Market Breadth Indicator Hints at Buying Opportunity

Though the recent S&P 500 Index (SPX) pullback was less than 3%, market breadth took a significant hit over the past couple of trading days. Market breadth indicators are good for telling us how many stocks are participating in the recent market action. The chart below shows the S&P 500, along with the percentage of S&P 500 stocks that are above their 50-day and 200-day moving averages. Despite the index holding above its 50-day moving average, only about 35% of the stocks were above that level. Instinctively, this seems like a warning for stocks going forward. In the analysis below, I see if the numbers suggest the same thing.

When Breadth Sinks

Using observations from the chart above, I’m looking at comparable instances in the past to see how the S&P 500 performed going forward.

First, I noticed the percentage of stocks above their 200-day moving average fell below 80% for the first time in several months. The table below summarizes six occurrences since 2000 where the percentage was above 80% for at least three months before breaking below that. For comparison, the second table below shows returns for the index anytime since 2000. It’s not a lot of data points, but it doesn’t suggest impending doom. Three months later, the S&P 500 averaged a 3.71% return with five of six returns positive. The one negative return happened in mid-2011 with the S&P 500 falling over 7% over the next three months.

Looking at the percentage of stocks above their 50-day moving average, a big proportion have fallen below that level. The table below shows how the S&P 500 performed going forward after the percent 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 the index returns are bullish after these occurrences compared to typical returns. Every time frame listed below, from two weeks to six months, shows a higher average return and percent positive when compared to typical index returns.

I mentioned earlier how the S&P 500 index was above its 50-day moving average, despite a significant proportion of stocks being below that level. So, I took the returns in the table above and I only considered the signals that occurred when the S&P 500 was not more than 2% below it’s 50-day moving average. In other words, the index was holding up well compared to the number of stocks failing that level. The results are even more bullish than before. Three months after these signals, the S&P 500 averaged a 3.69% return with 75% of the returns positive. Six months after the signals, the index averaged an impressive 9.38% return with all 12 returns positive. 

In conclusion, declining breadth may seem like a warning for stocks but based on the method above, it’s a buying opportunity.