A doctor checks a patient’s vital signs to find out how things are beneath the surface. For investors, though, checking on the markets means digging deeper than a simple glance at the Dow Jones Industrial Average.
Many market analysts turn to an indicator called “market breadth” to assess if an advance (or decline) is likely to continue.
Market breadth refers to how many stocks are participating in the general direction of the market. The broad averages can be driven higher or lower by large moves in only a few stocks, so it matters if most stocks are going along or actively resisting the trend.
For instance, as the Internet bubble began to pop in early 2000, most of the gains in the market averages could be attributed to only five to 10 of the largest stocks on any day. With most stocks underperforming the averages, the advance was bound to end. The decline that followed was of historic proportions.
To measure participation in an advance, we can look at the number of stocks that are trading above their 50-day moving average. A “moving” average takes the closing price of the stock over the last few days, always dropping older data and adding newer market action to reflect the most recent action. By averaging the prices, this technique removes much of the volatility of daily market action and offers a clear view of the trend.
There are several ways to look at this indicator. In its simplest form, readings above 50 percent are thought of as positive. In other words, if more than half of all stocks are above their moving average then the market is bullish.
When half are trading below their moving average, that is a bearish indication.
At the end of last week (April 3), 73 percent of all stocks were above their 50-day moving average. This number has been steadily rising over the past four weeks, a bullish trend.
However, recent volatility has shown us that — unlike in a long, generalized bull market — stocks can go down just as easily as they can go up.
Market breadth can also help us identify “overbought” and “oversold” conditions.
Technical analysts refer to a market as being overbought when it seems that everyone is fully invested and there is no new money available to push prices higher. Using the percentage of stocks over their 50-day moving average as a guide, when 80 percent of stocks are in “up” trends, the market has become overbought.
If so, while stocks can go higher, the best gains are probably behind us for now. In this case, it is better to preserve cash and wait for a better buying opportunity.
That is where we are now. Seventy-three percent is pretty close to 80 percent. With prices having moved more than 20 percent higher in only four weeks, as measured by the S&P 500, the market is likely to take a well-deserved rest. It may still go higher, but large gains like we’ve just seen are improbable.
Now is the time for investors to get their “buy” lists ready and watch for better opportunities.
Financial stocks led the way higher in the recent advance, with the Financial Select Sector Exchange Traded Fund (XLF) gaining more than 60 percent from the March lows. If this is the start of a new bull market, this ETF is a strong candidate to lead the way higher.
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