Wednesday, March 5, 2014

Assessing Market Health Through Breadth

Breadth measures the number (or percentage) of stocks trending higher or lower. The conventional wisdom is that expanding breadth is bullish. Is this true? The short answer is no.

And what are breadth measures saying about the health of today's market? The short answer is to be cautious.

Let's start with NYSE advance-decline issues (NYAD) which measures advancing issues minus declining issues. It recently made new highs. The chart below looks at prior new highs in NYAD versus drops in NYSE of over 10%.

New highs in NYAD does a bad job of warning of a large fall in equities. Each one of these falls was preceded by expanding breadth (issues). One positive might be that the second top in 2008 before the bear market was preceded by a NYAD divergence (lower high; see declining arrow). On the other hand, the 20% drop in 2011 was preceded by an expansion in breadth (see rising arrow). The same was true in the 1990s as well.

Using NYSE advance decline-decline volume (NYUD) isn't materially different. It made new highs right before the NYSE dropped 9% last summer. There were new two-year and three-year highs in 2010 and 2011 before drops as well.

Some analysts look at SPX relative to the an 'equal weight' version (SPXEW, i.e., all components weighted 1/500). This ratio recently expanded, a sign of broader participation in the rally.

This measure is not much more useful than the ones above. It caught the 2008 bear market but it also didn't warn of the big drop in 2011. There's also a problem of false-positives (dashed ovals) where breadth diverged lower but the market rose higher. There are too many false signals for this to add value beyond simply watching the trend in price.

Lastly, we can measure expansion and deterioration in breadth by looking at the percentage of SPX stocks trading above their 50-dma and 200-dma (lower panels in chart below). We have marked where breath deteriorated ahead of a top with a red line and where it expanded with a green line.

There's some good news here. Before 2013, a negative divergence in the 50-dma preceded many tops (red arrows). A negative divergence was clearly bearish.

That's not the same as saying the every top was preceded by a negative divergence; half were not (green arrows). So, like NYAD, NYUD and SPXEW, an expansion in breath was not necessarily a sign of good market health.

In 2013, there were two negative divergences in the 50-dma that did not lead to a top (blue lines). This caught many analysts off-guard. Ironically, the May 2013 high was preceded by a 3-month negative divergence and then a pop to a new high in breadth. A sign of better breadth turned out to be a sign of market exhaustion and a trap for bulls.

Another issue with this measure of breadth is that a negative divergence can exist for half a year before a top. As a timing tool, it is very poor.

Still, of the different ways of measuring the health of the market through breadth, the percentage above the 50-dma is the most useful.

So, what is breadth saying about the health of the current market?

The expansion in issues (NYAD and SPXEW) and volume (NYUD) would lead many to say the market is healthy. In the past, that hasn't been the case. There's no reason to make that assertion now either.

The percentage of SPX stocks above their 50-dma and 200-dma are diverging lower. Before 2013, that was a reliable signal of failing market health. That's the signal to watch and right now it is flashing a warning.