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Breadth Indicators How Healthy is the Trend? April 20, 2020 How do we Measure the Health of the Trend? In addition to measuring the attitudes of market players (sentiment), the technical analyst needs to look at the internal strength of a market. By looking at data specific to each market, the analyst determines whether the internal strength of the respective market is improving or deteriorating. On any given day, a stock price can do one of three things: close higher, close lower, or remain unchanged from the previous day's close. If a closing price is above its previous close, it is considered to be advancing, or an advance. Similarly, a stock that closes below the previous day's close is a declining stock, or a decline. A stock that closes at the exact price it closed the day before is called unchanged. Advance/decline data is called the breadth of the stock market. The indicators we focus on in this section measure the internal strength of the market by considering whether stocks are gaining or losing in price. The Concept of Divergence The most important technical concept for confirmation of a trend is called a divergence. As long as an indicator— especially one that measures the rate of change of price or other data (called momentum)— corresponds with the price trend, the indicator is said to “confirm” the price trend. When an indicator or oscillator fails to confirm the trend, it is called a negative divergence or positive divergence, depending on whether peaks or bottoms, respectively, fail to confirm price peaks or bottoms. A divergence is an early warning of a potential trend change. It means the analyst must watch the price data more closely than when the indicators and oscillators are confirming new highs and lows. Divergence analysis is used between almost all indicators and prices; a divergence can occur more than one time before a price reversal. What is an Oscillator? Oscillators are indicators that are designed to determine whether a market is “overbought” or “oversold.” Usually, an oscillator will be plotted at the bottom of a graph, below the price action. As the name implies, an oscillator is an indicator that goes back and forth within a range. Overbought and oversold conditions (the market extremes) are indicated by the extreme values of the oscillator. In other words, as the market moves from overbought, to fairly valued, to oversold, the value of the oscillator moves from one extreme to the other. Different oscillator indicators have different ranges in which they vary. Often, the oscillator will be scaled to range from 100 to —100 or 1 to —1 (called bounded), but it can also be open ended (unbounded). Important Breadth Indicators The Breadth Line or Advance-Decline Line The breadth line, also known as the advance-decline line, is one of the most common and best ways of measuring breadth and internal market strength. This line is the cumulative sum of advances minus declines. Ordinarily, the plot of the breadth line should roughly replicate the stock market averages. In other words, when the stock market averages are rising, the breadth line should rise. This indicates that a market rally is associated with the majority of the stocks rising. Important Breadth Indicators Advance-Decline Line to Its 32-Week Simple Moving Average Analysts have developed several variations of using the advance-decline line. One method is to compare it with its own moving average to give buy and sell signals for the market and, thus, create an oscillator. Ned Davis Research, Inc. used a ratio of the NYSE advance-decline line to its 32-week simple moving average. It found that from 1965 to 2010 when the ratio rises above 1.04, the per annum increase in stock prices as measured by the NYSE Composite Index was 19.3%, and when it declined below 0.97, the stock market declined 11.2% per annum. Important Breadth Indicators McClellan Oscillator In 1969, Sherman and Marian McClellan developed the McClellan Oscillator. This oscillator is the difference between two exponential moving averages of advances minus declines. The two averages are an exponential equivalent to a 19-day and 39-day moving average. Extremes in the oscillator occur at the +100 or +150 and —100 or —150 levels, indicating respectively an overbought and oversold stock market. The rationale for this oscillator is that in intermediate-term overbought and oversold periods, shorter moving averages tend to rise faster than longer-term moving averages. However, if the investor waits for the moving average to reverse direction, a large portion of the price move has already taken place. A ratio of two moving averages is much more sensitive than a single average and will often reverse direction coincident to, or before, the reverse in prices, especially when the ratio has reached an extreme. Important Breadth Indicators McClellan Summation Index The McClellan summation index is a measure of the area under the curve of the McClellan Oscillator. It is calculated by accumulating the daily McClellan Oscillator figures into a cumulative index. Important Breadth Indicators