line over the past several weeks, suggesting the direction has been positive. However, the latest data shows that those 2 lines have converged and are at risk of reversing, a signal that the direction of the trend could turn negative over the short term.
Adding ADX to your toolkit
ADX is an 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 of a potentially weak uptrend, investors that utilize this indicator and have short-term positions may want to have a cautious approach.
Next steps to consider
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