Behind price and volume, market breadth indicators are the most important “secondary” indicators to analyze, as they provide important information that price action may mask.
Market breadth tells us the number of stocks participating in an overall market move. As the Mag 7 stocks have shown, just a handful of big names can move an index that represents 493 other stocks. We want to know how many stocks are actually moving the market.
If an index is looking bullish and market breadth is positive (more stocks are advancing than declining), it tells us we have a strong rally.
However, if an index is looking bullish but market breadth is negative (more stocks are falling than rising), the rally is being carried by a few names (like the Mag 7). This serves as a warning sign: the rally is weak and we could see a market reversal on the horizon.
Why I’m closely following market breadth indicators
Price action can mask overall market weakness, hence I’m following market breadth indicators right now – a little more closely than usual.
Think of it this way: Your car may need service, but if it starts every time and gets you from point A to point B, you may not realize anything is wrong. By the time your car breaks down, it might be too late to reverse the engine’s damage.
My favorite market breadth indicator is the McClellan oscillator. This classic indicator presents data in daily and cumulative forms.
I look at two things:
- Instances when the breadth is above or below particular moving averages
- If the summation index displays a trend
When the oscillator reaches extreme levels, it pays to be contrarian. For example, you’ll see extreme readings when markets sell off hard over several days. This is my sign to make a bullish play in response.
I apply the same logic when markets are rising rapidly and the oscillator reaches high positive readings. In this case, I make a bearish (or at least a less bullish) play.
Back in March, the McClellan oscillator hit a -200 reading for a few days. The bearish trend was being priced in, so it took very little effort to lift the markets higher. Once market players saw this trend reversal, they became bullish immediately. It really looked like a light switch had been flipped – that’ show fast it happened.
What market breadth indicators are telling us
The oscillators (including the McClellan) are negative and heading lower. They have been trending down for days even while indexes have been moving higher. This bearish divergence hit on Friday, May 15. We could see more downside, as the oscillators are not quite at an extreme oversold reading.
When emotions run high, look at the technical indicators for a reality check. In this case, an oscillator will rationalize the situation for you.
