What is Market Breadth and why do we need to study it?
In one of my favorite books, REMINISCENCES OF A STOCK OPERATOR by Edwin Lefevre, where Jessee Livermore says “In a bull market your game is to buy and hold until you believe that the bull market is near its end. To do this you must study the general conditions and not tips or special factors affecting individual stocks…. Wait until you see, or if you prefer you think you see the turn of the market; beginning of the reversal of general conditions.”
For the stock or index fund investor, it is important to maintain a feel for the prevailing market conditions and market breadth can help us get an insight in the prevailing market conditions.
Each day a battle rages between bulls (pushing stock prices higher) and bears (pushing stock prices lower). Each side tries to pull the market in the desired direction while frustrating the other side. Prices for each stock move up and down during the day and at the end of the day for some stocks where the prices are higher than the previous day are called advancing issues. On the other hand where stocks prices are lower than the previous day are called declining issues. Stocks where prices have not changed from the prior day are called unchanged issues.
The breadth of the market is to gauge the number of stocks advancing and declining for the day. If more stocks are advancing than declining, this theory predicts that the market will be rising and vice versa. Indicators can be created to measure the force of the bulls and bears as they exert themselves.
One way to create a breadth indicator is to take the ratio of the advancing issues to the declining issues. Another breadth indicator is to use the Sherman McLean’s mathematical formula to create the McClean Oscillator and Summation Index. His mathematical formula uses the advancing issues minus the declining issues as its input to create the Oscillator and the Summation Index.
Taking the daily advancing issues and the declining issues for the day without any filter introduces a lot of noise (inaccurate information) in the data. I have however found that the McClean Oscillator and Summation Index are able to smooth out the noise and are able to give good buy and sell signals, though the signals are sometimes delayed.
To remove the noise from the data, I found stockbee’s filter and some filters used in Investor’s Business Daily for their stock screens useful. A stock which has a daily price move on high volume is a more significant indicator of the market direction than the one which has a price move on low volume. Again where the percentage daily price move is higher is more significant in gauging the market direction compared to where the percentage price move is small in the stock.
Now besides looking at daily price moves, let us look at different time spans. I found price change in a 3 month time span useful. Again stockbee uses this time span and Investor’s Business Daily shows 3 month changes on their indexes as a way to gauge the conditions in the market.
Market Breadth filters I found useful:
1. +2% or -2% price change from prior day on higher volume. I calculate the number of advancing and declining issue using these criteria. This daily data is used to create a McClean Summation Index.
2. +4% or -4% price change from prior day on higher volume. I calculate the number of advancing and declining issue using these criteria. This daily data is used to create a McClean Summation Index. I also plot the ratio of the last 5 days and last 10 days totals of advancing issues and declining issues.
3. +25% or -25% price change from 3 months ago. I plot the ratio of the advancing to declining issues.
You can calculate these numbers from any price data source. The numbers of advancing and declining issues may vary depending on your data source, but the overall trend of these numbers should be the same irrespective of the data source. If you find a problem in the trend of the calculated numbers, change your data source. It is very important to have good accurate data.
In the Market Breadth ratios published, green color of the ratio indicates a value of more than 2 and red color indicates a value of less than 0.5. Green color means general market conditions are to the upside and red color indicates the general market conditions are to the downside. These colors indicate breadth thrust. The Market Breadth ratios are also useful in interpreting the market when they are in extreme zones (outliers); this can show the market is extremely oversold. A third way is to see the market breadth diverging from the S&P500 index. In this case the S&P500 index may be trending up but the Market Breadth ratios may be trending down, showing a divergence in trend between the S&P500 index and the Market Breadth ratios. This indicates that most of the stocks are not participating in the markets up move, and soon the market may top out.
References: stockbee.blogspot.com (A very useful website to follow)
Market Breadth ratios is just one very useful tool to judge the general market conditions. I will discuss and explain other tools in future blogs. It is possible, if you are investing in momentum stocks (like the stocks with high composite ratings in Investor’s Business Daily) that the Market Breadth ratio may be giving a positive signal but your stocks are not making money. The time to be fully invested in the market is when the Market Breadth ratio is giving positive signals for the general market conditions and the momentum stocks general list (an index made of these stocks) is in uptrend and showing good price pattern formation. At other times one needs to be patient till all ducks are in a row, even if you feel the market is leaving you behind. To quote Livermore “One of the most helpful things one can learn is to give up trying to catch the last eight or the first. These two are the most expensive eighths in the world.”
Next Topic: Characteristics of Weak and Strong BUY signals in Market Breadth Ratios
In a weak BUY signal we do not get a 300 or more in the "4% UP" column for the prior 5 days before the BUY signal. This happened for the 4/26/2012 BUY signal. See chart below.
We did not get a reading of 300 or more in the "4% UP" column for the prior 5 days before the BUY signal. This indicates a weak BUY signal.
With this kind of signal commit only a portion of your portfolio money to the market. If the signal becomes strong later, add more money to the market. This strategy will limit the downside risk.
For the BUY signal to have some strength, we should get a 300 plus reading within 4 to 10 days after the BUY signal.
In the 4/26/2012 case we did not get any 300 or more in the "4% up" column for any day after the BUY signal. We actually got a sell signal before getting a 300 plus reading.
In a strong BUY signal we get a 300 or more in the "4% UP" column in the prior 5 days before the BUY signal. After that we should again get a 300 plus reading in the “4% UP” column within 4 to 10 days of the BUY signal, to give confirmation to the strength of the BUY signal. This happened for the 11/30/2011 BUY signal. See chart below.
We got a 300 plus reading 2 days prior to the BUY signal. Then we got a 300 plus reading in the "4% UP" column on the 7th day after a BUY signal, giving a confirmation to the strength of the BUY signal.
In cases like this we can be 100% invested.
