Technical Analysis (Part 7): Market Breadth

Last week in Part 6, we looked at Equivolume. This week, we look at one of the more established and quite straight forward technical analytical approaches to gauging the sentiment of any given stock market: Market Breadth.

What is market breadth?

Market breadth is all about upward, downward and sideways movement and range, principally applied to stocks and their stock markets, to gain an understanding of whether the overall market is bullish, bearish or flat. The concept of market breadth is used to measure the 'health' of any given stock market.

Many who analyse the health of a stock market, often use certain indices to form a subjective opinion. For example, you may take the FTSE100 in the UK or the DJIA in the US to give you a perspective on what the general US or UK markets are up to. There can be a problem with this approach though, which is what has led to the development of breadth indicators.

The main problem is that at some point, or maybe not at all, a stock index does not accurately reflect the general health of the overall market. This could be because the actual index being used only accounts for a small percentage or is not an influential part of the overall market. Or it could come down to how the index is constructed: Are its components heavily industry specific? Is its calculation weighted or how has its make up changed over the years?

Some examples of the approximate weighting shares of various indices' value to its total market:

Over time, various approaches and tools have been built to compensate for just a straight indices health check approach. These indicators are a derivative of price and volume.

In the stock price movement camp we have indicators such as:

• New highs vs new lows

• 52 week highs and lows

• Stocks > a given moving average

• Advance / decline line - and its derivatives

• McLellan oscillator

In the volume camp we have, for example:

• Up and down volume

• Arms Index

Other methods could include comparing indices from the same market and comparing how they diverge e.g. S&P500 vs Nasdaq100 vs Russell 3000 etc. Or by comparing their relative strength to one another, or for that matter, taking a more global view by adding in key markets to gauge global economic equity strength.

On your daily trading journey you may quite often come across these sort of indicators. Normally they are presented in a daily view such as below:

From MarketWatch.com a snapshot of the NYSE:

From Stockopedia snapshot of the FTSE 250 on a given day:

The beauty with technical analysis, is that it allows you to take these snapshots of time and graph them to give you a better indication and picture of the current market trend. Let's take a look at some of these indicators in more detail:

Some of the analysis of the tools needs no real translation as it's mostly common sense application. Highs and lows - It is very obvious what a 52 week high / low means and how many stocks are achieving this. Obviously, the more stocks at highs then the more bullish the market and vice versa. New Highs and Lows: The more new highs, the more bullish and vice versa for lows. These highs and lows can be indexed as can be seen from the StockCharts.com example below on the NYSE:

The same goes for stocks greater than a given moving average - the most common  moving averages used are 50, 100, 150 and 200 periods - (daily). Again the analysis goes, the more stocks greater than the moving average, the more bullish and vice versa. Which moving average should you use? That will depend on your time horizons. The shorter the moving average, the more variety in the number you are likely to get.

An example using StockCharts.com of the S&P500 using a 200 daily moving average, currently shows the S&P with just under 75% of its stocks greater than the key 200 period moving average. Compare this to the price chart of the S&P500 and see how it has grown in price since the stocks > 200 moving average were at lows of 20% in early 2016. The percentage levels on the chart, looks to be holding at around the 70%'s as the underlying price hovers near all time record highs.

Advance / Decline (AD) line is another very simple concept. On any stock exchange on any given day, there are a certain amount of stocks that have either advanced, declined or stayed unchanged. These numbers are collected and charted into the AD line. Normally, the difference between the advancers and decliners is taken and plotted. If the advancers are greater than the decliners, then the AD number is positive and vice versa for negatives. The number is then added to the cumulative AD line. What are you looking for in the AD line? If the AD line is trending up and the stock index price is trending up, then this is a bullish sign. For the bears, the AD line should be negatively trending in the direction of the bearish index price. A divergence between the AD line and price can signify a change in trend direction.

An example of the AD line on the S&P500 over the last 5 years (Charts: TradingView):

Derivatives of the AD line: McClellan Oscillator. McClellan turned the AD line concept into an overbought / oversold oscillator so users of the data could get a more meaningful interpretation of what the AD line was telling them. It is a bounded study between +100 and -100 and is similar in its concept and construction to the MACD indicator. The default inputs: the oscillator is the difference between the 19 day and 39 day exponential moving averages of the daily net advance / decline figures. To interpret it, anything above 100 is thought of as being overbought and anything under -100 oversold. A move from <> the zero line can be interpreted as shorter term buying and selling opportunities.

Continuing the example from the TradingView.com charts of the S&P500 with the AD line, we have now included the McClellan oscillator - see how it can give shorter term signals crossing the middle zero line and warnings of overbought / oversold conditions:

Market Breadth is a simple concept used to gauge market sentiment and to apply to your stock and indices trading.

Volume

Up & Down volume - on top of the advancing and declining stock issues, volume is added to allow a comparison between the advancers and decliners to see who holds the upper hand. Again, these figures are plotted as individual lines and often 'averaged' out to smooth the data to give it more meaning. Taking this a step further, Richard Arms (who we saw last week as the innovator behind Equivolume) combined the AD concept with advancing and declining volume.

ARMS Index (aka TRIN) is a ratio of two ratios: ARMS Index = (Advances/Declines) / (Up Volume / Down Volume) How does it work? If the number of advancing shares increase on low volume, the ARMS ratio will increase - translated this means that the rise in the advancing shares is weak and unlikely to be supported due to low volume. So when looking at a TRIN indicator on a chart you will have to look for the inverse - a high TRIN normally peaks at a bottom and a low TRIN at a top (>1 normally bearish & low number bullish). To aid analysis further, often a moving average is applied over the TRIN line to smooth the data to create further signals and strategies.

S&P 500 with ARMS Index applied (Charts: TradingView.com):

Conclusion

These market breadth tools, although simple in their construction, have served the stock markets well over the years and add a useful suite of analysis to the avid stock / indices trader.

Further Learning and Education:

If you are interested in learning more about market breadth then the following reading may help:

• Technical Analysis of the Financial Markets, John J Murphy, New York Institute of Finance, 1985.

• Technical Analysis, The Complete Resource for Financial Market Technicians, Charles D Kirkpatrick, FT Press, 2006.

• Technical Analysis Explained, 5th Edition, Martin J Pring, McGraw Hill Education, 2014

Next time: Technical Analysis (Part 8): Direct Price Analysis (DPA) - Trends, Support & Resistance