What is market Breadth?
Market Breadth is taking a look at the internal health of the overall market. Examining what the individual stocks within an index are doing relative to the index itself. What we often see in the price action of the indexes can often be misleading. You would expect that if the market is moving higher, then the stocks within that market would also be advancing in price. And if the market was declining, you would expect the stocks within that market to also be declining. Unfortunately this is not always the case. This is why checking under the hood so to speak is so important. It’s very easy to think that the markets are in good shape based on a quick glance of the S&P500 when truthfully many of the stocks within that index are actually beginning to roll over.
We can look at markets breadth to either confirm the current price action of the markets or show divergences between the two. When markets are rising and the breadth of the market is declining, caution may be warranted. On the other hand, when markets are falling and breadth is improving then we may want to keep an eye out for a potential reversal in trend.
What are some tools used for measuring market breadth?
Advance Decline Line: This is the main measure of market breadth, and is often called the Breadth Line. It is the number of advancing stocks minus the number of declining stocks. The AD Line is a cumulative measure of Net Advances, rising when it is positive and falling when it is negative. You can plot the AD Line on a chart and compare it to the index itself . This will allow you to see if the AD Line is confirming the price action of the actual Index, such as a rising index being confirmed by a rising AD Line or vice versa.
Secondly, we can use the AD Line to spot divergences. When the market is falling and the AD Line begins rising, we would call this a bullish divergence. The AD Line would be letting us know that despite the markets decline, more stocks are advancing vs declining. This often precedes a change in trend, and can give us early signs of what the market may do next. The reverse is true for a rising market with a declining AD Line giving us warnings of a change in trend to the downside.
Here is a look at Advance/Decline Line plotted below the SPY Index which is representative of the S&P500.. Now you can see that SPY is making a lower low, but the Advance/Decline Line is actually putting in a higher low. This is showing a positive divergence in market health compared to the S&P500 Index.
Net New 52-Week Highs: Another measure of market breadth can be calculated by subtracting new lows from new highs on a 52-week basis. This indicator gives you a score of internal market health. When the indicator is positive there are more new 52-week highs. When the indicator is negative there are more new 52-week lows. This can be taken a step further to create a cumulative High-Low Line to get a visual for the trend of the New Highs and New Lows.
In strong trending markets it is normal to expect the percentage of stocks making new 52-week highs to be greater than those making new 52-week lows. Keep an eye on the changes in these figures can help us gauge the strength of the underlying trend.
How to use Breadth readings?
As market participants managing risk is our main objective. And knowing when the environment is risk on vs risk off is important. Breadth can act as an added layer of confidence in your decision making on risk exposure. Keeping a close eye on the Advance/Decline Line and the Net New 52-Week Highs will allow you to be a step ahead and see potential changes in trend before too much damage is done.