What Is Breadth of Market Theory?
The breadth of market theory is a technical analysis methodology that predicts the strength of the market according to the number of stocks that advance or decline in a particular trading day, or how much upside volume there is relative to downside volume.
The breadth of market theory is often also called the breadth of market indicator.
- Breadth of market theory uses breadth indicators to help assess whether major stock indexes, or the stock market as a whole, is likely to rise or fall.
- Breadth indicators look at the number of advancing stocks versus declining stocks, or advancing volume versus declining volume.
- A rising breadth indicator, where advancing stocks and advancing volume is outpacing declining stocks and declining volume is generally considered positive for a price advance in the stock indexes.
- When a breadth indicator diverges with a stock index, it may warn of a potential change in the direction in the index.
Understanding Breadth of Market Theory
There are multiple ways to analyze market breadth, which is simply the health of the stock market as a whole. This health, or sickness, may not be evident just by looking at major market indexes like the S&P 500, Nasdaq 100, or Dow Jones Industrial since these indexes only hold a select group of stocks.
Breadth is typically a measure of how many stocks are advancing relative to declining. Or it may also include volume studies, such as volume in rising stocks versus volume in falling stocks.
Advance/decline indicators measure the number of stocks advancing and declining for the day. If the breadth indicator is rising, this theory predicts that the market is healthy and the rise in the index is sustainable. For example, if a market is comprised of 150 stocks and 95 stocks experience price gains while 55 stocks either experience no change or decline in price, according to the breadth of market theory, the market is currently considered strong or rising.
If the advance/decline falls while major stock indexes rise, this indicates that fewer stocks are participating in the rally and could forewarn of a fall in the indexes.
Breadth indicators are not accurate timing signals. While they may warn of a decline, they don't indicate when it will happen. Similarly, a rise in the breadth indicator while the major indexes are declining warns that buying pressure is building and the indexes may start to rise soon as well.
Breadth indicators often act in tandem to the price moves in indexes. For example, a rise in the index sees a rise in the breadth indicator. This is called confirmation. When the breadth indicator diverges it warns of a potential change in the index direction. Changes in index direction are not always forewarned by the breadth indicators.
Popular Breadth Indicators
Two popular market breadth methods include the Advance/Decline ratio (ADR) and the Advance/Decline line (A/D line). The ADR compares the number of stocks that closed higher against the number of stocks that closed lower than their previous day's closing prices. To calculate the advance/decline ratio, the number of advancing stocks is divided by the number of declining stocks. The advance/decline ratio is typically calculated daily.
The A/D line plots changes in advances and declines on a daily basis and the result is cumulative. Each data point is calculated by taking the difference between the number of advancing and declining issues and adding the result to the previous period's value, as shown by the following formula:
A/D Line = (# of Advancing Stocks - # of Declining Stocks) + Previous Period's A/D Line Value
The Arms index compares the advance/decline ratio to advancing/declining volume.
Example Breadth of Market Theory Analyzing the S&P 500
The S&P 500 could be compared with the NYSE A/D line to monitor underlying strength or weakness. The NYSE A/D line is looking at all stocks listed on the NYSE, while the S&P 500 is only tracking a select group of 500 stocks. The NYSE A/D line provides a broader measure of how most stocks are doing.
The chart below shows the SPDR S&P 500 ETF (SPY) along with the NYSE A/D line. In early 2018 the S&P 500 was moving lower, but in April the NYSE A/D line was making new highs. The S&P 500 was nowhere near its highs, yet ultimately the index followed suit and made new highs like the A/D line.
Once again, in early and mid-2019, the NYSE A/D line moved above prior highs in advance of SPY moving above corresponding highs. The S&P 500 followed suit and eclipsed the prior highs.