Market breadth plays a vital role in forecasting the overall health and direction of a stock market. As a potential indication of the top or a peak in market performance, market breadth can provide vital warning signals to investors. In this article, we will explore what market breadth is, why it matters, and how it might be signaling the end of the current market upswing.
At its core, market breadth is a technical analysis technique used to gauge the performance of the stock market. It measures the number of companies whose shares are increasing in value against the number of companies whose shares are decreasing. For instance, if 700 out of 1000 stocks are rising, the market breadth is positive. Conversely, if the scenario were reversed with 700 stocks falling, the market breadth would be decidedly negative.
Knowing market breadth has several benefits, one of which is its potential predictability of market peaks or the top. A divergence between market breadth and the stock market’s main indices, such as the S&P 500 or Dow Jones, signals a possible top. Essentially, this means that while the indices may be rising to new highs, the market breadth is declining, showing that fewer stocks are participating in the rally. A strong market is generally characterized by broad participation, so narrowing market breadth can be a warning sign of the end of the current market’s uptrend.
This type of divergence is often seen before larger market corrections or bear markets. One example can be seen in the U.S. stock market before the dot-com bubble burst in 2000. During those months, the S&P 500 continued to trend upward, but market breadth had begun to decline, demonstrating that fewer stocks were driving the market upward, a clear warning sign in retrospect. This is not to say that market breadth is the end-all, be-all indicator of impending downturns, but it is certainly a red flag that investors should keep on their radar.
Given the current economic climate, checking market breadth can be especially relevant. The COVID-19 pandemic has greatly affected markets worldwide, and as we navigate through these unprecedented times, it is crucial for investors to closely monitor market signals to make informed decisions. Currently, multiple reports and analyses show a potential divergence between the S&P 500 and market breadth, implying the possibility of a market top.
However, it’s important to remember that while market breadth can provide useful signals about the potential for a market top, it’s not an infallible indicator. Other factors like global economic conditions, corporate earnings, and investor sentiment all play a role in market movements. Therefore, investors should use market breadth as just one tool in their toolbox of market indicators.
Also, investors should consider that the market’s structure has changed over time. The influence of a few giant tech companies such as Apple, Amazon, Microsoft, and Google has skewed many indices due to their enormous market capitalizations. Therefore, it important to verify market breadth with other breadth measures that are not capitalized weighted.
In summary, market breadth can act as a useful tool for investors, providing early warning signals of an impending market top. As market breadth starts to diverge from the main market indices, caution may be warranted. However, investors should view market breadth in conjunction with other metrics when attempting to assess the health of the markets and the likelihood of a market top.
