Broader Market Indicators : Key To Understanding The Market Mood

Broader Market Indicators : Key To Understanding The Market Mood

The strength of the markets can be gauged by using several technical indicators. Investors at any point of time would always want to know if it is a ‘good time’ to invest in the equity markets. Market breadth, if positive, is one such indicator that prompts investors to increase their allocation to equity markets as the chances of winning in the market increases manifold. Yogesh Supekar discusses what exactly is market breadth and how does one ascertain if the market breadth is increasing even as Karan Bhojwani with the help of expert comments attempts to highlight technical indicators that can help analyse the market breadth objectively

Any investor before investing in the equity markets has some basic questions which needs answers. ‘Is the market going to do well? What kind of returns should I expect from the markets? Will my portfolio grow?’ These are the most rooted and quintessential questions an investor attempts to find answers to. The common perception is that if the Sensex (market) does well, the portfolio will also do well. However, in practical terms, investors may face a situation at times when the markets do well but their portfolio or wealth does not grow. When we say markets, it must be understood that we are referring to the Sensex or Nifty – experts call them the benchmark indices.

The year 2018 was especially an eye opener for investors when the key benchmark indices inched up while a majority of investors struggled to generate positive returns in their respective portfolios. What went wrong for investors? Was it the portfolio management strategy that went awry or was it the stock selection that went wrong? The highlight of the markets in 2018 was the missing ‘market breadth’ and that triggered underperformance for most investors’ portfolios and the performances of the mutual funds. What exactly is market breadth and how does one quantify it? Why is it essential to track market breadth?

Investors ought to know this while predicting the market direction. Harish Kute, a regular investor in the market, says, “I know market breadth is important. However, I have never understood the concept correctly. I do not know how exactly to interpret the market breadth and what tools are available to analyse it. I think it is high time I update my knowhow on market breadth indicator.” Indeed, there is a severe lack of awareness amongst traders and investors when it comes to using market breadth indicators.

Market Breadth: Good for Investors

For investors it is always useful to understand on an average how many stocks actually do generate positive returns and within that basket, how many stocks manage to generate returns in excess of 15 per cent. While it sounds great to know that there are close to 6,000 companies listed on the stock exchange, a closer look at the table alongside helps us understand that only 244 stocks on an average have delivered returns in excess of 15 per cent while only 52 stocks on an average, considering the data for the last 10 years, have been able to generate returns in excess of 100 per cent.

Also, we can see from the table how market breadth is important and can help investors create wealth. The years 2014 and 2017 can be said to be the years with better market breadth as a greater number of shares were seen generating positive returns and also the number of stocks that generated more than 100 per cent returns were higher in these two years. Such market breadth increases the probability of winning (positive portfolio returns) in a given year. Estimating market direction is one of the most basic and crucial steps in portfolio management. And by now we have understood that market breadth is crucial for investors and can help us understand the market direction.

Several indicators can be used to measure the force of the bulls and bears which can help investors decode the market direction. Volumes, for example, indicate traders’ level of participation while stocks making new highs or lows for the year reveal traders’ level of enthusiasm for the direction of market prices. That is why it is important to keep a tab on the number of stocks that are making new highs or lows as this data speaks of the breadth of a rally i.e. we understand how many stocks are participating in the movement – which is something an index cannot do. Thus, studying volumes, data on new highs and lows and advance or decline data can help investors understand the market direction. 

"The noblest pleasure is the joy of understanding"

Leonardo da Vinci
Italian polymath of the High Renaissance who is widely considered one of the greatest painters of all time.

INTERVIEW

"Breadth Indicators are Extremely Useful"

Prashant Shah,
CMT, CFTe, MFTA, MSTA Founder - Definedge Solutions 

We plot different indicators on the price chart that help identify momentum or extreme zones of a particular instrument. Indicators are invariably calculated on the price data of the instrument. For example, a 200-bar daily moving average on the Nifty 50 chart tells us about the broad trend of the Nifty. If the price is above average the line, the trend is bullish and vice versa. As you must be aware, Nifty 50 index is calculated based on individual weightage and the price action of its constituents. It does not necessarily reflect the broad market sentiments and the index heavyweights would typically influence the movement in the index. 

Consider the scenarios described below:

☛Nifty 50 Index > 200-period moving average

= Nifty is bullish.

☛More number of stocks in Nifty 50 > 200-bar average

= Health of the market is bullish.

