From the desk of Steven Strazza @Sstrazza and Grant Hawkridge @granthawkridge
While breadth has improved in recent weeks and months, the bulls still have their work cut out for them.
When we consider all our breadth indicators in aggregate, the evidence remains mixed. What else is new!? It’s been that way for the majority of this year.
Many of the major indexes made new all-time highs this week. Meanwhile, some advance-decline lines are moving higher, but others are moving lower. Some are at the top of their range, but others are at the bottom of theirs.
The advance-decline line measures stock market breadth based on cumulative net advances. In other words, it takes the number of advancing stocks on a given day and subtracts the number of declining stocks. That number is then added to the previous day’s value, creating a cumulative advance-decline line.
A/D line divergences occur when price is making new highs and the A/D line is NOT.
Just because there’s no divergence in the A/D line doesn’t mean the market can’t correct. We see this happen all the time. But when there is a divergence in the A/D line, we want to pay extra-close attention because there is a heightened possibility that price weakness will follow.
Let’s take a look at advance-decline lines for some of the major averages and indexes in the US equity market.
Here’s the Nasdaq and the New York Stock Exchange A/D lines:
The breadth improvement since September is illustrated well by the NYSE line bumping up against its highs from back in June. There is technically a slight divergence for now, as price has rallied back to fresh highs while the A/D line is sitting just below its Q2 highs. This can clear up any day and shouldn’t be too much cause for concern.
On the other hand, the Nasdaq A/D line has been dragging steadily lower since Q1 despite the index recently trading back to fresh highs. Considering the magnitude of this divergence, this is something we want to keep an eye on moving forward.
The gap in bullish participation between NYSE- and Nasdaq-listed stocks speaks to the rotation into value and cyclical stocks, as the NYSE has much higher representation from these names.
Now let's take a look at the advance-decline lines for the S&P 500, the S&P 400, and the S&P 600:
The large-cap S&P 500 is knocking on the door to new highs for the first time in almost two months. The mid-cap A/D line isn’t too far behind, as it’s pressing against its year-to-date highs as well. But the small-cap A/D line remains lackluster in comparison, still a good deal away from fresh highs.
Meanwhile, we see no divergences in the S&P 600 and the Russell 2000, which have yet to achieve new highs. If and when we do get new highs, bulls would like to see it occur in an environment where internals are far more supportive.
While it is a positive development to see an increase in participation from large- and mid-cap stocks, as both A/D lines are testing their highs from earlier this year, we want to be wary of the new highs from these indexes for now. Until we get a sustained breakout from the corresponding A/D lines, the potential for corrective action looms in the background.
It’s the same story we have been telling all year. The further down the cap scale you go, the messier it gets. Confirmation from these A/D lines in tandem would be a very bullish development and would act as strong confirmation of any new highs in the indexes.
Perhaps these A/D lines clean up the current divergences and resolve higher. Or maybe the indexes catch lower and these new highs fail. We’ll have to wait and see.
Everything mentioned above is merely a supplement to price action. At the end of the day, price is the only thing that matters when it comes to managing risk.
With that said, we’re always paying attention to breadth and looking at what’s going on beneath the surface in these indexes. Market internals offer us excellent information, particularly in terms of confirming what we're seeing at the index level.
Right now, we aren’t seeing much in terms of confirmation of these new highs at the index level. That doesn’t mean it can’t change. We could get confirmation during the next trading session. But it's definitely something we want to be aware of, as the market is more vulnerable to corrective action in the meantime.
