investing

Stocks: Look to Market Breadth for Direction

Will stocks as a whole advance or retreat? Sometimes it’s a question of who is buying what.

Things got gloomy for investors for a while. Between February 19 and March 23, stocks in Standard & Poor’s 500-stock index took a Wile E. Coyote–style plunge, losing 33.8% in just a month. Despite uncertainty about the length and severity of the pandemic-related shutdowns that triggered the sell-off, investors, like the coyote himself, once again grew optimistic, pushing the S&P 500 back up 28.4%. (Prices and other data are as of May 15.)

Lately, the market’s behemoths have been doing the heavy lifting. Just five stocks—Alphabet, Amazon.com, Apple, Facebook and Microsoft—account for 22% of the S&P 500 index’s market capitalization (share price times shares outstanding), a record level of dominance among a handful of companies. So far in 2020, the S&P 500’s five biggest stocks have returned 11.5%, on average. The average loss in the rest: 20.4%. “It’s okay for leaders to lead. But if the market’s generals are headed in one direction and the troops in another, then you have potential problems,” says Willie Delwiche, a strategist at investment firm Baird.

The generals-versus-troops metaphor is a common way of understanding an indicator known as market breadth, a measure of how many stocks are participating in a given market move. For investors practicing technical analysis (forecasting the direction of stock prices based on statistical patterns), understanding breadth is key to determining whether a rally in the stock market will lead to a sustained recovery or is masking further bouts of turbulence and downturns.

Making sense of the recovery. Wall Street traditionalists favor stock analysis based on fundamentals such as cor­porate earnings and business models. Fundamentals easily explain the precipitous drop in share prices in the wake of the COVID-19 outbreak, as government-mandated shutdowns slashed entire industries’ revenue streams to near-zero overnight.

It remains to be seen whether the gains from the market bottom are the beginnings of a bull or a prelude to a return to lows.

Assessing subsequent rallies, such as the one that began in March, is trickier. Clearly, such spikes represent a bet that the global economy and corporate earnings will return to growth when the pandemic’s effects on the economy subside. But absent a vaccine or widely available testing, the timeline for successfully reopening the economy remains nebulous. Moreover, economists differ on what sort of recovery we’ll see, and many companies have rescinded guidance on the health of their businesses, taking the level of uncertainty orders of magnitude higher for market forecasts that rely on traditional fundamental metrics.

That’s when assessing patterns in investor behavior becomes an important tool. From the technician’s perspective, recoveries from bear markets come in four stages, says Reed Murphy, chief investment officer at Calamos Wealth Management. First, the market becomes oversold. Check. Second, there’s a rally. Check-plus: The 31% bounce back to the recent high on April 29 is among the biggest rebounds of all time. That bodes well for stage three, when the market retreats again, “retesting” its recent low. Rebounds as large as the recent one are seldom followed by big downturns, says Murphy. So far, the market’s pullbacks have been modest, although a bigger correction isn’t out of the question.

The final stage in a recovery is a sustained rally, with stocks firmly established in bull territory. It remains to be seen whether the gains from the market bottom are the beginnings of a bull or a prelude to a return to lows. For investors looking to make sense of the current environment, breadth indicators can confirm the quality and sustainability of a rebound.

Charging ahead or in retreat. One way to measure breadth is to tally the number of stocks in a given index or exchange that are advancing and compare that to the number of declining stocks. More advances than declines indicates broad, positive participation in the market, says Steve Suttmeier, chief technical strategist at Bank of America Merrill Lynch. It’s especially true on days when the market index is down, because it confirms underlying support for the market despite the dip. Investors can track daily ups and downs as a ratio over time in the form of the advance-decline line, often plotted on a chart alongside the performance of a stock index. Look for the A-D line to move in the same direction as stocks. If indexes go up while the A-D line sinks, it signals weakness in the rally. On this front, the rally that began in March shows promise, with the number of advancers in the stock market remaining well above decliners as indexes have ascended.

Also keep an eye on the number of stocks hitting 52-week lows and highs. March saw 68% of stocks in the S&P 500 hit new lows—the highest level since the global financial crisis. Should the market head sharply down again without an expansion in new lows, investors can have some confidence that the lows in March were a true market bottom, says Suttmeier. If the market is reaching new highs, look for a broad swath of the market to post new highs, too. If few stocks make new highs in an up market, “it’s not a signal to sell, but it is a red flag,” says Delwiche.

Another way to tell if the generals have gotten too far ahead of the troops is to compare an index that weights stocks by their market value with a version of the index that weights each stock equally. Better performance from the equal-weight index indicates that the broad market is doing well, not just the big names, says Brian Andrew, chief investment officer at Johnson Financial Group. Since late March, the equal-weight S&P 500 has returned 27.2%, 1.2 percentage points less than its market-weight cousin.

A less-rosy assessment of the current rally comes from looking at stocks’ moving averages, calculated by adding up daily closing prices over a given period and dividing by the number of days in that period. In a robust market upswing, more than half of the stocks in an index will trade above their 200-day average, says Andrew. When stocks hit the skids in February, more than 90% of the stocks in the S&P 500 fell below their moving average; even after a sharp rally, only 37% currently trade above their 200-day moving average, according to Yardeni Research. “It’s great to see that stocks have rallied, but it’s not yet a rising tide lifting all boats,” Andrew says.

Don’t forget small-company indexes. Small caps tend to lead blue chips out of recessions, says Calamos’s Murphy. Small firms tend to be more sensitive to swings in the economy than bigger firms, and small-cap leadership signals investor confidence that the economy is improving, he says. So far, small caps have about kept pace with large caps since the market bottomed, a positive sign in the short term. But Murphy warns that a large contingent of small companies are still posting negative earnings, and the little guys still have ground to make up. So far in 2020, the small-company Russell 2000 index has shed 24.3%, compared with a 10.7% decline in the S&P 500.

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