Trader’s Narrative

Last week I suggested that market breadth doesn’t matter, until it does. By which I meant that inspecting every twitch of the cumulative breadth measure for the market isn’t all that useful.

Most of the time, this indicator is brought up because there is a “negative divergence” which then is used to argue that the market is floating on air and will come crashing (or correcting) down because not enough constituents are supporting its rise.

As I mentioned, the problem with this logic is that for the most part, the Nasdaq cumulative breadth has been in perpetual free fall:

The only time this indicator was able to mount a feeble come back was in 2003. And even then, it didn’t last long. While the market continued to rise, the cumulative breadth soon fell and broke through the low set in early 2003.

To see the recent graph of Nasdaq cumulative breadth, check out the link above.

The long term chart of the NYSE cumulative breadth is even more enigmatic. From 1995 to 1998 it rose along with the S&P 500. Then it decoupled and became it’s mirror opposite until the bear market bottom in 2003. And since then it has again, walked in agreement with the market index.

To anyone who proposes the theory of “negative/positive divergence”, I would ask, when should I have bought or sold? and why?

For example, should I have sold in the spring of 1998? and missed the massive run up to 2000? should I have bought in early 2000 because cumulative breadth was turning up and breaking the downtrend? wouldn’t that have resulted in massive losses?

Cumulative breadth simply doesn’t provide any sort of actionable insight. Unless I’m missing something huge. In which case, someone please forgive my elephantine ignorance and rescue me from myself.

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.