Watching breadth to assess market conditions is a useful tool for traders. Of course, in the market, price is judge and jury. However, I think of breadth as an important piece of evidence that traders should consider.
Market breadth is simply a measure of the number of stocks Advancing vs. Declining. I want to take a look at one measure of breadth and its implications - the New York Summation Index.
(click to enlarge charts)
The New York Summation Index has been declining since early February. Its performance indicates that the stock market has been rallying with fewer and fewer participants. This is also a good example of how breadth and price can diverge from some time.
Many stocks and sectors did make highs in early February. And many more made highs in the ensuing weeks. Some stocks have given up huge chunks of gains made in the rally since mid December. Others have had healthy pullbacks or consolidations. However, the indexes and many leading stocks remain resilient.
It's fair to say that the period of ascending breadth from mid December to early February created optimal conditions for bulls. Watching individual stocks, there were numerous clean breakouts with impressive follow through.
Almost all stocks and sectors rallied in this period. With breadth softening in early February, the environment, while still net favorable for bulls, certainly became more challenging. My observation from watching individual stocks is that breakouts were scarcer with many met by selling. This has only worsened in recent weeks with many stocks and sectors breaking down.
One of the questions all traders grapple with is whether this is a trending market or a choppy market. In a choppy market, traders with longer time frames tend to be frustrated as price tends to meander with breakouts and breakdowns faded.
Choppy markets can provide splendid opportunities for "scalpers" and traders of shorter term durations who can profit off range bound movements. A recent example of a choppy market was the August 2011 to October 2011 market in which the S&P500 traded between 1100 and 1200 with brief visits above and below the range.
Conversely, in trending markets the ideal strategy is to ride the trend and the biggest danger is jumping off the trend too early which tends to happen as trending markets generally follow choppy markets. Recent example of a trending market was the gorgeous move from mid December.
Using the New York Summation Index is a simple way to assess breadth. Breadth and price in sync are two important ingredients for a trending market. When they are not in sync, then caution is warranted especially for traders with longer time frames and choppy market conditions should be expected.
Currently, I would advise caution towards swing traders looking at longs due to weak breadth. However, when the New York Summation Index turns, it will be an excellent opportunity to "buy and hold" in the early stages of the second leg of this upmove that began in mid December.
Swing traders should take this opportunity to remain patient and study individual stocks for accumulation once breadth begins to reflect more favorable market conditions. For those determined or obliged to be in the market, I would advise tighter stop losses and more modest profit targets on the long side.
I will be regularly writing articles updating readers to changes in breadth and possible signals that the second leg of the upmove is set to begin.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
