Stock market breadth indicators (also known as internal indicators) are tools an investor can use to measure the strength of a price trend in the overall stock market. Using these indicators can help you know when to be in, or out, of the market. This article highlights three ways market breadth indicators can help you improve your investing results.
First, lets look at what a stock market breadth indicator is. Many investors like to look at stock indexes, like the S&P 500 index or the Dow Jones Industrial Average, to see how the stock market is trending as a whole. As you probably already know, these two broad market indexes are calculated in completely different ways, with the S&P 500 being market cap weighted (i.e. larger companies have a bigger influence on the index than smaller companies), and the Dow Industrials being price weighted (i.e. higher priced stocks have a bigger influence on the index than smaller priced stocks). As you can see from how these stock indexes are calculated, the price movement of a few stocks can actually mask the price movement of many other stocks in these indexes.
With the previous explanation in mind, lets look at three ways stock market breadth indicators can help you see what is really going on in the market.
The first way stock market breadth can help is by tallying the number of issues advancing or declining in price. You may have heard this referred to as advancing vs. declining issues, or the advance/decline line. What investors should look for here is strong participation in the predominant price trend by a majority of companies in the index that you are following.
The second way internal indicators can help you is by summing the volume of advancing or declining stocks within the index you are watching. This indicator is also widely publicised, and again, what you should look for is advancing volume to be strong vs. declining volume in a bull market, and the reverse in a bear market.
The third way breadth indicators can help your market analysis is by counting the number of stocks reaching new yearly highs versus new yearly lows. Obviously you want to see more new highs in a bull market, and more new lows in a down trend.
What all three of these types of breadth indicators have in common is that they are good at showing potential turning points in the market when their trend starts to diverge from the direction of the index price. For example, if the price of the S&P 500 index is moving higher, while advancing volume and advancing issues are declining, you should exercise caution if you are thinking about purchasing a stock, because fewer stocks are participating in the rally, indicating people are pulling money out of the market.
There are many books written on the subject of stock market breadth, and doing some research in this area should help you be a better investor.