Lack of Stock Market Breadth Warns of Danger Ahead

The hill that I thought was going to be the proverbial walk in the park during my run on Wednesday turned out to be a killer that forced me to gear down to walking pace halfway up. I got fooled by the picturesque environs which instilled an overestimation of my ability. It was as simple as that.

What you see may also not be what you get as far as the recent surge in U.S. stocks goes.

Earlier this week John Hussman observed the following:

The stock market has advanced in recent weeks on very dull volume and relatively tepid breadth. This type of action is typically associated with short-squeezes and a backing-off of sellers, without robust underlying demand. If you look at the dull price-volume behavior, the trailing breadth in the recent rally, and the growing divergences between the major indices and other market internals, it is not clear that buyers are particularly eager.

The issue at hand is that irrespective of various stock market indices hitting new highs, the so-called market internals remain weak. This refers to the lack of market breadth, and low volume being causes for concern as these play an important role in determining the sustainability of market strength.

One of the most widely used indicators of market breadth is the so-called Advance/Decline line. This line tracks the net difference between advancing, and declining stocks. The graph below shows the NYSE Composite Index together with its Advance/Decline line.

Source: StockCharts.com

The most telling observation from this chart is that the NYSE Index hit a new high last week whereas the Advance/Decline line is still below its July peak. This is referred to as “negative divergence,” and only points to a relatively small group of stocks – mostly large caps – being responsible for pulling the market higher.

The significance of this phenomenon is simply that since the start of the bull market late in 2002, the Advance/Decline line has on five out of six occasions hit a new high before the NYSE Index. Therefore, the current situation could possibly be an early indication of a possible trend reversal.

Another interesting observation regarding market breath is an analysis of the Bullish Percent Indices. These indices are calculated by expressing the number of stock in bullish trends as a percentage of the total number of stocks. The latest readings are:

NYSE Composite Index 65.4%

Nasdaq Composite Index 51.6%

Dow Jones Industrial Index 86.7%

The big money has undoubtedly been chasing the large Dow companies, and as a result, has created an amazing two-tier market. Concentrated leadership such as this makes me feel uneasy.

The bar chart of the daily trading volume of the NYSE clearly illustrates that the rally that commenced on August 16 has been characterized by relatively lack-lustre volume – not the type of market action usually commensurate with confident bull markets.

Source: StockCharts.com

Lastly, on a fundamental note, be cognizant of the following statement by Hussman:

The current price to forward earnings multiple is as high as it was at the 1987 peak, higher than it was before the 1990 bear market, and is in fact at the highest level that would have been observed in history except for the late 1990’s.

I did not make it up my running hill on Wednesday because I based my assessment on face value, and did not bother to take the time for a proper analysis. Let’s not take this market at face value, but instead, let's err on the side of caution instead of being caught unawares.

Comments

[Paul Theron]

John Hussman has been erring on the side of caution for quite a while now..

[Slim#1]

Good analysis of present market lacking volume, but still increasing. It's on steroids, supplied by the rate decrease several weeks ago.

[User 99233]

very good reasoning