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Stocks just had one of their worst sessions of 2021. While it may have surprised some investors, there were potential warning signals for traders using a certain kind of technical analysis: market breadth.
Market breadth is the science of using the aggregate performance of all stocks to assess overall conditions. It varies from other forms of technical analysis that focus on just a key index like the S&P 500 index. For example, simple trend analysis may look at just the highs and lows for the S&P 500. Breadth analysis uses advanced tools to monitor all 500 companies making up the benchmark.
The Advance / Decline Line is an important market breadth tool. It relies on two special indexes built into TradeStation. One displays the number of stocks going up (advancing) and the other shows the number going down (declining). The Advance – Decline Line indicator tool then aggregates their values into a single reading.
Not surprisingly, the Advance / Decline Line tends to follow the S&P 500. However there are times when it falls despite the overall index hitting new highs. This event, called “divergence” or “non-confirmation,” is the signal we’re looking for. It can show times when a rally isn’t supported by strong internal price action.
Divergence began on the S&P 500 in late June when the Advance / Decline Line started making lower highs. It continued into July, even as the broader index made new highs. While the signal doesn’t appear often, there are times when it preceded significant drops:
Technical analysis of stock charts offer other ways to assess market breadth. One is by using equal-weighted indexes, which treat all members of the S&P 500 the same regardless of their size. For example, Apple (AAPL) accounts for almost 6 percent of the S&P 500 — more than the 147 smallest members combined.
Stock traders can simply compare the Invesco S&P 500 Equal Weight ETF (RSP) to the SPDR 500 ETF (SPY). When RSP is outperforming, it means breadth is positive. When it underperforms (like recently), it means that most companies are lagging the broader market.
Second, you can analyze the number of stocks above their 20- and 50-day moving averages. Notice on the chart below how these lines trended lower before the current drop.
In conclusion, not all price action is created equal. The stock market can trend higher even as the strength erodes from within. Technical analysts can sometimes use market breadth to be ready when a pullback comes. Hopefully this post helps you understand how to use this tool in your own investing.
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