Investors: pay attention to market breadth

Investors: pay attention to market breadth

During the month of August, the ASX200 traded to a six-year high of 5645, meaning the local share index has now recouped close to 70% of the falls witness between 2007 and 2009, known now as the GFC. The question on many people’s mind is: will this rally continue?

One technique that we can use to help answer this question is known as market breadth, which, in a nutshell, involves assessing the overall health of the market by seeing how many of the 200 constituents are participating in the rally. The general rule is that if a high proportion of the 200 stocks are themselves moving higher, then the rally is likely to be sustained. On the other hand, if the ASX200 is being pushed higher due to the strong performance of just a handful of stocks, then the underlying health of the market is deteriorating, increasing the risk of a meaningful market correction.

There are many measures of market breadth that investors can use, but one of the easiest and most effective is known as the advance decline line. This line simply plots the cumulative number of stocks closing higher on the day, minus the number of stocks closing lower on the day.  

When a stock market is ‘healthy’, the advance decline line will continue to set new highs as the stock index itself makes new highs. Alternatively, if the stock market is moving higher while the advance decline line is setting lower highs by comparison, the overall health of the market is deteriorating, as fewer and fewer individual stocks are participating in the rally.

Chart 01 below shows the relationship between the ASX200 (top panel) to the ASX200 advance decline line (lower panel). The key thing to look for is a divergence or non-confirmation, which occurs when a new index high is not confirmed by new highs in the advance decline line. In other words, only a few top performing or large capitalised stocks are moving the market higher. We have marked on the chart the three divergences over the past seven years, which shows how each one led to a significant correction.

So what’s encouraging for local investors at present is that currently no such divergence exists, meaning that the current advance in the ASX200 is broad-based and thus more likely to be sustained. Any change to this, however, and we will be quick to alert our readers. 

Chart 01. The ASX200 index and the ASX200 advance decline line from 2006-2014, showing how divergences in the past have all led to significant market corrections

 

Source: eSignal, Rivkin. Data extracted 4 September 2014.

*Past performance is not indicative of future performance.

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