Trader’s Narrative

The NYSE cumulative breadth (daily advance decline) is showing signs of life. with its first victory over a previous high:

Referring to this, recently StockCharts blog wrote:

This show of relative strength in the AD Line reflects broad participation in the current advance and bodes well for the current uptrend.

Sounds good but what they are missing is that the cumulative advance decline line is notoriously deceptive. Although the NYSE started out as an exchange where the biggest and best US companies traded, over the years there has been a significant shift away from operating company common stocks to new and strange securities like municipal bonds ETFs, ADRs, bonds (yes, actual bonds trade on the NYSE!), etc.

At first these non-operating company securities were a small portion of the whole but over time, they have come to take such a large portion of the trading that the breadth numbers from the NYSE should be discarded. The only other option to ignoring the data is to painstakingly filter out these ‘pollutants’. There are very few services that provide such data, Lowry Research being one of them.

To see the wide discrepancy, you need only compare the NYSE cumulative breadth chart to the corresponding Nasdaq chart:

The difference between the two becomes especially large when interest rate changes. This is because most of the non-operating company securities are interest rate sensitive (like the municipal bond funds) and they move as a herd either up or down in reaction to different interest rate environments, skewing the NYSE breadth.

If we step back and look at a very long term chart of cumulative breadth for both the NYSE and Nasdaq, it becomes clear that this indicator isn’t really helpful at all. This is why, instead of the cumulative measure, I prefer to look at a simple moving average of advance decline numbers. This indicator, in contrast, is useful for both the Nasdaq and NYSE exchanges by highlighting both kinds of extremes in the market.

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Market breadth is what goes on inside the stock market. Most people pay attention to price, like the Dow or S&P 500 index. Market breadth looks at the number of stocks that are advancing or declining within an index or an exchange. It is a great way to measure the “health” of the market. After all, if the majority of securities on an exchange are falling, we can’t expect it to keep rising, right?

Or can we?

Every once in a while the bears point to the “negative divergence” in the Nasdaq index and the Nasdaq cumulative breadth. They get worked up over the fact that market breadth does not correspond to the market price. Here is the recent Nasdaq breadth, showing a waterfall decline, in contrast to the Nasdaq Composite index:

It sure looks ominous. Once you zoom out though, you realize that there’s something seriously wrong with this way of looking at the market.

NASDAQ Cumulative Breadth
Just for kicks, let’s go back to 1998. From there, the Nasdaq cumulative breadth fell consistently until October 2002. That’s right. Even though the Nasdaq was screaming higher, then topping out in early 2000, its breadth just barreled down paying it no attention.

Breadth continued falling until it made a sort of double bottom in early 2003, just as the Nasdaq was ending its bubble bear market. The recovery in breadth was short lived because it again started to fall in early 2004 and has been falling consistently since!

So it is obvious from this slice of history that Nasdaq breadth and the Nasdaq composite are completely decoupled. In fact, if we go back further in time we see that breadth has been falling continuously since, well, since I have data for it.

NYSE Cumulative Breadth
The other broad measure of breadth, for the securities on the NYSE, is not all that different. From a top in 1998 it fell continuously until early 2000. For the rest of the year it stabilized and in late 2000 started to rise. NYSE breadth found a top in May 2002. Yes, you read that right! As the market was going to hell in a hand basket, breadth was rising! For some reason, it decided to not rise in 2002 - I guess in sympathy to the stock market. But then in early 2003 as the market was rising, so did NYSE breadth. And it has continued to rise to this day.

My point is that we have so many positive and negative divergences between breadth and indices they purport to represent that cumulative breadth is basically useless.

I agree that a trend simply can not continue if less and less securities are participating in it. Eventually it exhausts itself and crumbles under its own weight as it becomes unsustainable.

The problem is that no one knows when, exactly, this will take place. And cumulative breadth certainly provides no insight whatsoever into this.

This is why I prefer taking a much simpler measure of breadth: the moving average of net advancers and decliners:

The above chart is the 30 day moving average but you can use any number you like, as long as it doesn’t introduce too much lag into the equation. It gives you not only timely signals, but it also pinpoints most, if not all, intermediate bottoms with ease.

I’ll show the long term charts of cumulative breadth for both Nasdaq and NYSE in an upcoming post. It really is eye opening.

If you’ve read this blog for some time you know that I’m a great fan of popping the hood on price and looking at what is really driving the market (Market Internals). One great indicator is the advance decline number which shows you, on any given day, how many stocks closed up and how many closed down.

Since this indicator can have wild swings from one extreme to the other the daily chart looks too “noisy” to be of any value. We can take out the noise by using a moving average or we can calculate a running total by adding each successive day to the previous and make it a cumulative indicator.

Here’s a typical way that this indicator is used (see graph on left). It comes from Michael Panzner who writes in the AOL money&finance blog.

He concludes from the graph that “since mid-April, this popular measure of market breadth has been something of a laggard, despite the fact that the technology-laden index has been trading near multi-year highs.” While not calling for a crash, he says that this means that the bulls will have to “tread carefully” because the “market lacks the broad participation necessary for a sustainable advance”.

Sounds reasonable, right? Let me show you why its incorrect.

First of all, we have to step back and take more data into consideration.

The graph below shows the Nasdaq cumulative advance decline numbers from around September 2005 to today. The red box contains the graph that Panzner shows above:

Things sure look different now, don’t they?

Negative divergences are all over the place. But the market actually goes up. In fact, if you keep going back historically you find that this is the norm. The long term Nasdaq cumulative breadth index looks like a ski hill with a few moguls here and there pausing the decline momentarily.

Very strange. Logic would seem to dictate that a stock market needs advancing stocks to power ahead. So why is it that we see a disconnect between a persistently falling cumulative breadth with lower lows and lower highs, and the market?

Believe it or not, there is a very good reason. But it is not apparent to everyone. It sure wasn’t apparent to me either. A few years ago when I noticed this strange and persistence divergence I contacted one of the best technical analysts that I knew: Helene Meisler. She was kind enough to school me.

From that point on I never bothered looking at a cumultive breadth graph again (until now) and instead used the moving average of advancers and decliners.

I’m surprised that Michael Panzner, who is as his blurb claims, is a 25 year veteran of the markets, doesn’t know. Or perhaps he does and purposefully cuts off his graph (red box above) at just the right spot to buttress his claim.

Hmm… do you think it might have anything to do with the fact that Michael Panzner is the author of “Financial Armageddon: Protecting Your Future from Four Impending Catastrophes“?

Such bombastic predictions may sell books but they won’t do much for your portfolio.