Wednesday, 9 May 2018

Stock Market: An In-depth Look at Market Breadth

I often heard some made a comment like, "The market breadth has been going down for more than a year, sooner or later, the market is going to take a dive if the breadth is too narrow."

Market breadth refers to the percentage of the market participants going up or down in a market. If fewer and fewer stocks making higher prices, it means the market breadth is narrowing. Sometimes the market (as measured by major index like SPY) can go up while the market breadth is narrowing, meaning the market indexes are going higher with fewer and fewer stocks advancing in prices. The market is being carried by fewer stocks. This is surely an unhealthy market. How true is this? And how few is few?

I decide to look at this question in greater depth.

There're several ways we can look at market breadth, each has its merit. One popular way is A-D Lines.

My fave way of looking at market breadth is the RSP/SPY ratio (or Equal Weight Index Vs Cap Weight Index). I divide the chart into zones of rising and falling RSP/SPY Ratios, and see how it relates to the general market (SPY).

Green vertical lines mark the start of a rising trend in the RSP/SPY ratio, and red vertical lines represent the beginning of falling trend of the ratio.

RSP/SPY ratio (or market breadth) from 2003 to 2018
(Click chart to enlarge)

Out of the 8 Zones from A to H, the market breadths of 6 zones move in tandem with one another. I.e. if market breadth rises, SPY too rises and vice versa. Except for 2 zones, D & H where they move in the opposite direction.

More importantly, we’re in zone H since the start of 2017. How worried should we be as this narrowing of market breadth is occurring right now?

As i thought about this question, it turns out that looking at trends is a complete wild goose chase.

To adequately answer this question, we shouldn’t just look at trends, we should also look at levels (of market breadth). This ratio is considerably higher today than what we have in the past.

Not surprisingly, the drop in market breadth is quite severe in 2009. Also, this January correction started when this ratio dropped close to the previous low in 2016. Just a coincidence? Maybe, maybe not!

The bottom line, this ratio is quite high historically today. So this ratio can fall some more before it’s considered low by historical standard. If we draw a line to get an average level, it would be somewhere around 0.34. Prices at zone H is considerable higher than this average level.

Yes, zone D is also at a reasonably high level. In fact zone D is slightly lower than zone H where we’re now.

The bottom line is that we shouldn’t look at TREND (of falling market breadth) so much, we should look at LEVEL more closely. We look at trend because of comment like the start of this post. "The market breath is falling or narrowing..." The word "narrowing" or "falling" suggests trend.

It’s the level of market breadth that a market cares if it’s too narrow to sustain the momentum, not trend.

There’s one more observation that further supports the idea of the level of market breadth is decidedly trumps trend.

Look at zone B1 (a period within zone B from 2008 Jan to August. 1 candle = 1 month), the market breadth actually rose, but it did little for SPY (it rose for only 2 months before rolling over). This is because its market breadth is quite low during this period, rising breadth from a low level wouldn’t make much different. Both zones A and B are below the average ratio of 0.34. In other words, the uptrend is no help in saving a low LEVEL of breadth.

One last note. If you only looking at this ratio(or market breadth) over a limited time-frame of, say 2 years, you would get a worrying picture like the one below like the comment appeared in the 1st paragraph of this post. It looks like there's a plunge in the market breadth from a peak in Dec 2017.

RSP/SPY ratio (or market breadth) from 2017 to 2018
(Click chart to enlarge)

The only cure for this worry is to gain a larger perspective by looking at this ratio chart that covers a longer time-frame like the 1st chart of this post, and you realize that this "plunge" is just a shallow downward slope, and the market breadth right now is still quite elevated.

In conclusion, from a historical perspective, despite more than a year of falling market breadth, the market breadth today is still quite healthy from a historical levels.

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