Market breadth indicators tell us how many stocks are taking part in the market
Although the youngest S&P 500 Index (SPX) withdraw was less than 3%, the market breadth suffered a significant slump in the last few days of trading. Market breadth indicators are good for telling us how many stocks are participating in recent market moves. The graph below shows the S&P 500 along with the percentage of S&P 500 stocks that are above their 50- and 200-day moving averages. Although the index was held above its 50-day moving average, only about 35% of stocks were above that level. Instinctively, this seems like a warning for the future of stocks. In the analysis below, I can see if the numbers suggest the same thing.
When the width decreases
Using observations from the graph above, I’ll look at similar cases in the past to see how the S&P 500 has performed in the future.
First, I noticed that the percentage of stocks above their 200-day moving average fell below 80% for the first time in several months. The following table summarizes six events since 2000 where the percentage was above 80% for at least three months before it was below. For comparison, the second table below shows the index’s returns since 2000. It’s not a lot of data points, but it doesn’t indicate impending doom. Three months later, the S&P 500 achieved an average return of 3.71%, with five out of six generating positive returns. The only negative return came in mid-2011 when the S&P 500 fell over 7% over the next three months.
If you look at the percentage of stocks above their 50-day moving average, a large portion has fallen below that level. The table below shows how the S&P 500 has performed going forward after the percentage of stocks above the 50-day moving average fell below 40% for the first time in at least three months. This gives us more signals showing that index returns after these events are bullish compared to typical returns. Each two week to six month timeframe listed below has a higher average return and percentage compared to typical index returns.
I mentioned earlier that the S&P 500 index was above its 50-day moving average, although a significant proportion of stocks were below it. So I took the returns in the table above and only considered the signals that occurred when the S&P 500 was no more than 2% below its 50-day moving average. In other words, the index held up well compared to the number of stocks that didn’t reach this level. The results are even more bullish than before. Three months after these signals, the S&P 500 achieved an average return of 3.69%, with 75% of the returns being positive. Six months after the signals, the index averaged an impressive return of 9.38%, with all 12 returns being positive.
In conclusion, decreasing width may seem like a warning on stocks, but based on the method above, this is a buying opportunity.