The Breadth of Market Indicators theory is a technical analysis theory that predicts the strength of the stock market according to the number of issues that advance or decline in a particular trading day.
Investors have been searching for ways to describe "the market" for decades. In the stock market analysts are using the "top down" approach where they look at the market, then the industry group and, finally, the individual stock.
In contrast, the phrase "it's not a stock market but a market of stocks" takes a "bottom up" approach based on the notion that the market is really the sum of the actions of all groups and stocks.
To reconcile these two methods, we need tools to generalize the behavior of all stocks and they all fall into the category of market breadth indicators.
One of the more commonly used is called the advance-decline line.
During bull markets, it is rather rare, if not impossible, for all stocks to be rising.
Speculators may have pushed up some issues to overbought conditions early and they are caught in short-term corrections.
Some industries, and their stocks, flourish during one part of the business cycle while others languish.
What the market needs in order to be classified as "healthy" are the basic technical underpinnings of rising trends, rising volume and rising participation from the masses.
For the stock market, this means both widespread interest from investors and traders and broad interest in the majority of issues available.
Some measures of market breadth involve the volume of rising stocks compared to the volume of falling stocks. Rising stocks should be getting the majority of volume in a healthy market. Strength indicators, such as the number of net new 52-week highs (vs. 52-week lows), quantify the portion of stocks that are trending higher.
Money flow measures the supply and demand for stocks and greater demand than supply pushes prices higher.
Each trading day, the exchange publishes statistics on how many of their issues closed higher and how many closed lower. The day's advance-decline for any market is simply the difference between these two numbers. Each day's net number is then added to a running total and the result is plotted in a chart.
If the chart is rising, the advancing issues are dominating the declining issues and the market is then said to be healthy. If it is falling, then the market is not healthy.
Most of the time, the advance-decline line and the price of the representative market index move higher and lower together.
It makes sense that in rising markets, the majority of stocks should be rising themselves. Conversely, in falling markets, the majority of stocks should be falling.
As with most technical indicators, the traditional stock market advance-decline line works at tops and at bottoms. It applies to all stock markets and covers many time frames (daily, weekly) to forecast short-, medium- and long-term junctures. Corrections and reversals work equally well.
The problem is that there is not always a divergence. The advance-decline can only point out unusual conditions but it cannot categorize them by length and severity.
Sometimes events happen that cause quick sentiment shifts, such as interest rate changes or political shocks (oil embargo, war, etc.).
Therefore, the advance-decline line takes its place in the trader"s toolbox as only one part of a technical team.
Market breadth is a key indicator of the overall health of the market. If only a few large stocks are rallying, it will boost the major averages, giving the impression that the market is very strong.
However, if the majority of the lesser-known stocks are falling at the same time, then the market will soon be heading for a decline in the very near term.
When this occurs, the market is said to have "Poor Breadth" or "Bad Breadth!"
Text in part by Bridge Information Co.