Measuring Market Strength: Technical Analysis 101

BALTIMORE (Stockpickr) -- There's an old saying on Wall Street that "it's a market of stocks, not a stock market." In large part, that's true. Single stocks often trade in directions that are divergent from the broad market; identifying those divergences is the domain of the successful trader.

But it's a huge mistake to underplay the importance of the stock market as a whole.

Clever sayings aside, the vast majority of stock movements are highly correlated with one another and with the collective market itself. That fact has become more evident than ever in the last few decades, as index funds became the most popular investment choice for Americans' retirement portfolios. With exposure to a diversified basket of stocks that's designed to track "the market," these funds are directly impacted by losses in the big indices they track.

Practically speaking, it makes a lot of sense that most stocks trade in tandem. It has more to do with the flow of funds into and out of the market than with the specifics of any particular stock. As investors tried to liquidate stock positions and free up cash in the recession of 2008, for instance, they were selling the good alongside the bad in order to stay solvent. In the process, even fundamentally sound stocks got pushed significantly lower as the broad market crashed.

But you don't need to be beholden to the market. By measuring market strength, you can target asset classes that look to be the strongest performers when times are tough, and you can spot early signs of broad market reversals when times are good.

Today, we'll explore some popular measures of market strength.

Relative or Absolute Market Strength

Market strength is a broad term that can mean a lot of things depending on how we define it. Market strength can be either a measure of a market's power to perform on a relative basis (vs. other markets) or on an absolute basis (vs. its own historical levels of momentum and investor participation).

First, we'll take a look at the relative strength of a market. Relative strength is a technical analysis metric that's not relegated to intermarket analysis (in other words, it can be used for individual stocks just as effectively), but it's arguably at its most powerful when used to help select the strongest asset class.

Essentially, relative strength is just the ratio of one asset to another over a period of time. By taking the daily close of the S&P 500 divided by the daily spot price of gold, for example, you'll get the relative strength of the S&P (or more broadly, of stocks) vs. gold. Because relative strength is a ratio of two disparate items, you don't need to pay attention to the absolute level of the relative strength chart. Instead, it's the trend that matters.

By looking at relative strength of various asset classes over the long-term, technical traders can determine when it makes sense to rotate a portfolio from a relatively weaker asset to relatively stronger assets. Of course, it's crucial to monitor the instruments themselves at the same time. Using relative strength alone, it's possible to invest in the "least worst" of two declining assets.

The abundance of new, commodity, currency and foreign equity exchange-traded funds has made this method of trend trading especially popular in recent years.

Using Absolute Strength to Spot Market Reversals

The other way to look at market strength is to compare a stock's current metrics against historical ones. By doing this, traders can get a sense of where in its investment cycle a market may be -- and also discern how much strength a trend has and when a reversal may be likely to occur. It's the latter half of absolute strength measures that makes them particularly actionable.

When we measure this type of market strength, we're looking at "market breadth." Breadth focuses on how individual issues in the market are contributing to its overall performance. The reasoning is simple: If an index like the S&P 500 is increasing but those increases are coming from just a few big stocks, the implication is that the uptrend is losing strength and is more likely to reverse.

As you might expect, many indicators exist to help identify market breadth -- far too many to detail for the purposes of this article. That said, it does make sense to take a look at the most popular: the advance/decline line, or A/D line.

In the chart below, the S&P 500's cumulative A/D line added confidence to the market bottom in March 2009. As the S&P bottomed, the A/D line told technicians that most stocks were participating.

 

The A/D line is essentially a running tally of the market's advancing stocks minus the market's declining stocks. As with relative strength, it's not the value of the A/D Line that matters (it's an arbitrary number), but the change in the A/D line. An upward sloping A/D line coupled with an upward sloping market means that the market's increases are due to an abundance of advancing stocks in the market.

When the A/D Line's trend becomes out of synch with the broad market, it suggests that the market is losing breadth and may be due for a reversal.

Scores of popular market breadth indicators are available in most charting software packages. Select one that makes sense to you, and you can start applying breadth measures to the broad market to spot signs of weakness. Remember that indicators such as market breadth are confirmatory. Wait for a technical signal based on price action before trading them.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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