Understanding the Crowd on Wall Street Requires Analyzing Breadth Indicators

Herding is a behavior frequently seen on Wall Street. Experts in behavioral finance define herding as the tendency of individuals to buy or avoid similar types of investments solely because they believe other investors are buying or avoiding those investments. One example was the bubble in internet stocks that developed at the end of last century. Many investors worried a bubble was developing but after watching other investors achieve large gains in the sector, they rushed in. In popular culture, herding is equivalent to the “fear of missing out” or “FoMO.”

It sounds irrational that a fear of missing out could cause investors to risk real money in the markets but they often rationalize it with different terms. In the internet bubble, analysts who might have been more focused on marketing than fundamentals recast the P/E ratio as the “price-to-eyeballs” ratio to justify ignoring the small or nonexistent earnings of many of these companies. For internet companies, earnings were considered to be irrelevant because eyeballs (the number of visitors to a web site) would eventually be converted into profits. This business plan can be summarized into the four points shown below:

  1. Create web site
  2. Count eyeballs
  3. ???
  4. Make money

Investors focused on the second or fourth steps and herded into internet companies, ignoring the fact that an important fundamental process, converting eyeballs to profits wasn’t well defined. Few analysts explained how eyeballs could be converted to money and few investors seemed to care. This demonstrates one problem with fundamentals – stock prices frequently move for extended periods of time without regards to fundamentals.

As traders, it’s our goal to ride trends as long as we can. Some traders turn to indicators based on breadth data to help them hold positions during trends. Breadth indicators measure how broad the participation in a price move is. A popular breadth indicator is the advance-decline line which is calculated by subtracting the number of stocks declining every day from the number of stocks advancing.

A/D line = advancing issues – declining issues

This data is available in the Yahoo! Finance market data center so you can maintain the indicator yourself or you can find charts already constructed on StockCharts.com showing the A/D line for the broad market and various sectors. When the A/D line is rising, we know that more stocks are moving up than down. Traders would say “breadth is positive” in this case. Breadth is negative when the number of declining issues exceeds the number of advancing issues. Rather than watching day to day moves in breadth indicators, it’s best to look at the chart with a big picture in mind. The chart below shows the A/D line during the internet bubble and it appears to be fairly easy to interpret.

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Breadth began to deteriorate in early 1999 but prices kept rising. This is a shortcoming in breadth indicators. They will almost always breakdown long before prices top. In hindsight, traders will point to the divergence and claim it was a reliable signal but in real time, the timeframe our brokers require us to trade in, breadth indicators will often be a year or more early in their warning.

Despite their popularity, breadth indicators should simply not be used to time market tops. Their track record is much better at bottoms.

StockCharts.com offers a library of sector breadth indicators.  This screen shows at a glance whether breadth is bullish or bearish in 9 different sectors. One way to use this information is to spot buying opportunities in market sell offs.

The charts shown at that site measure breadth as the percentage of stocks in a particular group that are moving up. For example, if there are 12 utility stocks in an index and 6 closed higher, this indicator (the A-D Percent) would be 50%. On some other web sites or data services, this indicator would be called the A-D ratio. The shape of the A-D ratio and the A-D line which was defined above will always be similar.

During a downtrend, any breadth indicator will be useful to follow. At StockCharts.com you can access breadth charts during a market decline such as the one that broad market indexes endured at the beginning of 2016. Examining the charts of different sectors can offer useful information. The chart below shows the financial sector with a 4-week moving average (MA) of the breadth indicator.

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An MA is designed to highlight trends. Notice in the chart that the MA is rising in the first weeks of 2016, a time when we know stocks were selling off. This tells us there is strength in that sector and this is likely to be among the market leaders when prices rebound. In this case, the Financial Select SPDR ETF (NYSE: XLF) delivered twice the gain of the S&P 500 after prices bottomed in February.

This is one of the few times divergence analysis can be profitable and illustrates the value of following breadth indicators in downtrends. Sectors going against the trend in a down move will most likely be the leaders in the following up trend.

You can apply this type of analysis with any breadth indicator. One of the most popular indicators is the percentage of stocks trading above their 50-day moving average. This indicator is simply what it says it is – the percentage of stocks on the exchange or within an index that are above their 50-day MA. This indicator applied to the stocks in the S&P 500 index is shown in the next chart.

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Moves below 25% and above 75% are relatively rare. But they are not considered to be trading signals. The standard way to apply this indicator is to assume buy signals are given when the indicator moves back above 25% after it has below that level and sell signals occur when the indicator falls below 75%. There will be whipsaw trades as there were near the bottom in February but that was a timely buy signal. Although the indicator gave a sell signal in early May, the S&P 500 index continued moving higher. This reinforces the point we made earlier that breadth indicators are best for buy signals and sell signals should be ignored.

As we saw with volume indicators in a recent blog post, technical analysts have developed a number of variations of breadth indicators. All attempt to show the same idea in slightly different ways.

The Most Active Stocks Indicator counts the number of advancing and declining issues in the list of the most active stocks. It is limited to the 10, 15 or 20 stocks with the highest volume depending on the source of the data. Although it uses less data in its calculation, the signals tend to develop at the same time as the broader A/D line which includes all stocks on the exchange.

Some of the variations can become fairly complex as the ARMS index does. This indicator is also known as the Short-Term Trading Index or TRIN. It is calculated by dividing the advance-decline Ratio by the advance-decline volume ratio.

ARMS Index = (advancing issues / declining issues) / (advancing volume / declining volume)

This was designed to be a short-term trading tool. The indicator will be below 1 when the volume is strong and the A/D line is relatively weak. This is considered to be a sell signal because it’s assumed everyone with money to invest has now bought and the market has, in effect, run out of buyers. High readings indicate volume is weaker than the A/D line and is considered to be a buy signal. The indicator is volatile as the chart below shows and signals are intended to help you time trades only for the next few days.

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In the chart above, the highest reading occurred on December 17 and preceded a short-term bottom by one day. The low reading on February 22 came almost two weeks after prices bottomed.

The ARMS index again demonstrates that complexity in an indicator doesn’t guarantee it will be useful. The extra work associated with the ARMS Index is unlikely to deliver more meaningful signals than a simpler breadth indicator would.

The shortest term breadth indicator is the TICK which counts the number of stocks that closed up or down on their last trade. This indicator is updated throughout the trading day. An up trick means the last trade in a stock moved up from the previous trade and a down tick indicates the price declined on the last trade. On volatile market days, this is widely reported on business networks including CNBC and can be useful. Extreme readings of 2,000 or more are rare and often signal intraday trading opportunities. As with other breadth indicators it works better for buy signals so short-term traders can consider buying when the Dow Jones Industrial Average is down a few hundred points and the TICK falls below -2,000.

Breadth indicators are useful for spotting buying opportunities and any breadth indicator can provide the information you need to spot potential winning trades. Consider the StockCharts.com breadth summary pages as a “shopping list” in the next market selloff. The sectors with the most positive breadth readings are the ones moving against the trend and most likely to deliver large gains when the selling ends.