Why Breadth Matters

Today I decided to use my Webster's Dictionary, a source that does not focus its definitions on the stock market, and look up breadth. While there are several definitions that essentially mean the same thing, the one that caught my eye was "comprehensive quality" because it explains why investors should care about market breadth.

We should care about the quality of each market move. And the advance/decline line provides a snapshot of that for us. It is not the best snapshot, but at the same time, it cannot simply be discarded as "old and no longer useful," as some have described it of late.

The cumulative advance/decline, or breadth, has its limitations. On the NYSE, there are so many closed-end bond funds that the advance/decline line is skewed toward financial stocks. This is most obvious when you read the names on the list of stocks at new lows. The list is littered with these bond funds. In fact, here is a long-term chart of the NYSE Financial Index and its relationship to the S&P 500. That steep decline, which still shows no signs of bottoming out, began exactly at the same time the advance/decline line topped out: April 1998. The two charts have moved in lockstep since that high.

So in order to get a clearer picture of the market's breadth, we should also look at volume. (These bond funds rarely account for a large percentage of the volume, so if we look at upside and downside volume, we may have a better idea of where the money is going.) You can see cumulative volume was keeping pace with the market averages right up through the July highs, confirming the rallies to new highs.

However, since that July high, it has never recovered. The recent rally to new highs in the Dow did not come close to matching the old high in this indicator. We call that a negative divergence. This cannot and should not be ignored or dismissed. The downside volume seems to be winning the war at the moment. It is most important for this market that we do not break these recent lows.

The other breadth indicator I watch is QCHA, or Quote Change, which can be found in Barron's Market Laboratory. Quote Change reflects the average percentage move for the average stock on the NYSE. (For example, if QCHA reads +32, it means that the average stock was up 0.32% that day). From this number, I calculate the market into an unweighted average. You see, all the market averages are weighted in some fashion or another, but this makes the stocks equal.

As with volume, the New York Unweighted Average was keeping pace with the averages until the July high. Since then, it has faltered miserably and cannot seem to recover. For the first time since the October low last year, the NYUA broke its uptrend line. You can see it has simply sat there, making very little attempt to rally.

These indicators -- the ones that have been confirming this narrow move in the averages for the past year -- have begun to falter for the first time during a corrective phase. While I have been complaining about the narrowness of the market for some time now, you can see that until the July high, there was a great deal of money flowing into enough names to keep these two breadth indicators on a steady course higher. However, this seems to have changed now.

The main thing to remember with all of these indicators is that there is no timing to them. They are early warning signs telling us that there has been an underlying shift in the market, but there is rarely any clue as to their timing.

For timing, I prefer the overbought/oversold oscillator. The oscillator is still in oversold territory right now. Of course, the market doesn't need to rally just because it's oversold, but it does mean the path of least resistance is up, not down. If the market doesn't rally during this period of being oversold, it is giving up a window of opportunity to have the momentum behind it.

Finally, I must mention the extreme pickup in stocks at new lows. Oh sure, it's filled with those bond funds again. But why? Bond yields have hardly moved in two weeks. Why the sudden pickup in selling in these funds? This was one of the indicators that had been turning positive, making me think enough damage had been done on the downside. I obviously underestimated the amount of selling left to be done. When this number doubles on one moderate down day, I get nervous.

As for individual stocks, it's the same old names again. In the Dow, Procter & Gamble (PG), Johnson & Johnson (JNJ) and 3M (MMM) continue to look like good charts to me.

Outside the Dow, the cereal stocks General Mills (GIS) and Kellogg (K) keep their bases going. So does Sara Lee (SLE). And Colgate (CL) has backed off after making a new high, relieving some of its overboughtness.

On the negative side, J.P. Morgan (JPM) seems to be struggling. A break of 120 would not bode well for this chart. Coca-Cola (KO) is still weak, although sitting on a lot of support.

Elsewhere, I can't help wondering why the oil stocks made their highs in April when oil was about five bucks lower. And I keep hearing that the oil service stocks will do well if the price of oil keeps rising. Oil is up to levels not seen since January 1997, yet these stocks are still languishing below their highs and struggling to maintain rallies. It's important to watch the way stocks react to news and these stocks appear to be ignoring the good news.

In sum, the market is still oversold and should continue to try the upside. Maybe Oracle's (ORCL) earnings will help technology or the Consumer Price Index will help the overall market rally. Either way, what we should care most about is the comprehensive quality of the rally. And if the quality isn't there, then we should expect another trip to the downside.

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