What is the Significance of Market Breadth?
Extracted from Gerald Appel's latest book "Opportunity Investing"
Published by Financial Times Press: October 2006 Most investors are at least generally familiar with the popular market indices that are used to define the composition and strength of the stock market. The
"Standard & Poors 500 Index," for example, is one such index. The "Nasdaq Composite Index" and the "New York Stock Exchange Index" are others. All of these are "capitalization weighted averages" of
the stocks represented by these indices – 500 for the Standard and Poors Index, approximately 3,600 for both the Nasdaq Composite Index and the New York Stock Exchange Index. One might think that daily
readings of a popular indicator such as the Standard and Poor's 500 Index might be secured by simply adding up the closing share prices of the 500 domestic and foreign issues that comprise this index to
secure the level of that index each day. This, however, is not the case. The index is "weighted by capitalization" so that the prices of the larger companies are given more weight in the
calculation of the index than are the prices of small companies included in that index. This means that if only a relatively small number of the largest companies advance on a given day, the
Standard and Poors Index might be up for that day, even though most companies listed on that exchange show a decline.
Conversely, if only a relatively small number of the largest companies decline
on a given day, the Standard and Poors 500 Index might decline even though most companies represented in that index advance on a given day. The weighting inherent in the Standard and Poors 500
Index, and in the more broadly based New York Stock Exchange Index (which includes all 3500+ stocks on the New York Stock Exchange) and in the Nasdaq Composite Index (which consists of more than 3,500 issues
but whose index level has been largely determined by as few as twenty to forty stocks at times) often results in erroneous perceptions by the public regarding what is actually taking place in the stock
market.
BREADTH INDICATORS
Breadth indicators reflect the percentages of stocks that are actually participating in market advances or that are actually incurring losses during
market declines. Among the measures of market breadth are the "advance-decline" relationships in the stock market on any given day. "Advancing issues" are stocks that rise
each day in price. "Declining issues" are stocks that fall in price. "Unchanged issues" are stocks that do not change in price. These ratios are often more significant than widely followed
major market indices such as the Standard and Poors 500 Index. For example, let's suppose that the Standard and Poors 500 Index advances by one-half of one percent on a given day. If 1800 issues
advance on the New York Stock Exchange that day, perhaps 1350 declining, the plurality, advancing minus declining issues, would be +450 (1800 – 1350), indicating that most stocks did advance in conformity
with the Standard and Poors 500 Index, a good breadth confirmation of the rise in that index. It might be said that day that there was "broad" stock participation in the advance – a favorable sign for
the stock market. Conversely, let's suppose that, although the Standard and Poors 500 Index gained one-half of one percent on a given day, only 1400 issues advanced in price whereas 1750 declined.
This would constitute a day of "negative breadth," more stocks declining than advancing – the rise in the Standard and Poors 500 Index is NOT confirmed by the action of the majority of listed stocks.
This non-confirmation would carry negative implications. The most favorable market climates take place during periods when the price actions of the major market indices are generally favorable AND when
market breadth readings are favorable – more stocks advancing than declining. These "breadth – price" confirmations indicate that most market segments are participating in market advances. The
odds improve that selections of stocks and/or mutual funds by investors will produce profit. During periods of negative breadth, more issues declining than advancing, the probabilities of selecting
winning stocks decline, even if the Standard and Poors 500 and other indices seem to be advancing. As a general rule, it is bullish when:
- New peaks in the major market indices are confirmed by concurrent or near concurrent new peaks in the cumulative advance-decline line.
- The percentage of issues advancing in price over a ten-day period is more than 60% of the total number of issues either advancing or declining. The ratio, (advances/ (advances + declines) is
greater than 60%, if 10-day totals of both advances and declines are employed. Such favorable market breadth ratios do not occur all that frequently and usually carry bullish implications when
they do occur.
- Market breadth remains positive or at least more or less neutral even if market indices do show some decline.
As a general rule, it is bearish when:
- New peaks in the major market indices are not confirmed by new peaks in the advance-decline line for several months. Bull markets generally become gradually more selective as time passes,
including fewer stocks. Breadth softening does not generally result in broadly based bear markets immediately but if breadth weakens for several months, bearish implications increase.
- There are patterns of continuing weakness in market breadth even as the price levels of major market indices maintain their advance.
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