I was thinking about market breadth yesterday and had some ideas about how to measure. There are many different ways to measure market breadth of stock participation in a given market move. I have seen countless cases of people using moving average cross overs to gauge the strength of weakness of the market, i.e. 50 day average crossing the 200 day average. But is there possibly a better way to measure the underlying breadth?
I was reading "Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing" by Michael Carr and he tested several measures of relative strength on many Fidelity Select sector funds. He found that a normalized moving average crossover on a weekly time frame worked well for measuring the relative strength of the funds. I setup a spreadsheet that uses the 8 week and 15 week simple moving crossover on 40 Fidelity Select sector funds and then ranks them. I don't really prefer to trade this way because of the inherent lag induced by the simple moving averages. You can often end up exiting positions during significant retracements.
Instead of using the relative strength to determine which funds were behaving the "best", I was thinking I could use it to determine market participation and whether there was strength behind the move. I setup a column in my spreadsheet to determine the percentage of the 40 funds that had an 8 week simple moving average above their 15 week simple moving average. When the reading was near 100%, I knew that almost all sectors were participating in the up trend. When the reading was near 0%, I knew all sectors were participating in the down trend. Of course you can optimize the moving average lengths to improve the indicator, but the overall goal is to understand the market breadth. Usually, as an up trend continues there is less and less participation until finally the strength collapses and a down trend initiates. This indicator can sometimes tell you when this occurs.
Obviously, this is just an idea right now and more research is need to see if it would be useful. I think one of the best ways to use it would be to determine when to enter longs and when to enter shorts. If the indicator is greater than some percentage, you could look for long entries. The opposite could work for short entries. Combining this indicator with a short term oscillator may yield an interesting strategy for swing trading the markets and entering on a pull back. This type of market breadth indicator may also help you avoid those times when the market is range bound if the percentages are near 50%.
Another useful way to use the indicator is to apply classical sector analysis theory. You can use the measure to see if most of the up-trending sectors are defensive (utilities, healthcare, defense) or offensive (technology, materials, consumer discretionary). Also, if we are beginning a new bull market uptrend, you could see which sectors are doing well to determine if there is new leadership and good sector rotation. In the Carr book, he develops a strategy to always be long the market by pick the best few sectors, which can result in large drawdowns during times like the 2008 financial crisis where everything is going down. You could use this indicator to determine when to exit all longs and be entirely in cash, or perhaps entering a bearish fund to capitalize on the downturn. I am sure there are plenty of other ways to use this indicator, but I am sure you are starting to get the idea how this market breadth indicator could be useful.
One final thought, I am not sure if the individual sector moving average cross over would be much different from the composite behavior of a moving average crossover on an index. I believe there would certainly be a difference if you were to setup the same moving average cross over count on the individual component stocks of the Russell 2000 index and compared it to a moving average cross over on the index itself. This idea could also be applied to any trend indicator too, not just a moving average cross over.
No comments:
Post a Comment