How to Deal With Bad Breadth

The U.S. markets are nearly back to all-time highs. Does that mean it’s time to pop the corks and celebrate?

Well, if you’re keeping track of market breadth, you’re probably still chilling the Moët & Chandon right now.

What is “market breadth,” you ask?

Think of it as the number of individual stocks that advance alongside broader market indexes like the S&P 500.

When the market is at new highs, “good breadth” means lots of individual stocks are hitting new highs all at the same time. Thousands of stocks should be hitting new highs on days when the indexes are doing the same. That’s a healthy market.

We want to see stocks move in the same direction. It makes everyone happy. (…So long as that direction is “up.”)

It’s also a sign of “good breadth” when equity indexes tank without a lot of individual stocks hitting new lows.

It means many stocks may have already bottomed and are set to turn back up. If your portfolio is holding up well amid market turmoil, chances are that breadth is healthy.

Bad market breadth is the opposite.

It’s bearish when the market is riding high on the strength of just a few stocks. It means stocks are weak, despite the indexes suggesting a healthy market. Once the overall market turns, it’s already been a nasty ride for the average stock.

Unfortunately for investors, that’s the situation we find ourselves in today.

A 10-week average of new highs versus new lows suggests that market breadth is at levels consistent with poor market returns.

By this measure, market breadth is at its worst level in nearly three years.

According to Ned Davis Research, when market breadth is at today’s levels (or worse), the annualized returns are -5.90%. This happens about 20% of the time, so it’s not all too often that we have this many stocks lagging the market. Walking into a 6% loss is a clear warning sign to hold off on allocating fresh capital to stocks.

One of the dangers to the market is that weakening market breadth is occurring as complacency creeps back into the market.

For example, the government is rolling back Dodd-Frank rules. You know, the rules designed to help prevent “too big to fail” situations that practically vaporized the worldwide economy for years.

Banks are also making plans to gear up proprietary trading. That’s the kind of trading that led to trillions of dollars in losses in the mortgage crisis.

I bring this up because the sense of complacency stems from the misconception that we’re finally out of the woods. After all, the markets are near their highs! What could go wrong?

Well, a lot.

The breadth of the market suggests plenty of stocks are already showing weakness. Put another way, there’s a good deal of rust forming under the hood of this historic bull market.

It may already be showing up in your portfolio. The market may be near new highs. But are the stocks in your portfolio keeping pace?

If not, don’t put good money after bad. The odds suggest lower stock prices until breadth begins to improve!

Good trading,

John

 

This post was originally published on the Rich Investor.