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Just for a change, I thought I would write an article about something that Tim Vollans and I discussed earlier in the week (he's a genuinely inspiring guy to chat with and coincidentally, in charge of editing my articles)...
What's different this time is that Tim and I had opposing views on the importance of Market Breadth.
My stance is/was that rallies with narrow market breadth are not to be trusted and are symptomatic of bubble-type behaviour.
Tim’s viewpoint was that breadth wasn’t all that relevant and that we should just deal with and trade the rally as it happens, rather than worrying about levels of participation.
Given our opposing views, it seemed appropriate to try and look for evidence and or academic studies that could shine a light on which view was most right.
Probably the best place to start is with an explanation of what we mean when we talk about Market Breadth.
Essentially what we are talking about is a distribution, or if you prefer, how many stocks within an index, sector or some other grouping are participating or moving in the same direction as the wider group.
Narrow breadth is when only a few stocks are 'beating' the average, e.g.
And the opposite when most stocks are beating the average.
Some people like to equate Market Breadth with the health of the market/rally and there are various ways to gauge or measure the health of the patient.
For many years I have been a big fan of Investors Intelligence and its technical models and indicators. One of these is the bullish % measure, an indicator developed by II that can trace its roots back to 1955.
The indicator is expressed as a value ranging between 0 and 100 and it shows us the percentage of stocks within an index that are in a Point and Figure bull trend.
We won't get into P&F charting. Suffice to say that it's a very mathematical and binary approach to tracking the markets & one that sees stocks in one of two possible trends or states: bearish or bullish with little or nothing in between.
In the first chart below we see the bullish % reading for the Dax and then the second adds an indicator overlay to the DAX index displayed in green.
Much like RSI, there are over-bought and oversold boundaries in bullish percentage with 68 or above being seen as overbought and 32 or below as oversold.
As with RSI it’s possible to have an overextension in either direction and we can see that in action in the charts below.
The bullish % reading for the Dax typically tops out at or just above 80% and bottoms below 10% as it did in October 2022. Turning points in the bullish % can often coincide with changes in index momentum.
Another measure of Market Breadth is the percentage of stocks trading above selected moving averages. In the table below we see this data displayed as a heat map by S&P 500 sector and MA periods.
We can see that Info-tech has broad-based participation with 73% of stocks in the sector trading above their respective 50-day moving averages, for example.
Participation in this sector is far higher than any of its peers across all MA periods. It’s also far higher than the participation of the broad market although that has begun to pick up modestly in recent weeks.
We can also try to get a handle on breadth by looking at the number of new highs and new lows among individual stocks. The chart below plots net new highs among stocks listed on the Nasdaq exchange. 👇
Having established what Market Breadth is we now need to discover if there is any actionable correlation or connection between the various indicators and index performance.
Somewhat surprisingly there is a particularly large body of work on the subject.
Herding for Profits, a 2021 paper by Zaremba, Szyszka et al can shine some light on the subject...
“This paper shows that market breadth, i.e. the difference between the average number of rising stocks and the average number of falling stocks within a portfolio, is a robust predictor of future stock returns on market and industry portfolios for 64 countries for the period between 1973 and 2018.
We link the market breadth with herd behaviour and show that high market breadth portfolios significantly outperform low market breadth portfolios”
So it seems there is evidence to support the idea that higher market breadth within an index rally will deliver better returns than a rally without that breadth.
Of course that doesn't mean that we can ignore narrow based rallies, but we do need to recognise that fewer drivers may mean that a narrow rally could be less sustainable.
Against that wider breadth rallies can be associated with herding as investors and traders crowd together.
The post-lockdown bounce is the perfect example of investor crowding. It was fun and profitable while it lasted but it unwound just as quickly and everyone headed for the exit at once.
On that basis, I think we can call our debate an honourable draw (but Tim still wants the last word)... 👇
Tim: This chart caught my attention. According to Brian Belski, chief investment strategist at BMO Capital Markets, if an index rally is led by Mega Cap stocks, 11 out of 12 periods have seen positive price returns in the following months...
So, we should also look to the quality of the leading stocks and the context to see if narrow breadth really matters...