What exactly do we understand by Breadth of Market? Breadth of market indicates breadth of participation. It can be interpreted in a variety of ways. Breadth can be interpreted to indicate the number of stocks participating in a rally. Breadth can also be interpreted to indicate the number of active investors in the market. But why is breadth of the market so important?
Whenever there is a rally in the markets,the primary question is whether the rally is sustainable. That depends on the breadth of the markets. Normally, a market rally accompanies by market bread this considered to be more sustainable. On the contrary if the market has been rallying with narrowing breadth then it is seen as an indication of weakening conviction in the market.
Using Advance / Decline ratio as a measure of breadth of market..
The Advance / Decline ratio or the A/D ratio is one of the most popular measures of breadth of markets. The A/D ratio is simply the ratio of the number of stocks that advanced in a day to the number of stocks that declined on a day. A/D ratio of 2 indicates that for every 1 stock that is declining there are 2 stocks that are advancing. But A/D ratio at a point of time does not say much. The A/D ratio has to be looked at over a period of time to actually understand how the A/D ratio is trending.This trend gives you a better picture of the sustainability of a rally or otherwise. Consider the chart below..
The above chart captures the A/D ratio of BSE companies over a period of 8 months between Jan 2017 and Aug 2017. The A/D ratio by itself has been quite volatile but if you plot a trend line it is clear that the underlying trend of the A/D ratio is downward. That is normal as over the period of last 8 months, the Nifty has moved up by nearly 21.3% and at higher levels some amount of caution and scepticism is bound to creep in. But then, the A/D ratio is purely a measure of market breadth and it does not say much about the intensity and direction of the market breadth. For that the Intensity ratio of markets can be quite helpful.
Measuring the intensity ratio of the market..
The chart above captures the intensity of the breadth of the market over the last 8 months between Jan 2017 and Aug 2017. We have already seen that the breadth of the market has hovered around the 1 mark but has shown a declining trend. That is typical of any market that is gradually trending towards new highs and some amount of caution is warranted here. That is why we look at the intensity of the market through a combination of the Circuit Ratio (Upper Circuit Stocks / Lower Circuit stocks) and the H/L Ratio (Stocks hitting 52-week highs / stocks hitting 52-week lows). What does the above chart tell us and how do we interpret it.
The 52-week High/Low ratio is indicating a declining trend. That means the number of stocks hitting 52-week lows is rising faster than the number of stocks hitting 52-week highs. That again reinforces the view given by the breadth of market A/D ratio that there is pressure on the markets at higher levels. However, the Upper Circuit / Lower circuit ratio is still showing a rising trend. That means there are more stocks on an average day that are hitting upper circuit compared to stocks that are hitting lower circuits. This could be because a lot of small cap stocks have been hitting upper circuits consistently and that may have more to do with speculative trends in the market.
The crux of the interpretation is that while the market is tiring at higher levels, the intensity of the weakness is nothing to worry about.
Keytake-aways from the Breadth of Market..
There are 4 key interpretations that a trader /investor can derive from for breadth of market analysis..
It gives a trader a picture of whether the market is topping out or bottoming out. That gives a cue to traders as to whether they should buy on dips or sell on rises.
For an investor it is a clear indicator of how much aggression must be built into his investment decisions. A weakening breadth of market means that investors should adopt a phased approach to buying rather than committing all their funds at one time.
For portfolio managers looking to hedge the risk in their portfolio using futures and options, the combination of market breadth and intensity gives them cues on whether then need to hedge and the extent to which they need to hedge their risk.
Lastly, breadth of market is a very important indicator for the exchanges and the regulator from the risk management and surveillance points of view. A weakening breadth combined with intensity indicates that the regulators and exchanges must get more cautious about market risk.
Market breadth is a very intuitive method of judging the markets. Since it captures the market perspective of traders,investors and speculators, it tends to be fairly reliable as an indicator!