Useful Trading Tools - Part Four: Stock Market Breadth

Previous posts in this series have looked at unique data visualization, volume information, and the NYSE TICK.  Today we'll take a look at stock market breadth and what we can learn from measures of strength and weakness across a broad range of shares.

The idea of monitoring breadth comes from the fact that index movement by itself can be deceptive.  Because most of the major stock market indexes are capitalization weighted, a small proportion of large cap shares can disproportionately influence the overall index movement.  For instance, the broad list of NASDAQ shares may not be particularly strong, but solid updays in $GOOG and $AAPL can push the NASDAQ 100 Index higher.

As a rule, breadth narrows as intermediate and longer-term bull moves age.  At important intermediate-term lows, we often see something similar:  the majority of shares will make lows ahead of the overall indexes.  If a market has been rising with an increasing number of stocks making fresh new highs, my working hypothesis is that a uptrend is intact.  When we see divergences--higher index prices with fewer shares participating in the strength--my hypothesis is that we may be topping out.

There are many ways of measuring market breadth.  One of the most popular is also my least favorite:  advance-decline lines.  I find those are slower to pick up divergences than measures of the number of stocks making fresh new highs and lows.  Another measure that I like and will post about shortly is the proportion of stocks trading above their moving averages.

The above chart is unique in that it looks at the number of common stocks across the major indexes that are making fresh three-month highs minus those making three-month lows.  I obtain these data from the Barchart site, which also posts other useful technical data.  In a longer-term uptrend, peaks and troughs in the new high/low data will occur at higher price points; vice versa for downtrends.

You can see that new highs vs. lows have been waning in the last few days, but also since late December.  I am watching this closely, as it suggests that we may be toward the top of a rangebound consolidation period in stocks at the very least--especially given the expansion of new lows during the most recent market drop.

Further Reading:  Derek Hernquist on Market Breadth