How Strong Is the Market Right Now?
13.6% — that’s how far the S&P 500 has rallied since the start of 2012, even counting today’s market gut punch. Not too shabby, right?
Looking back at the history of the stock market, a 13.6% year is a pretty good year. For most investors, that number is a good enough “status report” on what stocks are doing. It’s all they need to know to judge the strength of the market.
But you’re not like most investors…
So today, I want to show you a better way to measure market strength.
Let me be clear — that 13.6% statistic isn’t worthless. It tells us something pretty important: Stocks have been going up since January. But what we don’t know is how stocks have been going up. Has the climb been quick and strong? Has it been anemic?
To answer that question, we need to look at the market’s breadth. In short, market breadth describes the strength of the market. While there are tons of different market breadth indicators out there, they all basically do one thing: break down how much individual stocks are contributing to the market’s overall performance.
The logic is pretty simple: In a strong rally, the market is moving higher because almost all of its individual stocks are moving higher. In an anemic rally, however, the market may be moving higher only because strength in one or two big names (like Apple) outweighs the drag of many poorly performing names.
In an anemic rally, the performance numbers that most investors rely on are tricking you. That’s because even though the big indexes are reporting gains, picking any random stock in the market is more likely to result in losses — that’s because the majority of names are moving lower, but only a few heavily weighted ones are moving up. It’s harder to find winning trades in those kinds of markets.
It’s also harder for weak markets to sustain themselves. If most names are moving sideways or lower, but the market is moving up, thanks to one or two oversized components, then once those huge components lose steam, so will the market. In a market with strong breadth, rallies are much less likely to lose their steam, since so many stocks are participating in them.
So how do you measure market strength?
There are more than a few breadth indicators out there. I’ll focus on only a couple of my favorites for right now.
The A/D Line
The first is the Advance/Decline Line, an indicator that’s essentially a running total of the number of net advancing stocks each day. The idea behind the A/D line is that if more stocks increase than decrease on a given day (a net increase), then the market is showing strength and the A/D line increases. If more stocks are losers than winners, the line decreases.
Here’s a look at the A/D line alongside the S&P 500 right now:
The top chart shows the A/D line, while the bottom shows the S&P 500 index. (You can create an A/D chart anytime you’d like at StockCharts.com by using the symbol $NYAD.)
As you can see, when the market was falling back in June, the A/D line started making higher lows, a phenomenon called a bullish divergence — it indicated that the decrease in the broad market was happening because of just a few big names and that the market was actually gaining strength. Sure enough, it tipped us off to the multimonth rally we’ve been enjoying since then.
If the A/D line was moving lower while the market was moving up, we’d call that a bearish divergence — it’s a sign that the market is weakening and a move lower in stocks could be around the corner.
Right now, both the A/D line and the S&P are moving higher. That tells us that the A/D line is confirming the uptrend in stocks — after all, as the S&P 500 moves higher, we want the strength of the rally to increase in kind. If it doesn’t, the rally could die off easily.
Back when I first started trading, I noticed something interesting — I’d start seeing breakouts in my watch list stocks right before the market made big moves higher. While it’s harder to measure, it’s become my favorite market breadth indicator.
Watch list breakouts make sense as a market breadth indicator. After all, a breakout is a “hard move,” since buyers have to overwhelm gluts of selling pressure for it to happen. Anytime we see a bunch of stocks making “hard moves” higher, we’ve got a good signal that buyers are getting control of the market.
Obviously, using watch list breakouts as a market breadth indicator isn’t ideal for most amateur traders — it means that you’ve got to be actively watching a ton of individual stocks. But there’s an easier alternative: the Percent Bullish Index.
Percent Bullish does a similar job by identifying the percentage of all stocks that are showing bullish signals based on a simplified charting method called point and figure (you can learn more about how P&F charts work in this tutorial I wrote last year for TheStreet.com). You can chart Percent Bullish at StockCharts.com using the ticker symbol $BPNYA.
I’ll admit that Percent Bullish is not as refined as my other method, since it’s looking at signals on all charts, not just nice breakouts on selected charts (it doesn’t identify “hard moves” either). But it’s a quick way to get a feel for the best market breadth indication I know of.
Here’s a chart of Percent Bullish Index right now versus the S&P:
The signals work the exact same way as the A/D line: You want to see rallies get confirmed, and you want to watch out for divergences where the two charts start to trend differently.
Since both are moving higher in the chart right now, that’s a good sign for stocks as we approach 2013. Look at market breadth charts often — they can tell you a whole lot more about the market’s strength than the performance stats that everyone else is focused on…
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