While the moving average captures the broad trend in the instrument, the second measure above is the ‘breadth indicator’ that captures the overall health of the market. Breadth indicators are not calculated on the price of a particular instrument. They evaluate the market sentiments by measuring the number of stocks of a sector or group above or below particular criteria, 200-bar average price in the above example. Using the moving average, we can calculate the percentage of stocks trading above 200-day moving average in Nifty or any other index or group and plot it on the chart. This indicator would oscillate between 0 and 100. 

A reading of 50 per cent means an equal number of stocks are trading above and below the moving average, suggesting a balanced market. The indicator scans all the stocks in the group and therefore tells us about health of the overall market and state of the trend. It can be calculated in different timeframes but remember it is calculated on a group of stocks and not on the index value. Hence, it gives us a true picture of the market sentiment. The breadth indicator can help us in reading broad-based trends and exhaustion phases. Rising breadth is bullish because it indicates that there is participation from maximum stocks from the group. Similarly, a falling breadth is bearish because it indicates lack of participation.

The trend of most of the stocks will be bullish when the overall market trend is strong and up. But exhaustion sets in when little fuel is left in the tank to keep the momentum going. Taking long positions in such a scenario is not advisable even though the trend is up, and the chart patterns are bullish. Breadth extreme zones indicate that there is a possibility of euphoria or panic sentiment extremes. Below is a chart plotted with 200-day moving average breadth indicator on the group of Nifty 500. The indicator dropped sharply towards the end of the market meltdown in March 2020. The breadth indicator reading at lows suggested that only 4 per cent stocks from the Nifty 500 universe were trading above their 200-day moving average.

This is extremely bearish because most of the stocks are in a downtrend and trading below their 200-day moving average. But this also suggests an oversold condition. The breadth overbought and oversold zones are hugely different from overbought-oversold zones based on price-based indicators. Breadth indicators are calculated on group of stocks – the mean reversion setups or investing in relatively strong stocks when breadth indicators are at extreme zones can prove highly profitable. This might give you some idea about the possibility of including breadth indicators in your trading systems. 

There are different types of indicators that are based on price, volume, trend, volatility or momentum. All these indicators can be used to calculate breadth. For example, Relative Strength Index or the RSI is a popular indicator. We can plot it on Nifty and call it bullish when RSI is trading above 60 on Nifty. But how about calculating how many stocks in Nifty are trading above RSI 60? It will give us an idea about how many stocks in Nifty are in a strong momentum.

The market rotates through trend and volatility cycle in different timeframes. Consider this scenario:

☛Trend > Volatility = Trend is strong, trade breakouts and ride the move.

☛ Volatility > Trend = Caution, trade pullbacks and keep booking. 

How to Decide on Trend and Volatility?

We discussed about trend-based breadth indicators. We can also plot volatility-based breadth indicators. There are volatility-based indicators and ATR percentage is an indicator that calculates the average true range of a particular stock. High ATR indicates that the stock is more volatile and vice versa. Below is a chart showing breadth indicator that calculates the number of stocks trading above their 5 per cent ATR in Nifty 500 index.

The above chart shows that the indicator recorded a high in March 2020 suggesting that stocks were moving in a wide range. The indicator was consistently falling till August 2020. Interestingly, Nifty went up by more than 30 per cent during this period. It shows that the trend was strong, and volatility was contracting. Trend following systems, breakouts and riding the move should be a preferred strategy during such times. Breadth indicators are extremely useful, but they are lesser explored because of lack of awareness. 

INTERVIEW 

Gautam Shah,
CMT Founder and Chief Strategist, Goldilocks Premium Research

"It is Important to Gauge the Pulse of the Market Using the Concept of Breadth"

Strong bull and bear trends are difficult to quantify as extreme readings can stay over a period of time. Two great examples were seen in 2020 with the fall in March and the rise thereafter in the last few months. Two technical words – ‘overbought’ and ‘oversold’ – are loosely used in today’s times and it has been seen that a trend can stay overbought or oversold for long periods of time. To understand how ‘strong’ an uptrend is or how ‘weak’ a downtrend is we use the concept of market breadth. Also, with benchmark indices becoming more and more irrelevant it is important to gauge the pulse of the market using the concept of breadth.

There are various methods of analysing breadth using the concept of advance or decline, new 52-week highs or lows, percentage of stocks hitting overbought or oversold territory, the more popular yet reliable percentage of stocks trading above or below the averages and many more. For the ease of understanding, below is the percentage of stocks in the NSE 50 that are trading above the 200- day moving average. The data is of the last seven years that has seen multiple uptrends and downtrends. Note how this percentage figure is fluctuating depending on the market movement. However, studying this over a longer period gives us a way to ‘quantify’ overbought and oversold readings.

