Market Breadth Indicators: An Important Measure of Sentiment

Market breadth is simply how many stocks are being bought vs being sold and how much volume is behind it.  Breadth is an ideal temperature gauge of the market’s health at any point in time, and like most indicators is a current read of where price action is likely headed.  Basically, this is not where the money is flowing but what direction (in or out).  Coupled with other sentiment tools such as put/call ratio, volatility index, rydex ratio and polls we can get a very accurate idea of participant attitude and behavior, thus giving us some powerful predictive power.  It’s not always perfect and the timing will usually be off but sentiment is a valuable tool in our toolbox.  Properly reading current market breadth indicators give us a leg up.

There are several different market breadth indicators out there that basically give us the same information just presented with a slight difference.  The main one I use is called the McClellan Oscillator, derived by Sherman and Marian McClellan back in 1969 as a ‘tool for measuring acceleration in the stock market’.  At the time very few prominent technicians were in practice and the Oscillator was adopted by many as a key element to examine breadth.  Simply put, the tool takes end of day data and presents it in cumulative chart form.

The specific data include the advance/decline line and the daily breadth.  Taken together and then smoothed (10% and 5% EMA’s for trend analysis) an oscillator is created with mathematical results.  The key here is interpretation of the reading where the market may be trending or ending a trend (overbought or oversold).   By itself, the MC Oscillator is a great tool but accumulating all the values gives an even better reading, called the summation index.  This is also provided to prove the trends power and strength and potential for continuation.

On April 23, Tom McClellan will be joining me in a great FREE webinar session after the market close (link here to sign up).  Tom is the son of the McCllellans who created the indicator and manages the MCOscillator  report published daily.  

Other well-known tools include the Arms Index or the TRIN (short term trading index).   The ratio consists of advancers/decliners divided buy up/down volume.  Dick Arms first recognized a strong relationship between depth and breadth and corralled a very simple reading of these two.  In general, a reading over 1 in the ratio is considered a bearish reading while under one is bullish.  But I have found this to be a great contrarian tool at the extremes, hence very high readings indicate the bears are routing the bulls, and smoothed reading (14 day) of 1.5 indicates a powerful rally should ensue within days.  Likewise with a very low Index read of .4, too many bulls are on the bus.

Another useful gauge of breadth would be the Chaikin Oscillator, created by Marc Chaikin.  This tool interprets the accumulation/ distribution of the MACD (moving average convergence/divergence).  The oscillator is high intensity and noisy, it subtracts a 10-day EMA from a 3-day EMA of the accumulation distribution line, and outlines the momentum implied by the accumulation distribution line.  The stronger the reading the more momentun in price action.

On June 25, Marc Chaikin will be joining me in a great FREE webinar session after the market close.   Marc and his team publish reports daily and have a great site called Chaikin Analytics.

In closing, use the market gauges carefully to determine momentum, trend and strength.  These are very reliable and predictable tools (along with on balance volume and up/down volume ration) but should be used with others to confirm the analysis.

Bob Lang, Senior Market Strategist and trades various option trading newsletter Explosive Options.