Wednesday, December 28, 2016

Using Breadth to Assess Market Strength and Weakness

This is the third post in my indicator series.  The first took a look at tracking moment to moment buying and selling pressure in stocks; the second extended the look at demand and supply to a slightly wider time frame.  Here we take an even larger perspective to view a sensitive measure of market breadth:  the number of stocks making new three-month highs minus the number making fresh three-month lows across all listed stocks (red line).  (Raw data from the Barchart site).  I find the one-month and three-month breadth numbers more sensitive to shifts in market strength and weakness than the traditional 52-week figures.

Strength versus weakness in the high/low numbers tells us whether the broad market is gaining or losing strength as the index moves higher or lower.  Early in market cycles, we'll see breadth expand as the index makes new highs; breadth will contract as the index makes fresh lows.  As cycles mature, we begin to see sector rotation and breadth no longer track the directional movement of the index.  Thus, for example, we'll see situations like the left side of the chart, in which bounces in breadth cannot produce fresh index highs and then new lows in the index occur on improved breadth.  Those breadth divergences, coming late in market cycles, are worth tracking for potential reversal moves.

Notice there are other times, such as following the recent U.S. election, in which breadth moves sharply higher as stocks rally.  This is typical of the early phases of market cycles and is generally followed by further momentum.  The state of market breadth thus helps us distinguish periods in which we want to trade momentum patterns versus value ones.

Whereas the uptick/downtick stats give us a short-term picture of demand and supply, the daily breadth stats are helpful in viewing the market's larger picture.  Some of the best trading opportunities arise when short- and longer-term pictures align.

Further Reading:  Tracking Breadth Across Market Cycles