Always Focus On Breadth Of The Market

A successful self trader – Rule # 3

Market breadth has a plethora of interpretations. It can refer to the number of stocks, or sectors or themes. But the moral of the story is simple. Never bet on a market direction that is not supported by breadth. Market breadth gives the legs for the market to stand on. In fact, the final and decisive confirmation of a market trend is always the breadth. Broader the trend, more affirmative the direction!

Understanding market breadth

There may be a variety of ways to understand market breadth, but the best way is through a live market example. On the day of the Union Budget 2015, the market was sharply pulled down by ITC. Higher than expected, excise on cigarettes, led to aggressive selling in the stock. The index which was sharply down in the afternoon had rallied by evening. But, why did this happen?

It is a classic example of how a market without adequate breadth cannot sustain direction. Due to its weight in the Index, ITC had a disproportionate impact on the markets. However, the lack of breadth did not allow the downtrend to sustain. By evening, the market had closed at its monthly highs. This rule is almost universal in markets. You need breadth for a market trend to sustain!

When people look at charts, pivot points, supports and P/E ratios, they must also focus on breadth. The 1992 bull market did not sustain as it was driven by a single theme of replacement value. The 1999 bull faltered in a few months as it was purely led by technology companies. The 2003-08 bull market was driven by all round growth in earnings and efficiency. No doubt, it lasted a full 5 years!

3 WAYS TO JUDGE MARKET BREADTH

Look at the advance /decline ratio

Number of stocks advancing versus number of stocks declining is a classic giveaway. You can just look at the A/D trend over a period of time and judge whether a particular trend is gathering steam or faltering.

Look at the concentrations of New Highs and New Lows

This is again a classic giveaway. If the news highs and new lows are concentrated in one sector or theme, it is not a broad-based market. In a broad market, you find stocks across the board making news highs or lows.

Look at the Mid-cap indices; they don’t lie

Probably, the most irrefutable evidence of a broad based market is the participation of mid-caps. Rarely has a bull market of large cap stocks alone, sustained for too long. Mid cap participation is a must to lend credence!

“Narrative is linear, but action always has breadth and depth. It is therefore a lot more solid” – Thomas Carlyle

6 IMPORTANT FACTS ABOUT MARKET BREADTH…

  1.  A market breadth improving on the back of high delivery volumes is a more definitive indicator than a case of market breadth improving on the back of intraday volumes. Intraday trading, being speculative in nature, do not send a credible signal about the buying interest in a stock!
  2.  Market breadth is one of the lead indicators of the market and not necessarily conclusive. The trend in market breadth has to be understood in sync with other more fundamental and technical factors. In isolation, this metrics can be quite misleading.
  3.  Market breadth has the tendency to be extremely volatile. During market peaks, the market breadth can shift quite suddenly from positive to negative. Distinguishing a real breadth shift from a fake breadth shift is a fairly difficult task as most indicators in both the cases may look fairly similar.
  4.  Market breadth is highly sensitive to changes in regulation. Look at two famous examples. In 2005 when SEBI launched the inquiry into penny stocks, the breadth suddenly turned negative. Similarly, in 2009 when the pledged shares data was shared, the breadth suddenly turned negative.
  5.  While understanding market breadth, look at two sub-factors. Firstly look at whether non-F&O segment is showing an improvement in market breadth. Secondly, also look at whether the Trade-to-Trade segment is showing better breadth. Since this is a non-speculative segment, it is more reliable.
  6.  Finally, also try to evaluate market breadth with respect to institutional versus retail participation. More often than not, institutional buying interest reflects a blanket allocation from a macro perspective. It is not exactly an indicator of the breadth of market. A retail-driven breadth is more reliable.

 A PRACTICAL APPROACH TO MARKET BREADTH:

Back in 1991-92 the entire bull market was led by the replacement theory. Not surprisingly, it just lasted for a few months and subsequently crumbled under its own contradictions. The next bull rally in 1994 was again a narrow rally driven by FII buying into select stocks. Once the FII flow subsided with rising US interest rates, the tide turned and the market started slumping.

Why was the 2003-08 bull market so different? Unlike the 1999 rally, which was purely led by a global technology story, year 2003 was the base of an actual bull market. Massive investment in infrastructure eased business in India and lower taxes had put more money in the hands of people. Above all, the internet, telecom connectivity and air transport was making Indian businesses almost cost inelastic. Not surprisingly, this advantage was supported by breadth, and lasted a full 5 years.

TAKEAWAYS FROM THE “MARKET BREADTH” DEBATE…

In technical analysis there are varieties of indicators that are referred to as the Breadth of Market Indicators. As a trading rule, this is extremely important for traders and investors because you are always safer when you are on the side of the market breadth. The chances of being caught out in the cold are extremely low. Market breadth is more relevant when you are holding mid-cap stocks because the liquidity in such stocks can vanish quite fast!

For the more aggressive investors, market breadth is an important indicator of the turnaround in the market. Once a trend is identified, the entire market tries to pile on. Identifying market breadth shifts around the turnaround helps an investor tweak his investment strategy accordingly. It is said prices, volumes; news flows can all be misleading as it is controlled by a few players. But breadth is something a handful of traders can never control. Which is why, market breadth become so critical!

12 responses

  1. Excellent- This is also useful for day traders- when they see an explosive rise in a stock and not supported by its peers and the sensex then there is an opportunity. and viceversa

    Like

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