What is market breadth and why is it so important?
Most recently, we have been hearing the outcry about market breadth, which has deteriorated significantly. At Tramondo, we strongly believe in the importance of what the market shows us beneath the surface. Therefore, market breadth is a component of our four pillars in our risk management framework (Big Picture, Market Sentiment/Internals/Technicals).
Some may wonder why market breadth is so important. In this “Notes from the Field” we shed some light on the concept and why it is a very useful tool to gauge the strength of a market trend.
Market breadth tools provide a different kind of analysis of the equity markets, which other technical indicators cannot. To make informed investment decisions, you need to look beyond the movements of the market, often gauged by index levels performance. Therefore, by looking at market internals, we move from a one-dimensional view of markets to a two-dimensional one.
Breadth components are readily available from online sources and consist primarily of daily and weekly statistics. At Tramondo, we focus on Up/Down volume, Advance/Decline, new Highs/Lows, TICK & TRIN, leading stocks/sectors, equal weighted indices & percentage of stocks participating in trends. In this “Notes From The Field” we focus on the last – S&P 500 and its constituents (in %) trading above their 200-day moving average.
Market breadth indicates how many stocks are involved in a particular movement in an index or stock market. An index may go up, but more than half of the stocks in the index go down, because only a handful of stocks make such large gains that they lift the entire index. This is a phenomenon we have seen recently in the U.S. with the strength of the mega-caps. A healthy rally in the stock market, therefore, favors the good fortune of a broad selection of stocks, or to put it differently, a tide that lifts all boats. On the other hand, an unhealthy rally is usually underpinned by a constantly narrowing breadth, which indicates the market rally is supported by fewer names and index performance may be misleading. Therefore, market breadth indicators can warn of reversals and reveal strengths or weaknesses in an index’s tape that are not visible by simply looking at an index chart.
So, what can we do with such information? Generally, investors use market breadth indicators and index charts together.
Chart 1: S&P 500 & 200-Day Index: Investors can use this index to see what percentage of stocks in the S&P 500 are trading above their 200-day moving average. A rising indicator above 50% indicates broad market strength.
Now, we look for one of two occurrences:
Confirmation – Confirmation occurs when the index chart and the breadth indicator show the same direction. Either both factors show a rising market, or both show a falling one. That is, one report confirms the other and vice versa.
Divergence – A divergence arises when the index chart and the market breadth indicator show two different directions. This likely indicates that an index reversal is imminent, or at least the risk/reward profile of the market is subpar.
Like with any indicators, market breadth are not foolproof numbers, but they are critical to successful investing. A drawback is that they lack the fine timing aspect because it is impossible to know how long a market may be in a trend. Therefore, it is a rather longer-term indicator and works best on weekly charts. This underlines the famous quote by economist John Maynard Keynes: “Markets can remain irrational longer than you can remain solvent.” As such, market breadth must be considered and evaluated along with other indicators.
Looking at today’s market breadth, it certainly shows some darker clouds on the horizon and reflects a classic distribution phase (divergence). This is underpinned by a steadily narrowing market breadth. In other words, it is only the FAAMNG names and semiconductors that support the current bull-market.
We know that the world never reaches its zenith in a day but deteriorating market breadth is one of the classic signs of the beginning of a major market top. As a result, we do not recommend using market breadth as a stand-alone indicator of market timing, rather it should be used along sentiment as well as volume and price analysis (market technicals). Certainly, breadth is also useful for finding significant market lows during extreme market moves (e.g. GFC -57%, divergence).
In summary, at Tramondo we incorporate market breadth analysis into our risk management framework as a reliable indicator of the current market health and view it as a useful indication on how aggressively we want to be positioned and whether to buy the dips or sell the rips.