Market breadth indicators are an important tool in an investor’s toolkit to assess the health of the stock market in its different stages. They allow us to see what is going on underneath the surface of the broad indices, much like an X-ray. There is a wide array of different ways to look at breadth: For example, what percentage of individual stocks or sectors is in a short-, medium- or long-term uptrend? Are there more advancing or more declining issues? What is the ratio between the number of individual new highs versus new lows over different time frames?
The most significant results can be seen at extremes, when several indicators align to paint a similar picture. But, as we will see, breadth indicators are by no means perfect.
Let’s begin by having a look at different ways market breadth can be used to help judge the health of the market, then we’ll assess the current situation.
In a rally, breadth thrusts often signal significant underlying strength. This can be especially useful after a period of market weakness, suggesting the return of market strength and a lasting rally. There were several excellent thrust signals in the end of 2020 and in the beginning of 2021.
The 2020 US presidential election period makes for an interesting case study, because the end of the September to October market correction was marked by two exceptionally strong breadth thrust, interspersed by a “panic day” sell-off close to the last correction low — just before the election took place.
Conversely, in a sell-off, extremely weak breadth (which actually is the same as strong downside breadth, as all stocks fall in unison) can indicate a panic sale into a market bottom. But, if significant pockets of relative strength remain, we could conclude that there remains potential for further downside, if these stocks are finally caught up in the chain reaction.
Market Breadth Deterioration at Highs
On the other hand, breadth deterioration has preceded many significant market declines and bear markets. This weakness below the surface often becomes important when we see a divergence between price and breadth: the index makes new highs, but the breadth indicator does not, which implies that only a few strong stocks are carrying the market’s advance.
Both qualitative and quantitative studies show that the divergences in, for example, the NYSE Advance-Decline Line has a high correlation to important stock market peaks.
Limitations of Breadth Deterioration Warnings in 2021
Historical data shows without a doubt that market breadth deterioration is a powerful tool to anticipate weak markets, as many important market tops were marked by an underperformance of an increasing number of individual stocks. But, as any other tool we use to analyze the stock market, it is not infallible, it merely tilts probabilities for the future direction of the market in one way or the other.
It is a useful tool that indicates increased risk (or good opportunities). Unfortunately, 2021 is a year that clearly shows the limits of breadth indicators as a standalone market timing tool.
In practice there are two main ways we can experience failure:
a) Breadth deterioration can take a long time to build up, while the market continues to rally. Being too early is indistinguishable from being wrong — it’s simply not very useful.
We are experiencing a prolonged deterioration in market breadth right now, and it can take a lot of patience and prudent position sizing to manage to profit, if breadth should suddenly matter.
After initial signs of deteriorating breadth in June of 2021, serious breadth issues were obvious by July, when a variety of breadth indicators started to dominate the discussions in the fintwit community. Alas, the S&P 500 pullbacks that followed became increasingly shallow and insignificant all the way into mid-September.
Quantitative studies combining broad, long-term breadth metrics (e.g. NYSE McClellan Summation Index and Net % of New Highs – New Lows) were showing an increasingly high likelihood of bad outcomes in August, but still nothing significant has happened yet.
b) Divergences can also resolve without a market correction ever occurring — a pattern which is not obvious to detect even in hindsight. We may be experiencing a “Stealth Correction”, as one market segment after the other goes through a significant decline without managing to pull the broad market down. This shows up as weak market breadth, which may resolve itself when each weak sector has found its respective bottom, and breadth indicators start to improve.
We saw a first hint that this may be happening in the form of a breadth thrust that showed up in the NYSE Up Volume Ratio in the beginning of September.
Too bad — these are completely opposing messages! So, what now?
Weight of the Evidence
The approach of weighing the evidence of a variety of analytical tools makes the most sense to me, and here the jury is still out during a seasonal period that is prone to sudden setbacks. The S&P 500’s rally is very extended, and the market trades at levels that have historically seen consolidations or corrections in year two after a major low. Central bank liquidity, which is one of the key drivers of this relentless advance, is growing less vigorously, and is in danger of starting to contract. Fundamentals are beginning to show signs of deterioration, while high valuation and rising inflation are a potentially dangerous combination…
Currently, it still looks prudent to stay careful.
Good luck with your trading, and thank you for reading!
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