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Strong Breadth, Strong Momentum, Strong Market?

Trillion Dollar Meltdown

Here's something I bet you never thought you'd hear from a company that prides itself on being the world's largest market forecasting firm: Taken in isolation, traditional technical indicators can bite you in the [place where the sun don't shine].

Case in point: In early afternoon trading on Wednesday, June 9, the Dow Industrials enjoyed a triple-digit rally and regained the coveted 10,000 level. And as prices rose, one popular buzzword made its way into the financial blogosphere: Breadth. The stock market's advance/decline (A/D) readings suggested that the tank for further gains was full.

"Stocks Surge. Volume: On the NYSE, winners beat losers more than five to one on volume of 600 million shares." (June 9 CNN Money)

Yet -- by the market's close, street had erased its entire gains, and then some.

So, what went wrong? The short answer: Markets don't exist in a vacuum. If they did, a 5:1 A/D ratio would be reasonable to conclude that a bottom was in place. But there is a larger picture to consider, one that is never complete until the Elliott wave structure says it is.

On this, EWI's team of experts prepared the following close-up of the DJIA from April 1930 to July 1932.

Dow Jones Industrial Average Breadth 1929

Check it out:
This period includes 42 days in which the A/D ratio was 4:1 or higher, and still, the Dow plummeted 86%. Moreover, the strongest A/D ratios occurred near the top of countertrend rallies.

Bottom line: Without the context of Elliott wave patterns, positive breadth is an insufficient indicator and does not always suggest a strong market.

The same conclusion can be drawn for widely held gauges of momentum, such as buying and selling climaxes. Taking nothing else into account, a high buy number rightfully suggests a market that is firing on all cylinders. Yet, an extreme buy climax, paired with a rapidly maturing wave pattern, is a surefire sell signal.

For example, in the days leading up to the April 26, 2010 peak in stocks, our analysts used this very combination to foresee a coming reversal in the market's gains. Here, the April 19 Short Term Update presented the following close-up of buy/sell climaxes versus the Dow since May 2009 and wrote:

"Last week saw 467 buying climaxes, a number that places the weekly tally on the list of the ten highest readings in the 20 + year database. The evidence... implies the market is at the start of a decline."

Dow Jones Industrial Average Breadth 2009

The 1,000-plus point plunge since then speaks for itself.

Now, if you want to see these indicators in their rightful context, subscribe risk-free to Financial Forecast Service today.


Disclosure: Shorting Stocks