Understanding the Indicators and Signals in the Index Breadth Model – Diving Beneath the Surface

The video above and article below explain the breadth indicators used in the Index Breadth Model and the key levels used to generate signals.

This article will explain the breadth indicators used in the Index Breadth Model, the key levels used to generate signals and the indexes used for the models.  These models are updated every Friday in the market timing report.

Executive Summary

  • The index breadth models use five breadth indicators
  • 10-day EMA of Advance-Decline Percent to identify breadth thrusts
  • Bullish with move above +30% and bearish with move below -30%
  • %Above 200-day SMA for long-term trends
  • Bullish with move above 55% and bearish with move below 45%
  • %Above 150-day SMA for medium to long term trends
  • Bullish with move above 65% and bearish with move below 35%
  • %Above 100-day SMA for medium-term trends.
  • Bullish with move above 75% and bearish with move below 25%
  • High-Low Percent for new 52-week highs and lows
  • Bullish with move above +10% and bearish with move below -10%
  • Models for S&P 500, S&P MidCap 400, S&P SmallCap 600 and Nasdaq 100
  • Models are bullish when at least 3 of 5 indicators are on bullish signals
  • Models are bearish when at least 3 of 5 indicators are on bearish signals
  • A 5/200 day SMA cross is added to $SPX model for trend confirmation
  • $SPX model is bullish when breadth is bullish and the trend is up
  • $SPX model is bearish when breadth is bearish OR the trend is down
  • The S&P 500 model is the most important of the four models
  • SPX model beat buy and hold from 2/1/2001 to 6/1/2020
  • SPX model returned 6.7% per year with 16% Drawdown & 66% exposure
  • SPY returned 6.24% per year with a 55% Drawdown & 100% exposure
  • Model is designed to stay on the right side of the big trend

Introduction

Stock market breadth plays an important role in broad market analysis because it reflects what is happening under the surface. Price action, in contrast, shows us what is happening on the surface. Even though price action is the single most important factor, I would place breadth a close second when it comes to broad market analysis.

The S&P 500, for example, has 500 moving parts (stocks) and index levels do not always reflect what is happening inside the index. Breadth indicators allow us to look inside and take the vital signs for the stock market. In short, breadth indicators measure the degree of participation and help identify significant shifts in this participation.

Breadth indicators are key to determining the overall market environment: bull or bear.  The Index Breadth Models use five breadth indicators in four indexes to analyze and assess the broad market environment. I want to trade the long side and look for bullish setups when the broad market environment is bullish.  Conversely, I want to be defensive and selective when the broad market environment is bearish. More aggressive traders can consider short positions and bearish setups.

Picking the Benchmark for Breadth Indicators

Most breadth charts use indicators based on NYSE or Nasdaq stocks, not both. Breadth indicators based on just one exchange are seriously lacking. For example, NYSE breadth indicators exclude Apple, Microsoft, Google, Facebook, Cisco, Amgen, Celgene, Amazon, Starbucks, Comcast, Netflix, Ross Stores, Expedia, Costco and many other key Nasdaq stocks. Personally, I cannot use a broad market indicator that does not include these stocks.

As the name implies, “breadth” indicators should capture a wide swath of the stock market. This is why I derive my core breadth indicators from four indexes: the S&P 500, the S&P MidCap 400, the S&P SmallCap 600 and the Nasdaq 100. The first three are representative of the entire stock market because they capture large-caps, mid-caps, small-caps, Nasdaq stocks and NYSE stocks.  Nasdaq 100 breadth captures performance for large-cap techs and high-beta names.  Also note that 82 stocks in the Nasdaq 100 are also part of the S&P 500 and these stocks account for some 40% of the S&P 500.

The following breadth indicators and models were developed using Norgate data and Amibroker software. There is nothing wrong with StockCharts’ breadth data, but I need data going back further than 2010 and signals that can be quantified using testing software. Furthermore, Norgate breadth indicators are based on data that is not adjusted for dividends, which is my preference. The numbers may be different than those seen on StockCharts because of calculation differences and dividend-adjustments. My preference is data that is not adjusted for dividends. See this article for details.

Breadth Thrusts using AD Percent

The first indicator is based on Advance-Decline Percent, which is the percentage of net advances ((advances – declines) / total issues).  This indicator shows us the degree of participation, up versus down, on a daily basis. Readings above +80% show strong upside participation, while readings below -80% show strong downside participation.  

AD Percent is quite choppy because up and down days alternate on a regular basis. I apply a 10-day exponential moving average and look for breadth thrusts. A bullish breadth thrust occurs when the 10-day EMA exceeds +30%, while a bearish thrust triggers with a move below -30%. A move above +30% reflects broad upside participation over a short period of time. This breadth thrust is like a rocket lifting off and can signal the start of an extended advance. Conversely, a move below -30% shows broad downside participation in a short period of time and this can lead to further downside. 

The example above shows a bearish breadth thrust triggering in late February 2020 as the 10-day EMA of Advance-Decline Percent plunged below -30%. The bottom window shows the signal line hitting -1 for confirmation. A bullish breadth thrust triggered in late April with a move above +30% and this remains the active signals.

