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Breadth Divergence May Not Mean Much at Trader’s Narrative

I’m continuing to think about the theme of the recent anemic volume and what this breadth (or lack thereof) means for the market. If you haven’t already, check out Wayne’s contribution today about extremely lopsided volume days. To explore this from another angle, I decided to take a look at the McClellan Summation Index for a clue. As you may know, this is a well known and long standing indicator that measures breadth in the stock market, and well, oscillates around the zero line.

There are a few ways that the Summation Index is used as a guide. When it is rising, it indicates that money is flowing into the stock market. When it is falling, that money is leaving the stock market. You can think of it as a supply/demand indicator, similar to the proprietary Lowry Buying Power and Selling Pressure indicators.

As well, when it falls to approximately -1000 it indicates a washout of selling and an inflection point in the market. The last bear market was so ferocious that the NASDAQ Summation Index fell to -1725. I prefer to use the NASDAQ (instead of the NYSE) Summation Index because on the big board the advance decline numbers have gotten too polluted with non-operating company components.

This indicator is also used to find divergences between breadth and price. So for example, if breadth is falling - as shown by a lower high on the Summation Index - as the S&P 500 index or the NASDAQ Composite goes higher, this divergence is a flashing red signal that the market is on thin ice.

Not surprisingly, the past few months show exactly this type of divergence: the NASDAQ Summation index has not been able to put in a “confirming” higher high and higher low concomitant with the higher price in the S&P 500 index and the NASDAQ composite.

While I’m sure a lot of people looking at this will get bearish and call into question the longevity of the current cyclical bull market, when I looked at the past 10 years I couldn’t really find evidence that such a divergence is really anything to worry about.

To show you what I mean, take a look at the corresponding charts for the NASDAQ Composite, the NASDAQ Summation Index and the S&P 500 Index (click to see larger chart in new tab):

NASDAQ composite long term chart Mar 2010
NASDAQ Summation Index long term chart Mar 2010
S&P 500 index long term chart Mar 2010

If we cherry pick bits and pieces of the chart, for example the year 2007, we can definitely argue that a divergence of this kind leads to lower stock prices. But when we look at the wider picture, they don’t really mean much. For example, in 2005 and into 2006 breadth (as measured by this indicator) was rather weak. But that didn’t stop the bull market.

Neither did the strong breadth back in early 2002 provide the bulls with enough reasons to actually end the bear market. Personally, I’m just going back to using this as a market timing indicator the way that I described above and leave this divergence analysis to others.

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