One of the oldest and easiest-to-interpret indicators in the stock market is market breadth. Some folks call it the advance/decline line, but no matter what you call it, it measures how broad or how narrow a rally or a decline is.
It works by measuring breadth versus the underlying index. So for the S&P 500® Index, we would compare the cumulative advance/decline line to the S&P 500 itself. If we look at a long-term chart of the two together, as you'll see below, you can see that in October 2007, there was a negative divergence where the S&P made a higher high in August, but the cumulative advance/decline line (breadth) made a lower high. These are shown as points A and B.
An upbeat sign?
Since that time, we have been in a bear market, and breadth has basically kept pace with the S&P, as they rallied together and dropped together. However, since the November 20 low in the S&P 500, there has been a slight change in this pattern. If we look at the very short-term chart of this indicator and the S&P together, as seen below, we can see that during the decline of the week ending December 6, breadth was outperforming the index (red arrow). The S&P has since caught up, but breadth has been holding steady, keeping pace with it. This is one of the first positive signs we've seen in the market since it made the highs of October 2007.
As stated above, this indicator is a measure of how broad or narrow a rally is, and this recent action suggests that the rally is broadening, which tends to be bullish for the market.
On a much shorter-term basis, the market may be overbought. Typically, such an extreme overbought reading will lead to a pullback followed by a renewed rally. If this market hadn't been so volatile of late, we'd expect a pullback, after a 20% rise, along the lines of 3% to 5%. However, lately this market has not exhibited such "normal" behavior; instead, the corrections have been well over 5%, and often in the course of one day!
On the chart above, I've boxed two points where the overbought/oversold oscillator got this high before. The left box is March 2007. If you squint hard enough, you can see that the market actually had a 3% correction from that extreme overbought reading. It then went on to enjoy a nice upward climb into the summer of 2007. The right box is December 2007. There, too, was a three percent correction which was followed by a rally, but this time to a lower high, which then proceeded to sink ever lower.
Have we seen this pattern before?
Based on the improvement in breadth as discussed above, I'd like to believe this extreme overbought situation will be more like March 2007 than December 2007. The most important point right now is to not chase rallies when we are this overbought. Let the market come down and correct, and then we can look for another rally thereafter. Once we get those two swings (down then up), we can assess the health of the swing up and decide if it is to be more like March 2007 or December 2007.
Market breadth measures advancing stocks versus declining stocks in an index. It shows how broad (more advancers than decliners) or narrow (more decliners than advancers) a rally or decline in the market is.
Until November 20, breadth and the market were in sync, rising and dropping together. But since then, breadth has outperformed, which tends to be positive for the market.
The market may be currently overbought, but it remains to be seen whether it will resume its downtrend, or merely correct and turn back up to resume its rally.