Market Breadth: A Powerful Tool You Might Not Be Using

 

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  • FOMO

    Academics can make almost anything sound boring. FOMO, or the fear of missing out, is often associated with amazing vacation pictures on Instagram or tweets of a life of luxury. But, the concept dates back to a 1990 article by Dr. Dan Herman who explains:

    “I first observed this phenomenon that I later named “The Fear of Missing Out” in the mid 90’s, while listening to consumers at focus groups and during individual in-depths interviews.

    Despite the variety of research topics and business categories being explored, most consumers expressed – at one time or another –a clearly fearful attitude towards the possibility of failing to exhaust their opportunities (and complementarily, to miss the expected joy associated with succeeding in doing so).

    It struck me as an extremely significant new development in consumer psychology, and in the following years I have been researching FOMO as a socio-cultural phenomenon, as a motivation, and as a personality factor. Having studied its implications for marketers, my belief is that this motivation might be one of the central factors in the decline of brand loyalty.”

    FOMO extends far beyond Instagram and consumer psychology. It’s an important concept in the stock market.

    Quantifying Investors Chasing Experiences

    In the stock market, the concept applies to investors and stocks. Of course individual stocks don’t fear anything but we can see that when just a few are making a move, the market isn’t likely to trend strongly. This is the idea of market breadth indicators.

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  • Breadth indicators are a tool to see how widespread a trend is. There are many variations but the most popular might be the advance decline line, or the A/D line. Advances are the number of stocks that go up on any given day. Decliners are stocks that go down. The A/D lines tracks this.

    The idea is that if most stocks are going up, the market averages are also going to be moving higher. When a majority of stocks are falling, the averages should be in down trends. The A/D line is available at a number of web sites and can be seen in the chart below.

    NYAD stock chart

    Source: StockCharts.com

    The first thing that you may notice is that the chart shows an up trend. This is bullish. This means that most stocks are moving up and that is simply because investors are driven by FOMO. They fear missing out on potential gains and are buying a broad based group of stocks.

    This chart conflicts with many headlines and the opinion of bearish analysts but the chart shows data and reveals what investors are doing with their money rather than what they are saying or thinking. That makes this a valuable indicator.

    Breadth Often Leads Market Turns

    The next chart provides a longer term view of the A/D line.

    NYSE Advance/Decline line

    Source: Yardeni.com

    This chart includes the run up into the market top in 2008 and the subsequent bear market. The A/D line, in red, began to turn down before the market index, the NYSE Composite Index in this chart. All major indexes show a high degree of correlation and any can be used for an analysis.

    The A/D line will often diverge, or move in the opposite direction of the index, before a significant trend reversal in the index. The divergence shows a shift in the consumer psychology, so to speak, with consumers or investors changing before the trend is obvious in the price.

    In addition to the A/D line, there are a variety of other breadth indicators including the Arms Index (which is also call the Trading Index or TRIN), the McClellan Oscillators and New Highs-New Lows for the NYSE. Other breadth indicators use volume in their calculation or new highs.

    All breadth indicators are designed to show what is going on beneath the surface of the price action. Unlike momentum indicators, breadth indicators are all designed to display different insights into the market action.

    The Arms Index is shown in the next chart.

    TRIN stock chart

    This index is more volatile than the A/D line because it is designed for short term trading. This indicator could be more useful for traders with a time frame measured in days rather than weeks or months. The Arms Index is showing potential weakness in the short term in the chart shown above.

    The ARMS index is also different from the A/D line in that it is an oscillator, oscillating or moving above and below a central value. Oscillators tend to be more useful for short term trading.

    All breadth indicators, whether they are calculated based on the daily close, volume, new highs or some other criteria, they are all measuring participation. They show, in effect, what the majority is doing in the market. They are calculated with data from the market but they show the psychology of investors.

    In a speculative market, investors will be buying good companies and less profitable ones because they expect gains. In down markets, they will be selling more than they are buying and they are likely to buy only the more conservative issues.

    These behaviors are captured in breadth indicators. When investors are buying anything, breadth is rising. When they are focused on high quality issues, breadth is narrow. In both cases, breadth indicators can provide insights that price data alone will not reveal.

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