Lack of stock market breadth flashes red light

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Picture the scene: A dirt road twisting upward at a 60-degree incline, with vineyards lining the sides and a clear blue sky above – a picture of tranquility by any definition. This is the hill I tackled yesterday as part of my daily run. But alas, what I thought was going to be the proverbial walk in the park turned out to be a killer that forced me to gear down to walking pace halfway up. I got fooled by the picturesque environs instilling an overestimation of my ability – as simple as that.

What you see may also not be what you get as far as the recent surge in US stocks goes.

John Hussman observed the following earlier this week: “The stock market has advanced in recent weeks on very dull volume and relatively tepid breadth. This type of action is typically associated with short-squeezes and a backing-off of sellers, without robust underlying demand. If you look at the dull price-volume behavior, the trailing breadth in the recent rally, and the growing divergences between the major indices and other market internals, it is not clear that buyers are particularly eager.”

The issue at hand is that irrespective of various stock market indices hitting new highs, the so-called market internals remain weak. This refers to the lack of market breadth and low volume being causes for concern as these play an important role in determining the sustainability of market strength.

One of the most widely used indicators of market breadth is the so-called Advance/Decline line. This line tracks the net difference between advancing and declining stocks. The graph below shows the NYSE Composite Index together with its Advance/Decline line.

11-oct-12.jpg

Source: StockCharts.com

The most telling observation from this chart is that the NYSE Index hit a new high last week whereas the Advance/Decline line is still below its July peak. This is referred to as “negative divergence” and points to only a relatively small group of stocks – mostly large caps – being responsible for pulling the market higher.

The significance of this phenomenon is simply that since the start of the bull market late in 2002, the Advance/Decline line has on five out of six occasions hit a new high before the NYSE Index. The current situation could therefore be an early indication of a possible trend reversal.

Another interesting observation regarding market breath is an analysis of the Bullish Percent Indices. These indices are calculated by expressing the number of stock in bullish trends as a percentage of the total number of stocks. The latest readings are:

• NYSE Composite Index 65.4%
• Nasdaq Composite Index 51.6%
• Dow Jones Industrial Index 86.7%

The big money has undoubtedly been chasing the large Dow companies and thereby created an amazing two-tier market. Concentrated leadership such as this makes me feel uneasy.

The bar chart of the daily trading volume of the NYSE clearly illustrates that the rally that commenced on August 16 has been characterized by relatively lack-lustre volume – not the type of market action usually commensurate with confident bull markets.

11-oct-2.jpg

Source: StockCharts.com

Lastly, on a fundamental note, be cognizant of the following statement by Hussman: “The current price to forward earnings multiple is as high as it was at the 1987 peak, higher than it was before the 1990 bear market, and is in fact at the highest level that would have been observed in history except for the late 1990’s.”

I did not make it up my running hill because I based my assessment on face value and did not bother with proper analysis. Let’s not take this market at face value – rather err on the side of caution than be caught unawares.

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7 comments to Lack of stock market breadth flashes red light

  • GW [USA]

    Thanks for the great post today. Those comments by John Hussman really made me think over my current strategy. I believe you may of saved me some losses. Thanks!

  • stevo

    FYI.

    Please refer to my post of 8 Oct. 07:

    Support/resistance points: 120* 1575; 90* 1561; 60* 1548.

    And SPX data, 11 Oct 07:

    High 1576.09 (120* 1575, strong resistance)
    Low 1546.72 (60* 1548, high cut in half, *-wise)
    Close 1554.41 (half-way point between 60* and 90*: 1561 + 1548 = 3109 /2 = 1554.5)

    As all life cycles, so must the markets. The ridiculous, JP Morgan “Baidu” story was an excuse for first, taking money from the weak longs, and subsequently, from the ill-positioned shorts. As I said, several posts back, mid-October should prove to be an interesting time for this index. However, the irregular uptrend in the SPX should resume.

  • Ian Nunn

    I have been enjoying what you share for a couple of months now. One technical question: in the chart of $NYAD and $NYA, how did you overlay them on the same graph? I subscribe to the basic level of service at Stockcharts and have wanted to do this but couldn’t figure out how. And their customer service is virtually non existent.

  • Ian, the steps to create the overlay on StockCharts.com are as follows:

    (1) Start off drawing a chart for $NYAD.

    (2) Select the “Cumulative” option from the drop-down menu under “Type”.

    (3) Go to “Indicators” and select “Price”.

    (4) Type $NYA in the “Parameters” block and select “Behind price” from the “Position” block.

  • [...] seemingly positive price trend, thereby casting doubt on the sustainability of the rally (see “Lack of stock market breadth flashes red light”). This in itself is not a timing indicator, but a warning signal of impending [...]

  • [...] outlook. It is for this reason that I recently posted two articles expressing my concern, namely “Lack of stock market breadth flashes red light” (October 11, 2007) and “Global stock markets: pop ‘n drop” (October 16, [...]

  • [...] the market’s warning signals, especially the lack of breadth (see “Lack of stock market breadth flashes red light” – October 11, 2007), have been around for a while but yet few people paid attention and [...]

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