Wayne Thorp will speak at the 2015 AAII Investor Conference this fall; go to www.aaii.com/conference for more details.
The goal of fundamental investing is to find companies that will be able to generate increasing earnings and dividends over time which, in turn, will power share prices upward. However, as we know, stock prices do not exist in a vacuum. Most of us have probably spent a good amount of time researching what we consider to be the “perfect” stock, only to see its price fall after we have bought it. This is because the overall market trend has a tremendous impact on individual share prices. Therefore, having an idea of where the market is headed can be beneficial to your investing success.
While indexes such as the S&P 500 index garner a lot of attention in the financial press, the movements of many stocks are not captured by any market index. Therefore, many technicians and traders follow market breadth indicators to get a feel for how widely the full range of stocks is participating in the movement of the market.
Market breadth indicators are the aggregate of data from multiple stocks and are used to determine whether the market is in an uptrend or downtrend or is moving sideways as well as to identify market tops or bottoms.
As mentioned, most market indexes only capture a small segment of the stock universe. The S&P 500 tracks the 500 largest U.S. companies, while the Dow Jones industrial average is made up of only 30 companies. Knowing that these indexes are up or down on a given day does not give us an idea of how broad-based the move is—whether the majority of stocks moved in the same direction as the index. Advance/decline data is useful in interpreting the overall breadth of the market.
Figure 1 shows several market statistics from the Yahoo! Finance website (finance.yahoo.com). This example shows statistics for the New York Stock Exchange NYSE, American Stock Exchange Amex, NASDAQ and over-the-counter bulletin board (BB) as of the end of trading on August 28, 2012.
The first set of data shown on the table is the number of issues that are advancing, declining and unchanged from the previous trading day for the NYSE, Amex, NASDAQ and BB. Advancing issues are those with prices higher than the previous day’s closing price. Declining and unchanged issues are similarly determined relative to the previous day’s close.
The most oft-quoted advance/decline statistics are those for the New York Stock Exchange. Comparing the number of advancing issues to the number of declining issues provides an indication of market momentum. For August 28, 2012, advancing issues outnumbered declining issues 1,768 to 1,280 or 56% versus 40%. On the same day, the Dow Jones industrial average was down 0.17% and the S&P 500 fell 0.08%.
When most stocks are participating in a general market move—advancers greatly outnumbering decliners—the market is said to have good breadth. However, if only a subset of the market—such as the Dow Jones industrials—is advancing while the majority of stocks are declining, the market has poor breadth.
Advancing, declining and unchanged data can be further manipulated to give rise to several other indicators, including the advance/decline ratio and the advance/decline line.
The advance/decline (A/D) line is the most popular measure of market breadth. It is a measure of how many stocks are taking part in a rally or sell-off. It is a running total of the net number of advancing or declining issues:
A/D line = (number of advancing issues – number of declining issues) + previous A/D line value
This result is then plotted on a chart, as shown in Figure 2. Here we see the daily advance/decline line for the NYSE for the last six months (to August 28, 2012) from StockCharts.com. The black line represents the daily A/D line, which is very erratic. Moving averages are sometimes used to smooth the line. In Figure 2, the blue line is the 10-day simple moving average of the A/D line and the red line is the 50-day simple moving average of the A/D line.
When more stocks are advancing than declining, the A/D line rises; conversely, it falls when decliners outnumber advancers. An upward or downward trend in the advance/decline line provides an indication of the market’s overall strength.
The A/D line can be used by itself, as shown in Figure 2, or with a price chart of an index to look for divergences—the A/D line and index moving in opposite directions. A divergence suggests that the move in the price chart is not being supported by the broader market and should serve as a warning that a turnaround in the index or market may be coming.
A variation on the advance/decline line is the advance/decline ratio, which divides the number of advancers by the number of decliners:
A/D ratio = number of advancing issues ÷ number of declining issues
Unlike the advance/decline line, the advance/decline ratio will always be positive. Looking at the data from August 28, 2012, in Figure 1, the A/D ratio for the NYSE was 1,768 ÷ 1,280 or 1.4; meaning that 1.4 times as many NYSE stocks were up that day as were down. Any ratio less than one (1.0) means that more stocks declined than advanced.
A variation on the advance/decline line is the advance/decline spread. It charts the difference between the number of advancing issues and declining issues for a given market index. Unlike the A/D line, which is cumulative, the A/D spread is calculated separately for each day:
A/D spread = number of advancing issues – number of declining issues
The A/D spread is a fast oscillator fluctuating around a zero line. Extreme values point to overbought or oversold levels for the market, while movements above the zero line mean that more stocks are advancing than declining, and vice versa. Traders may choose to smooth or slow its movement by using a moving average.
The absolute breadth index indicates market participation regardless of market direction. This measure of internal volatility calculates the absolute value of the difference between the number of advancing and declining issues, making it a variation on the A/D spread:
Absolute breadth index = | number of advancing issues – number of declining issues |
Since the index is an absolute value (thus, the use of the “|” symbols bracketing the formula), it is always positive (the term “absolute” means “regardless of sign”). Therefore, the absolute value of –100 is 100 (as is the absolute value of +100). High readings indicate market activity and change, while low values indicate a lack of change, or inactivity.