Advance-Decline Ratio This ratio is determined by dividing the number of advances by the number of declines. The ratio or its components are then smoothed over some specific time to dampen the oscillations. Using daily breadth statistics between 1947 and 2000, Ned Davis Research, Inc., found 30 buy signals were generated when the ratio of ten-day advances to ten-day declines exceeded 1.91. These signals averaged a 17.9% return over the following year. In only one of the 30 instances did the signal fail, and the loss then was only 5.6%. Important Breadth Indicators Breadth Thrust A thrust is when a deviation from the norm is sufficiently large to be noticeable and when that deviation signals either the end of an old trend or the beginning of a new trend. Martin Zweig devised the most common breadth thrust indicator, calculating a ten-day simple moving average of advances divided by the sum of advances and declines. The indicator signals the start of a potential new bull market when it moves from a level of below 40% (indicating an oversold market) to a level above 61.5% within any 10-day period. This is a rarely occurring sentiment, which carries tremendous import with market watchers. Up and Down Volume Indicators Breadth indicators assess market strength by counting the number of stocks that traded up or down on a particular day. An alternative way to gauge market internals is to measure the up volume and down volume. Up volume is the volume traded in all advancing stocks, and down volume is the total volume traded in declining stocks. Up and down volume figures are reported in most financial media. Considering the volume, rather than only the number of stocks traded, places more emphasis on stocks that are actively trading. With the breadth indicators, a stock that moves up on very light trading is given equal importance to one that moves up on heavy trading. By adding volume measures, the lightly traded stock does not have as much influence on the indicator as a heavily traded stock. The one caveat with using volume is that occasionally an enormous trade in a low-priced stock will upset the daily figures Up and Down Volume Indicators The Arms Index The Arms Index measures the relative volume in advancing stocks versus declining stocks. When a large amount of volume in declining stock occurs, the market is likely at or close to a bottom. Conversely, heavy volume in advancing stocks is usually healthy for the market. The numerator is the ratio of the advances to declines, and the denominator is the ratio of the up volume to the down volume. If the absolute number of advancing shares increases on low volume, the ratio will rise. This higher level of the Arms Index would indicate that, although the number of shares advancing is rising, the market is not strong because there is relatively low volume to support the price increases. This ratio, thus, travels inversely to market prices (unless plotted inversely), tending to peak at market bottoms and bottom at market peaks. This inverse relationship can initially be confusing to the chart reader. Up and Down Volume Indicators Volume Thrust Using up volume and down volume only and forming an oscillator that is a moving average of the ratio of one to another produces an oscillator that has an excellent history of producing profitable thrusts, especially on the Nasdaq. Shown is a chart (Figure 14.10) that represents the specific method devised by Ned Davis Research, Inc. It is a ratio of the 10-day up volume to the 10-day down volume with thresholds at 1.48, above which is a thrust buy, and 1.00, below which is a sell. The performance is measured by the prospects for the market when the ratio is in one of three ranges. Above 1.48, the Nasdaq advanced for an annualized gain of 38.9%; between 1.48 and 1.00, the annualized gain declined to a positive 12.9%; and below 1.00, it produced a loss of 7.4% annualized. https://jigsaw.vitalsource.com/books/9781119543534/epub/OPS/c14.xhtml#c14-fig-0010 https://jigsaw.vitalsource.com/books/9781119543534/epub/OPS/c14.xhtml#c14-fig-0010 Up and Down Volume Indicators Ninety Percent Downside Days (NPDD) Paul F. Desmond, in his Charles H. Dow Award paper (Desmond, 2002), presents a reliable method for identifying major stock market bottoms that uses daily upside and downside volume as well as daily points gained and points lost. A 90% downside day occurs when, on a particular day, the percentage of downside volume exceeds the total of upside and downside volume by 90% and the percentage of downside points exceeds the total of gained points and lost points by 90%. A 90% upside day occurs when both the upside volume and the points gained are 90% of their respective totals. What he found was that ■ An NPDD in isolation is only a warning of potential danger ahead, suggesting, “Investors are in a mood to panic” (Desmond, 2002, p. 38). ■ An NPDD occurring right after a new market high or on a surprise negative news announcement is usually associated with a short-term correction. ■ When two or more NPDDs occur, so do additional NPDDs, often 30 trading days or more apart. ■ Big volume rally periods of two