Here are a few points to note from this chart:
☛ In the last 2.5 years the percentage number has topped out in the 72-78 zone many times.
☛Notice the highs in August 2018, April 2019, June 2019, January 2020 and recently August 2020.
☛With this data we know that whenever the percentage number crosses the 72 level the market tends to get genuinely overbought and a top is seen.
☛Secondly, in the last week of August 2020, a few days before the actual market topped, the breadth study topped out and reversed leading to divergence. Usually, when the markets top out, stocks in general start to correct much before the index. This advance indication is beautifully captured through this study.
☛Thirdly, in the last week of March 2020 we witnessed an extreme reading of 2 per cent, never seen in seven years. This just gave one the indication that the breadth was too weak already for the downtrend to continue. Thereafter, the markets bottomed in the last week of March 2020 and a large recovery was seen. Such extreme readings are wonderful markers for the months ahead.

The above explained factors can be used to gauge the strength of the existing market trend. This can be done on the broadbased NSE 500 index or the sectoral indices of banking, automotive, etc. to understand the pulse better. Remember, this study should be used in conjunction with other technical tools for best results.

Significance of New Highs and New Lows

Several financial dailies and websites dedicated to the stock market proudly publish the data of those stocks making fresh highs and lows. The data must be important and hence it gets so much of coverage. But why is this data significant for investors? When the stock of any company hits a fresh high for the year or a life high it reassures all the stakeholders that the company is on the right track and not only are the investors getting rich but also the management team’s efforts are getting validated. Fresh highs create optimism in the business that attracts fresh attention from traders and institutional investors who are looking to profit from the underlying positive momentum.

Usually it is seen that the rallies (breakout) from 52-week highs can be explosive as traders usually migrate to stocks that are showing positive momentum and consistent profits. As and when the broader markets witness many such shares making new highs, the rally can drive most shares up, thus squeezing the short sellers which further ignites the rally. Such a process can even lead to a new bull market. Obviously, the opposite is also true and hence a tab on 52-week low data and fresh lows can be advantageous to the investors.

From the table we can see that tracking how many stocks are making life highs versus life lows can indicate the market breadth. If too many stocks are making their respective life highs it can be used as a signal to understand that the markets could be overheated. At the same time, when more than the average number of stocks is touching their respective life lows, it could be a signal of the market close to being at the bottom. For example, in 2020, 65 stocks were seen making life lows while the average number of stocks that made life lows in the past four years was 39. Any long-term investor studying market breadth would have picked up this data concluding that the markets were close to the bottom in 2020.

"I know of no way of judging the future but by the past"

Patrick Henry
American planter, orator and politician. 

Conclusion

It is extremely important that investors pay enough attention to the market breadth while analysing the markets. Market breadth reveals the strength in the market momentum and can aid in making better investment decisions which may lead to improved portfolio performance. Tracking market breadth by using breadth indicators helps derive an unbeatable advantage. Market breadth indicators measure market breadth and help investors understand the amount of force and the level of participation behind market moves. It is common to see basic data such as volume, advance or decline and new highs or lows used in building technical indicators that reflect the market breadth.

Investors and traders should never ignore the volumes that go behind the price action as strong volumes indicate the fact that buyers are winning when the prices are up and vice-a-versa. Advance or decline data simply states how many different companies are participating in the rally and it is extremely easy to interpret the advance or decline data as more the number of companies that take part in the rally, broader the market move is. Stocks making new highs and new lows indicate exceptionally positive or negative feelings towards the price action or performance and it is essential to keep a tab on the number of stocks making new highs and lows.

In case many stocks are making new highs or fresh lows, the movements in the broader market will usually mirror that sentiment. And here is where the market breadth indicators are most useful – when there is divergence in performance. Investors and traders should never ignore the important divergence signal given by the market breadth indicators. At times the market breadth shrinks while the key benchmark indices move in the opposite direction. Such divergence indicates that the price action or movement is not supported by market participants. One can expect a volatile movement in stock prices when the market breadth indicators are in an overbought or oversold condition.

That said, intelligent traders and investors must know how to use the market breadth data profitably. Market breadth data or indicators should wisely be used in conjunction with a price chart. The market breadth should never be used to justify an otherwise bad trade. In other words, price action on charts should dominate the decision-making process. The market breadth should be used only to confirm the price movements in a given market. Normally the market breadth and price action (new highs) should move in a similar direction.

 

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