Companion statistics to the advance/decline numbers are the number of stocks reaching new 52-week highs or lows for the day. Referring again to Figure 1, you can see these statistics for the NYSE, Amex, NASDAQ and OTC bulletin board.
Increasing numbers of stocks reaching new highs and fewer stocks reaching new lows are representative of a bull market, with the reverse being true of a bear market.
On August 28, 2012, 108 NYSE stocks reached new 52-week highs while 32 NYSE stocks hit new 52-week lows.
Another way to use new highs and new lows data is to calculate the daily difference between the two and track this value over time. In other words, subtract the number of stocks hitting new lows from those reaching new highs:
New high/low oscillator = today’s new highs – today’s new lows
Since, on a daily basis, the value can experience significant fluctuations, moving averages are used to smooth the figure.
In general, this new high/new low oscillator reaches extreme lows just ahead of a major market bottom. As the market turns up from the major bottom, the indicator will rapidly rise in value: Many new stocks make new highs because it is easier to make a new high when prices have been at depressed levels for an extended period.
Over time, a divergence may develop as fewer stocks are reaching new highs—i.e., the indicator value falls, while indexes continue to make new highs. This bearish divergence is often a signal that the current uptrend in the markets is weak and may reverse.
Again, to smooth the daily fluctuations, some technicians use a moving average of the value.
A different method of “smoothing” the daily difference between new highs and new lows is to keep a running total of these differences:
Today’s cumulative new high/low line value = yesterday’s value + (today’s new highs – today’s new lows)
Figure 3 is the market breadth page from StockCharts.com that contains cumulative advance/decline and new highs/new lows charts for the NYSE, NASDAQ and Amex.
Volume (the total number of shares traded) is often used in technical analysis to confirm the strength of the move for an individual security or for the overall market. A trend is more meaningful if there is high relative volume supporting it. When volume is low and trading is thin, buy and sell decisions can have a disproportionate impact on prices.
We can also look at volume from the standpoint of the volume for stocks that have advanced in price (advancing volume), declined in price (declining volume) or have not changed (unchanged volume). We would expect advancing volume to be higher than declining volume during market uptrends and reversed during market sell-offs. When volume does not confirm the overall trend in the market—i.e., when a divergence exists—this is an indication that prices will reverse to match the trend in volume.
The up/down volume indicator (also called the up/down volume spread) shows the net flow of trading into or out of the market. It is the daily difference between the volume of advancing stocks and the volume of declining stocks:
Volume spread = volume of advancing issues – volume of declining issues
The volume spread is a fast oscillator fluctuating around a zero line. Traders may choose to smooth or slow its movement by using a moving average. As it crosses the zero line, look for a change in the trend of the overall market. Furthermore, as the oscillator reaches extreme levels (high or low), this may be an indication that the market is overbought or oversold.
Figure 4 shows a daily price chart for the Dow Jones industrial average DJIA as well as the volume spread for the NYSE (plotted in the lower pane). Interestingly, between late-July and mid-August, the two charts had been diverging—the Dow Jones industrial average was reaching higher highs but the trading volume of advancing issues was not rising in conjunction. Following this divergence, the Dow Jones industrial average reversed course and entered a downward trend.
The up/down volume ratio is up volume divided by down volume:
Volume ratio = volume of advancing issues ÷ volume of declining issues
Figure 1 shows that on August 28, 2012, the trading volume for advancing NYSE issues was 1.01 billion shares while declining issues traded 1.14 billion shares, for a volume ratio of 0.89. This means that 0.89 times as many shares advanced as declined that day. Values above one (1.0) indicate that the trading volume in stocks whose prices are rising is outpacing the volume in stocks whose prices are falling.
When examining this ratio, a peak in its value at new market highs serves as confirmation of the upward trend in stocks.
Combinations of trading statistics have been constructed to capture fast-changing market trading information into a single statistic. The traders index called TRIN, developed by Richard Arms, divides the advance/decline ratio by the up/down volume ratio:
TRIN = (number of advancing issues ÷ number of declining issues) ÷ (volume of advancing issues ÷ volume of declining issues)
The TRIN measures the distribution of the up and down volume to the number of advancing and declining issues. The TRIN is always positive, with a value less than one (1.0) meaning that advancing issues are getting more than their share of trading volume, a bullish indicator for the market. When the TRIN is greater than one (1.0), declining shares are getting the bulk of the trading volume, which is a bearish indicator. Readings near one (1.0) are interpreted as being neutral.
When the market makes a strong upward move on high volume, for example, advancing volume will overwhelm declining volume. Even though the number of advancing issues may far outpace the number of declining issues, the large ratio of advancing volume to declining volume will offset the advance/decline ratio, and the TRIN will fall.
Figure 5 is a six-month daily price chart for the Dow Jones industrial average as well as the TRIN for the NYSE. The solid red line is the daily closing value for the Dow Jones industrial average and the solid blue line is the daily closing TRIN for the NYSE. The gray bars represent the 10-day simple moving average for the TRIN.
By gaining an understanding of the direction of the overall market, investors and traders alike can gain the upper hand. However, there is more to gauging the movement and strength of the market than just following the major market indexes. Market breadth statistics like those discussed here provide additional insight into the direction and strength of markets as well as the typical stock.
Wayne A. Thorp, CFA, is senior financial analyst at AAII and editor of Computerized Investing. Follow him on Twitter @AAII_CI.