Breadth Improvements Point To Higher Stock Prices

JC Parets
April 4, 2018

I look at facts. There are many people who choose a variety of other factors that aren't necessarily true. Market participants all over the world look at economic data (which are estimates), statements from CEOs of companies (do you trust them all? if not, which ones and why?), analysts ratings (are opinions) and an infinite of other metrics that have no history of being fact. Price, on the other hand, is the only truth we can be confident in believing. I'm selfish, if I can't trust that my data is correct, how could I possibly trust the outcome?

The way I look at markets is very simple: we want to see relative strength and positive momentum. Today, we're going to stick with momentum itself and what has happened the past few months. To be clear, I explain my entire process of analyzing momentum on this page. The get to the point of this post, we all need to understand that when momentum is in a bullish range, it is confirming that prices are in, or still in, an uptrend. It's when momentum falls into a bearish range that the evidence points to a downtrend in price, or at least a market that is no longer an uptrend.

I look at 5000 charts a week, every week. This isn't something I do on occasion. This is what I do. Take my word for it, or start tracking it yourself, when the price of a stock or commodity or market index is in an intermediate-term uptrend, momentum, using a 14-period RSI, is above 30. When prices are correcting within an ongoing uptrend, we do not see oversold conditions (below 30 RSI). The same can be said in bear markets when RSI fails to reach 70 in momentum. That would be characteristic of a downtrend in price:

bullish vs bearish momentum chart

This is a market of stocks, not a "stock market". Say what you want about market cap weightings or FANG stocks controlling a large percentage of the indexes. There are 3000 stocks in the Russell3000, and if there are more of them going up than going down, the indexes will follow them higher. I would argue there is more information in stocks as a group, then obsessing every day about a dozen or so super mega cap stocks.

We talk a lot about market breadth. To me, that means looking at what the market is doing collectively, not just at the index level. There are many ways to measure this including advance/decline lines, list of new highs/lows, volume and a number of others I've seen out there. I find value in some of that stuff, but usually it's worthless. Where I have found the most value is in what I like to call Breadth of Momentum. This is a way to measure the health of the overall market based on where stocks are on the momentum scale, positive or negative.

Here is a good example of what I mean. In early 2016, the stock market indexes made new lows in January and then again in February before the rally from the past 2 years began (yes 9 months before any election). At the January lows in price, a large number of stocks reached oversold conditions, confirming a bearish range in momentum. However, at the February lows, a much smaller percentage of stocks hit oversold conditions. This improvement of breadth coincided with new lows in price:

When we see that sort of divergence, it is evidence that the strength underneath the surface is not being seen at the higher index level, that is likely being dragged down by a few of its largest components. This is a weight-of-the-evidence approach we're taking here. Put your FANGs aside, and turn off the noise machines for one minute and consider the fact that there are 3000 stocks where investors worldwide are putting their money. The Russell3000 represents approximately 98% of all investable assets in the U.S. equities market. Let's respect that, not ignore it.

Fast forward to the first quarter of this year and the bears are in a similar predicament. Although we're not coming off an 8-9 month correction like we were in early 2016, but a 10-week correction did occur, and we did have key bottoms on back to back months. The curious thing here is that fewer stocks at last week's low reached oversold conditions than the early February bottom.

In other words, while the prices of all the indexes made new lows this past week, fewer stocks displayed bearish momentum characteristics. That improvement of breadth is consistent with higher stock prices moving forward.

From a risk management standpoint, this makes it relatively easy on us. The bet we are making is that yes, in fact, breadth did improve this week and we want to continue to be buying stocks into this weakness. The counter-argument to this is that negative momentum shoots up among stocks throughout the Russell3000, and prices of the indexes take out the first quarter lows. In that environment then our thesis is completely incorrect.

The fact that risk management here is very clear is helpful. I think considering the risk is priority number one. The higher probability outcome here, in my opinion, is higher stock prices in general. We want to be buyers of strong stocks. I list my favorite ones here:

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Cheers,

JC

 

 

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