More and more people in the market are worried about “breadth.”
Breadth is basically the a measure of how many stocks are going up in the market against how many stocks are going down. And because of how the averages are computed, more stocks can be rising than falling, or vice versa, without seeing an exact replication of this phenomenon in the level of the average itself.
Right now, breadth is bad and people are worried.
The market’s view is that when breadth and the corresponding action in markets are out of whack, they will eventually converge. Meaning that a market with “bad breadth” — i.e. a lot of stocks going down — will eventually see the averages roll over.
And so over the last few months, the market’s poor breadth has been taken that a sign the market must go lower.
But in a note to clients on Tuesday, J.C. O’Hara at FBN Securities writes that while this concern might be valid were the market rising on terrible breadth, the fact is that stocks have been going sideways for some time and in sideways market, that rule doesn’t necessarily hold.
O’Hara writes that while there is no disputing the fact that breadth is thinning, “we do find trouble in making the statement, ‘Breadth is dwindling thus the market should pullback.'”
To sum up our findings; when the market trades for an extended period of time in a narrow range, breadth often weakens. Those markets, however, frequently break to the upside during the second half of the year and that breakout is accompanied with improving breadth. Breadth breakdowns in these narrow range markets did not provide an accurate forecasting signal for the overall market, rather provided a coincidental reading as to what is currently happening.
In his note, O’Hara also includes this chart, showing how a sideways market with bad breadth in 1992 eventually saw stocks break higher.