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.

Here is a great illustration of the point I made earlier about how NYSE breadth numbers can be misleading because they are now skewed by interest sensitive non-common stock securities (such as bonds, CEFs, munis, etc.).

Here is a chart, courtesy of SentimenTrader.com, which shows the movement of the 30 year bond yield compared to the long term moving average of the NYSE advance decline numbers:

As you can see, they usually are mirror opposites of each other. When one is making a bottom, the other is making a top and vice versa. Of course, it isn’t a perfect correlation because the NYSE isn’t comprised of only interest rate sensitive issues. There are still many common stock securities which also have an effect on the breadth numbers. But it is obvious that what we are seeing is a blending of the two forces.

Here is a more up to date chart of the same showing the last 3 years: