Markets change character slowly. The transition from a bull market to a bear market takes time to develop as a top forms. By the time the bear market is confirmed, many stocks are already showing losses. To spot potential turning points, technical analysts look at breadth indicators to signal when a large number of stocks are showing losses.
Breadth indicators measure how many individual stocks are moving in the direction of the market trend. In a bull market, we would expect to see most individual stocks moving up. In a bear market, most stocks will fall. As stocks transition between the two phases, breadth provides important clues about what should happen next.
There are a number of ways to measure breadth and many of them are complex. Analyzing breadth usually involves looking for divergences between the indicator and the price action. Divergences occur when the indicator fails to confirm a new high or low in prices. There are a number of ways to define divergences, and most are subject to the assumptions of the analyst.
While breadth can be difficult to interpret, we always try to look at things from the simplest possible perspective. The table below shows how many stocks are in downtrends based on the 200-day simple moving average (SMA):
The trend in this data shows that investors are buying high-quality stocks and selling risky investments. Some analysts refer to a “risk-on/risk-off” market, and this data indicates we are in a risk-off environment.
If we say that hope and fear are the primary drivers of market action, bull markets are based on hope. Investors buy stocks because they are hopeful about the future and expect earnings to rise. In that environment, high-risk stocks with smaller market caps tend to lead the market.
That is clearly not the situation at hand. The majority of the smallest stocks are now heading down.
The breadth data above appears to show that fear is beginning to drive investment decisions. Investors are less willing to accept risk, and they are bidding up the prices of large-cap stocks while avoiding the riskier stocks in the market.
Large-cap stocks make up only 8% of the stock market. In the other 92% of the market, one-third of stocks (32%) are in downtrends. This could be the beginning of a bear market.
This data is a sign of market weakness. We have been bulls for a long time, and this alone is not enough to push us fully into the bear camp. But this is something that needs to be watched. Michael will be updating this data in his weekly Market Outlook on ProfitableTrading.com until it shows a clear trend one way or the other.
Despite the warning from breadth data, market prices are still heading higher. As long as prices move higher, we are in a bull market by definition. But now may be time to prepare for a possible bear market, and there are several specific actions that should be considered:
1. Use market strength to decrease exposure to the stock market. Now could be the ideal time to book profits in large-cap stocks that are doing well.
2. Increase cash within your investment account to prepare for the buying opportunity that follows any price decline. If prices on large caps continue to move higher, that cash could be used to buy small-cap stocks when that sector turns bullish.
3. Buy insurance against a market loss in the form of put options. Given the strength in large caps right now, they would be the best stocks to buy puts on. Puts on iShares S&P 100 Index (ETF) (NYSEARCA:OEF) with an exercise price of $76 expiring in March 2014 are trading at about $3.25. OEF is currently trading near $75.75. If it falls by 10% to $68.17, these puts would be worth at least $7.83, for a gain of more than 140%. That profit could help offset losses in other positions.
Breadth data could be wrong just like any other market indicator can be. However, breadth is now flashing a caution signal to investors, and taking steps to protect your wealth could be the best course of action.
This article was originally written by Michael J. Carr and Amber Hestla and posted on ProfitableTrading.
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