Last week, fewer than 25% of S&P 500's constituents were trading above their 50-day moving averages and fewer than 45% above their 200-day moving averages. According to analysts, this represents the weakest breadth ever recorded, suggesting that mega-cap stocks are masking significant weakness underneath the surface.
Historically, similar divergences have been relatively rare and have sometimes appeared before major market peaks, including in 2014 and 2021. However, breadth divergence is not a timing signal by itself.
When the S&P 500 rises, the natural assumption is that the stock market is broadly getting stronger. But an index can rise even when a large portion of its constituents are falling. This is particularly important for capitalization-weighted indices such as the S&P 500 or the Nasdaq, where the largest companies have a disproportionately large influence on the index.Market breadth measures how broadly a market move is distributed among its individual stocks. A market rally supported by hundreds of stocks is fundamentally different from a rally driven by only a handful of large companies.
What is market breadth?
The simplest measure of breadth is the number of advancing stocks versus declining stocks. For example, imagine that the S&P 500 rises 0.8% on a particular day. If 400 stocks rise and only 100 fall, the rally has strong breadth. Many stocks are participating. But suppose the S&P 500 rises 0.8% while only 150 stocks rise and 350 decline. The index is still going up, but the participation is much weaker.
One commonly used indicator is the advance/decline (A/D) line. Each day, the number of declining stocks is subtracted from the number of advancing stocks, and the result is accumulated over time. A rising A/D line therefore means that participation is broadly improving, while a falling A/D line indicates that fewer stocks are participating in the upside. Another popular measure is the percentage of stocks trading above their 50-day or 200-day moving average.
Chart: S&P 500 (CFD contract) and A/D line indicator (Advance-Decline Line by Nepo123 on TradingView)
What is a breadth divergence?
A positive breadth divergence occurs when the index is falling or making new lows while breadth is improving. For example, the S&P 500 might be going down, while the A/D line rises. This tells traders that although the headline index remains weak, more stocks are beginning to participate on the upside. It can be an early indication that selling pressure is losing strength.
A negative breadth divergence is the opposite, the S&P 500 might be making new highs, while the A/D line declines. The index is still rising, but fewer stocks are supporting the move.
This does not automatically mean that the market is about to fall. It means that the rally is becoming increasingly concentrated and therefore potentially more vulnerable if the stocks driving the index higher begin to weaken or there's a negative catalyst.
How traders can use breadth
Breadth is best used as a confirmation tool, rather than as a timing signal by itself. Suppose the S&P 500 breaks to a new all-time high. If the A/D line also breaks to a new high and the percentage of stocks above their 50-day moving averages is rising, the breakout has broad participation. This gives traders greater confidence that the underlying trend is healthy.
If the S&P 500 makes a new high, but the A/D line has been declining for several weeks and fewer stocks are above their 50-day moving averages, the trader should not automatically short the market. Instead, the trader might become less aggressive with new long positions, tighten risk management or pay closer attention to whether the leading stocks begin to weaken.
The same concept works in reverse. If the S&P 500 makes a new low, but the A/D line makes a higher high, the market may be showing early internal improvement. Selling is becoming less widespread even though the headline index remains weak.
This article was written by Giuseppe Dellamotta at investinglive.com.from Investinglive RSS Breaking education Feed https://ift.tt/mHMJeT0
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