Market breadth is an ideal way to gauge the temperature of the market’s health at any point and at any time. Like most indicators, it provides an idea of where price action is likely headed.
Market breadth is simply how many stocks are being bought vs. being sold and how much volume is behind it. It does not tell us what sector, stock or index people are buying into; rather, it tells us whether money is flowing in or out of the market as a whole. Coupled with other sentiment tools, such as the put/call ratio, volatility index, rydex ratio and polls, we can get a very accurate idea of what investors and traders are thinking and doing, thus giving us some powerful predictive reads. Of course, our analysis of these indicators is not always perfect, and usually, our timing will be off, but sentiment is a valuable tool in our toolbox. Properly reading current market breadth indicators give us a leg up.
Naturally, there are several different market breadth indicators out there. In general, they provide us the same information but present that information slightly differently. Let’s take a look at three of them.
The one I use the most is called the McClellan Oscillator, which was developed by Sherman and Marian McClellan in 1969 as a “tool for measuring acceleration in the stock market.” At the time, the industry had very few prominent technicians, so the Oscillator was widely adopted.
At its most basic, the tool takes end-of-day data and presents it in cumulative chart form. The data includes an advance/decline line and daily breadth. Taken together and then smoothed using mathematics, (10% and 5% emas for trend analysis), an oscillator is created. The key, of course, is interpreting the reading to understand where the market may be trending or if it’s reaching the end of a trend (overbought or oversold).
By itself, the McClellan Oscillator is a great tool, but its summation index, which accumulates all the values, provides an even better reading, as we can see a trend’s power, strength, and potential for continuation.
If you want to learn more about this tool, your chance is coming up on April 23 when Tom McClellan will join me for a FREE webinar after the market close (sign up here). Tom is the son of the McCllellans and editor of the McClellan Oscillator report, which is published daily.
Arms Index (TRIN)
Dick Arms was the first trader to recognize a strong relationship between depth and breadth, so he corralled them into a very simple reading called the Arms Index, or TRIN (Traders Index) that uses a ratio of advancers/decliners divided by up/down volume. In general, a reading over 1 is considered bearish; under one is bullish.
I have found this to be a great contrarian tool at the extremes. Very high readings of around 1.5 indicate the bears are routing the bulls. If the reading lasts 14 days, a powerful rally should ensue soon. A very low reading of .4 means too many bulls are on the bus, and a reversal downward in the markets will soon happen.
The Chaikin Oscillator interprets the accumulation/distribution of the MACD (moving average convergence/divergence). The oscillator is intense and noisy; it subtracts a 10-day EMA from a 3-day EMA of the accumulation distribution line, and it outlines the momentum implied by the accumulation distribution line. The stronger the reading, the more momentun in price action.
On June 25, Marc Chaikin, who created this great tool, will be joining me for another FREE webinar after the market close (sign up here). Marc and his team publish daily reports via their website, Chaikin Analytics.