General market: Long-term signpost No. 1

When I began investing years ago, I followed a number of different general market indicators. During the Bubble Era of the ‘Nineties, I narrowed my long-term indicators down to two. Since then, I have never seen the need to alter that. In this post, we will look at one of them — breadth.

When stocks form a primary bear market bottom, most of them do so at the same time. This contrasts to a primary bull market top, which is an extended process that usually occurs over a period of months. This topping process normally begins as the Federal Reserve is lifting the overnight federal funds rate and as long-term Treasury yields are rising.

So while the blue-chip averages like the Dow Industrials and the S&P 500 continue setting new highs, industry groups and individual stocks begin topping and rolling over. Most market participants’ focus is on the averages and the names in their portfolios. But beneath the surface, a deterioration in the broad market, i.e. the average stock, commences.

The breadth of the advance is narrowing.

In most cases, this decay will continue until the Dow and S&P top and descend into a new bear market. It would be uncommon for a divergence to begin and then cure itself by matching a high in the averages with a high of its own.

Breadth defined

The average stock’s health can be defined a few different ways, including the number of 52-week NYSE highs and the percent of NYSE stocks above their 200-day moving average. The preference here is to use the cumulative daily NYSE advance-decline line. (The Nasdaq version of this is not used, as it has a long-term downward bias due to so many younger companies eventually going out of business.)

The absolute level of the a-d line is meaningless. It is the slope that is important. Specifically, when the a-d line cannot confirm a new high in the S&P with a high of its own, this is called a “negative divergence.” After a divergence has gone on for a few months, the major averages are often poised to see their bull market end.

This indicator is used as a long-term signpost, not as a precise timing device. It is an excellent measure of overall market health. Each of the last five primary bull markets ended after a divergence lasting a median of four months was registered, as shown below.

 

 

 

 

In sum, market momentum, or the internal strength of the stock market, tends to peak several months on average before a primary bull top is printed. As shown above, one divergence led to a top 12 months later and another 16 months afterward. Thus, breadth is used as a long-term signpost, not a precision indicator. For more precise timing, position traders, or those whose focus is the intermediate term (several weeks to several months), should use the price/volume behavior of the major averages and the action of the leading stocks.

Breadth divergences can nevertheless be useful for those with 401-K or other long-term retirement accounts and for the multitudes who just want to satisfy their intellectual quest to identify the end of a bull market.

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