Breadth Thrusts in the Stock Market: What Comes Next?

 The previous post noted a late week bounce in stocks that had a defensive quality, with consumer staples and utility shares outpacing stocks in such sectors as energy and consumer discretionary.  On Monday there was another bounce, but the percentage of energy shares above their five-day moving averages went from about 22% to almost 96%.  The beaten down real estate stocks went from 43% to 63%; financials went from 17% to 58%.  Consumer discretionary shares went from 25% to 46%.  Tuesday the overall market (SPY) dipped, but again we saw a rising percentage of XLY, XLE, XLF, and XLRE stocks above their five-day averages.  By Wednesday, fully 94% of all SPX stocks were trading above their five-day moving averages.  In other words, we went from a defensive market theme to an aggressive one, creating a breadth thrust:  the great majority of shares participated to the upside.  This strength continued through the week.  The change of market theme was signaled by a shift in the patterning of market breadth.

So what does this market breadth thrust suggest going forward?  We can look from two perspectives:

1)  The presence of strength - I went back to 2006 and identified all market occasions in which more than 90% of SPX stocks were above their 3, 5, and 10-day moving averages at the same time.  Interestingly, out of well over 4000 market days, this only occurred on 42 occasions.  Over the next five trading sessions, the market was down by an average of -.26%, compared with a gain of +.18% for the remainder of the sample.  No particular edge here, even going out 20 days.  Returns over a next 20-day period were volatile, with 17 of the 42 occasions rising or falling by over 5%.

2)  The absence of weakness - If we get a true breadth thrust, we should see very few stocks demonstrating weakness.  I track the number of NYSE stocks giving sell signals on two technical indicator measures:  the Bollinger Bands and the Parabolic SAR.  These track price action over differing time periods.   On Friday, we had 10 or fewer stocks giving sell signals on both measures.  Out of almost 900 market days in my database, this only occurred on 7 occasions.  Again, very unusual.  The number of occasions is too small for reliable statistical inference, but it is noteworthy that the market overall underperformed over the next ten trading sessions and outperformed 30 days out.  Most interesting, four of those seven instances occurred as a cluster in April of 2020.  The question this invites is whether the current period (possible Fed pivot in rate policy due to bank concerns) is similar to the 2020 period (Fed pivot in the face of COVID impact).

Analyses such as these are meant to help in the formulation of credible market hypotheses, not the generation of infallible ideas.  Breadth thrust may be most important in the context in which it occurs.  If it occurs as a "blowoff" following a period of strength, we would expect volatile and negative returns going forward.  If it occurs following a protracted selloff, we would expect volatile and positive returns going forward as a function of short-covering and new buying.  At present, I'm open to the notion that we are, indeed, seeing a regime shift in the stock market, reflecting a change in central bank policy.  If that is the case, near-term weakness could become an opportunity to participate in longer-term cyclical strength.

 Brett Steenbarger, Ph.D

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