I chose ten days because I am looking for a powerful short-term move to signal a significant change in participation. 20 days is a bit too long and 5 days is too short.  Marty Zweig also used a 10-day EMA for the Zweig Breadth Thrust. Keep in mind that these settings are my personal preference and one size does not fit all trading styles. These are just the settings I have settled on after years of chart watching.

Measuring Strong Trends with High-Low Percent

52-week highs and 52-week lows are chart milestones that occur during strong trends. At the risk of stating the obvious, stocks forging 52-week highs are in strong uptrends and leading, while stocks hitting 52-week lows are in strong downtrends and lagging. The difference between the two tells us if more stocks are in strong uptrends or strong downtrends. This is valuable information on the market environment.

High-Low Percent is the percentage of net new highs ((new highs – new lows) / total issues). High-Low Percent is positive when new highs outnumber new lows and negative when new lows outnumber new highs. If there were 67 new highs, 5 new lows and 500 total stocks, High-Low Percent would be +12.40% ((67 – 5)/500 = .1240).

As opposed to breadth thrusts, which are often leading indicators, High-Low Percent acts more like a trend-following indicator because it takes time to reach such milestones.  High-Low Percent is less sensitive than AD Percent because we do not see big positive-negative shifts from day-to-day. New highs can dry up when the market falls, but we rarely see a sharp surge in new lows with a one-day decline.

The chart above shows High-Low Percent for the S&P 500 in the middle window and the signals in the lower window. High-Low Percent whipsawed in August 2019 with a move below -10% and above +10%, but stayed bullish as new highs remained fairly strong until February 2020. A bearish signal triggered in late February with an expansion in new lows and this signal remains active. It would take a move above +10% to reverse this signal.

Measuring Trend Participation with 3 Indicators

The humble moving average remains one of the most popular methods for trend identification and the breadth models employ three different moving averages. A 200-day SMA covers around 9 months and represents a long-term trend (at least in my book). A 100-day moving average covers three and a half months and represents a medium-term trend. A 150-day SMA sits in the middle and represents a medium to long term trend. Breadth turns bullish as more stocks move into uptrends (above these moving averages) and bearish as more stocks move into downtrends (below these moving averages).

The bullish and bearish thresholds widen in uniform fashion as the moving average period shortens. The Percent Above 200-day SMA turns bullish with a move above 55% and bearish with a move below 45%. The Percent above 150-day SMA turns bullish with a move above 65% and bearish with a move below 35%. The Percent above 100-day SMA turns bullish with a move above 75% and bearish with a move below 25%.

The chart above shows all three indicators with their bullish and bearish thresholds. All three turned bearish in October 2018, bullish in February 2019 and bearish in February 2020. All three triggered bullish in early June 2020, but these signals did not last as two of the three flipped back to bearish a few days later.

Putting it All Together

At this point, we have five indicators, which is an odd number that ensures an absolute majority at any time.  The 10-day EMAs of Advance-Decline Percent are the early warning indicators that often trigger first, as they did in January 2019. The High-Low Percent and %Above Moving Average indicators often trigger later and represent follow through signals to the initial thrust.

Signals and Results

The strategy goes long when the breadth model is net bullish AND the 5-day SMA is above the 200-day SMA. The strategy exits when the breadth model turns net bearish OR the 5-day SMA moves below the 200-day SMA.

Trading SPY with this strategy returned 6.7% per year with a Maximum Drawdown of 16.2% (dividends included). The Compound Annual Return is slightly higher than that of buy-and-hold and the Drawdowns are much better. There were 13 winning signals (68.4%) and 6 losing signals (31.6%). The table below shows these signals over the last 19+ years. This period includes two bear markets and some volatile periods.  

The next image shows the equity curve in green and the buy-hold SPY equity curve in blue. This basic timing strategy outperformed buy-hold and avoided two bear markets.

The next image shows the drawdowns with the three biggest occurring in 2008-2009, 2015 and 2020. Drawdowns are going to happen and we need containment strategy.

The next image shows the monthly and annual returns for the strategy. There were some great years (2003, 2009, 2013, 2017), some so-so years (2004, 2010, 2018) and some negative years (2002, 2015 and 2020).

Conclusions

Identifying the broad market environment is the first step in the investment or trading process because getting the broad market environment right is more than half the battle.  Index prices are good for trend analysis, but they do not tell us what is happening under the surface. Breadth indicators, in contrast, measure overall participation and capture underlying conditions. Conditions are favorable during bull market environments and we should embrace risk. This is when I want to find and take bullish setups. Conditions are unfavorable during bear market environments.  This is when I want to be more risk averse and defensive. This is a time to preserve capital, limit exposure to stocks and look for bullish signals in stock alternatives.

The images below shows examples for the Nasdaq 100, S&P 100, S&P MidCap 400 and S&P SmallCap 600 Models.

Thanks for tuning in and have a great day!

-Arthur Hill, CMT
Choose a Strategy, Develop a Plan and Follow a Process

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