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Every Breadth You Take

Indices and Breadth Charts

More Breadth Charts

Some significant technical damage has been done to the markets since the peak in September. Most of the major averages are down 7 to 10%, with companies that are perceived to be in the worst position to deal with the fiscal cliff (eg, high dividend paying companies) showing the greatest damage. You can see the four primary US indices on the left side of the first graphic above (S&P 500, Dow Industrials, NASDAQ, and Russell 2000).

But I thought I’d share with you some of the breadth indicators that I follow that give me a clue as to the internal workings of the stock market and whether the selling pressure is about to change directions.

To give you a feel for what you are looking at, the four graphs on the right side of the top graphic plus the eight graphs on the bottom graphic are all classified as breadth indicators.

Breadth indicators measure the level of participation of individual companies in market moves. Over the years that I’ve used them, I’ve become comfortable with certain levels as indicating that either selling or buying moves have, at least in the near term, run their course. I have drawn blue horizontal lines on these graphs to show you where those levels are, and if you review these twelve breadth indicators, you will see that we are near or have surpassed the levels that indicate selling pressure has run its course – at least in the near-term.

You may be familiar with the names of some of these indicators:

> the Advance/Decline Line measures the difference between the number of stocks advancing in price and the number of stocks declining in price

> the Hi-Lo Index measures the difference between the number of stocks making new highs and the number of stocks making new lows

> the % of S&P 500 companies trading above the 50 and 200 day moving average

> the Volatility Index is an index based upon Options and is an indicator of fear among traders – the greater the fear, the more Puts that are bought to protect against market drops

> the Bullish Percent Index shows how many companies have a bullish chart pattern on a point and figure chart

> the McClellan Oscillator is a short-term view of buying and selling pressure

> the Summation Index is an intermediate-term view of buying and selling pressure

> the Force Index is a trend indicator that gives a short-term view of buying and selling movements of investors

> the TRIN is also known as the Arms Index is a trading index that measures the number of shares traded in the market instead of the dollars

> the Put/Call Ratio demonstrates the sentiment in the market as to whether buyers are bullish or bearish based upon whether they are playing the options market in a bullish or bearish manner

> the TICK indicator measures on a cumulative basis whether the last trade in the market was a buy or sell

Each of these measures shows a different aspect of what is happening within the market and gives us an insight into what investors are doing.

As we have discussed previously on the blog, the stock market is influenced by actual earnings, the perception of future earnings, and how much investors are willing to pay for those future earnings (aka, sentiment).

These breadth indicators demonstrate in an objectively calculated manner something as subjective as sentiment – and it is in this conversion of the subjective to the objective that they hold their real value for an investment decision. You want to make sure that you are buying when sentiment seems too negative and selling when sentiment seems too positive – as demonstrated by the relationship of these indicators to the horizontal blue lines on the graphs.

Will they ever all show exactly the same thing? It would be rare, but we did see it in March 2009 when I wrote to you that we had begun to move from a heavy cash position to a fully invested position. If you remember back to that time, we were dealing with a stock market crash that took over 50% from the value of the S&P 500 – more for other indices. Since then, the S&P 500 has more than doubled.

As with every investment decision, we have to use these indicators in conjunction with other information. We started raising cash in client accounts in September when these indicators showed the market was nearing a top. That proved to be a good decision as we sold many holdings much higher than today’s prices.

However, at this time, even though the indicators show selling pressure has abated, the prospect for our economy to go over the fiscal cliff is still fairly high. Congress is on Thanksgiving break and the President is on an international trip, so no negotiations are taking place, and when they return they will have roughly one month to come to a compromise position that will not harm our economy, which will be a big job.

Since the price of the market is based upon future earnings and how much investors are willing to pay for those earnings, it is likely that if we go over the fiscal cliff earnings will be down (for at least a quarter or two) and the sentiment that drives investors pay more or less for those earnings will be squarely in the “less” camp.

So, we are taking a cautious stance until we see positive movement on this issue. We are, however, not selling anything at this point given that the indicators show the market should move higher in the near-term. Until we know the outcome of the fiscal cliff, caution is the best plan.

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