Market breadth pattern analysis is the third part of an overall market analysis consisting of (1) monetary conditions analysis for long term forces, (2) primary breadth trend analysis for intermediate term forces, and (3) market breadth pattern analysis for short term forces I believe affecting the broad stock market.
First of all, I would like to give credit to Stockbee’s Market Monitor (MM) which inspired me to look deeper into the importance of looking at stocks making significant moves (+/-4%) as a breadth statistic. Other popularly known breadth statistics include advance/decline numbers, up volume/down volume numbers, new high/new lows, and bullish percentage.
Using Market Breadth Statistics to Differentiate Counter Trend Move vs Trend Change
Perhaps one of the most stressful and difficult challenge for momentum trader is to identify whether counter trend move against us represent a change of trend or just a pullback move which stop all newbies out of the market before the trend continues its march.
Market breadth statistics help us do just that in the stock market. The premise is that market trend requires participation of all common stocks. Market trend cannot be sustained by trending move in just a handful of highly capitalized stocks.
In a bull market, money flows to the stock market as risk appetite grows and ultimately reach lower quality stocks. When risk appetite is not that great, only the best quality of them will continue to rise.
Near the end of a bear market, firstly there usually is a panic selling. Then less and less stock participate in its march down. Higher quality stocks which were sold during the panic will be accumulated by those in the know. As a result, participation to the downside diminish. Before the market return to bull market, though, participation from lower quality stocks is needed before a bull market can be sustained. Often, this start with bang! There will be repeated days with high number of stocks being accumulated without high number of stocks being distributed in between.
Now assume there is a tendency for the market to move in a manner necessary to frustrate the majority of players. Short lived counter trend move is one such way for the market to frustrate the majority of us because it will turn our profitable position quickly into a loss and leave us behind before the market move in our favor again — but without us. Nothing is more frustrating than this. Money will flow from the accounts of these frustrated newbies to those few with more experiences.
Now, what is the most cost effective way for a counter trend rally in the market indexes to happen? Yes, move the few stocks with the most influence in the indexes. These are usually highly capitalized and liquid stocks. Being liquid, the transaction cost of moving them is minimal. Being highly capitalized, its move significantly affect the index. This operation cannot be done in less liquid small cap stocks. This is the key to the success of market breadth statistics in separating real trend change versus counter trend move in market indexes.
Thus, trend change requires wide participation among common stocks to significantly move in the same direction while counter trend move is associated with sharp move in market indexes without wide range participation from common stocks.
Market Breadth Pattern Analysis
The objective of market breadth pattern analysis is to objectively and mechanically detects trend continuation, exhaustion, and trend reversal in the broad market by looking at price actions of individual stocks more closely. In addition, awareness about important support and resistance levels are incorporated in the detection.
After extensive studies of past market breadth data, we have so far the following patterns. The names of the patterns are self-explanatory.
|Trend Continuation||In Bullish||SidewaysBreakout|
|Trend Reversal||From Bearish to Bullish||SellOffReversal|
|From Bullish to Bearish||RangeBoundSelling|
Logically, these patterns only exist during certain phase of market cycle. For example, Sideways breakout bullish pattern will not be detected in a Weak market state. Such breakout might actually be a dead cat bounce. RangeBoundSelling will not be detected in a Strong market state because in a strong market, selling usually invite bottom dip buyers. That is why detection of prevailing market state is a very important part of this system. Up to today, you might read the market state reading casually. You should not, it is an important part of the system. In fact, on a stand-alone basis, using only market state reading, we will have a decent trend following system.
|Pattern||Exist in Strong Market||Exist in Sideways Market||Exist in Weak Market|
Brief Description of Each Pattern
Some key features of the patterns are described below:
|SidewaysBreakout||Breakout in sideways market marked by repeated accumulation.|
|BreakResistance||Breakout over significant resistance level accompanied by accumulation.|
|DeadCatBounce||Distribution in weak market after weak bounce.|
|WeakMarketBreakDown||Heavy distribution and breakdown in a weak market.|
|FireSellExhaustion||Termination of several days of heavy distribution on down trending stocks.|
|StopAtSupport||Index find it hard to cross below significant support level after several days.|
|AccelRiseExhaustion||Index advance rapidly without much accumulation to accompany.|
|StopAtResistance||Index find it hard to cross above significant resistance level after several days.|
|SellOffReversal||Heavy accumulation after sell-off has been observed.|
|FailedBreakDown||In a weak market, index breaks below support unsuccessfully.|
|AccelDeclineExhaustion||Index falls in accelerating manner but without much distribution observed.|
|1BarReversal||Index breaks recent low and reverse on the same day with many stocks showing activities.|
|SupportsReversal||Index breaks support level and reverse on high accumulation.|
|RangeBoundSelling||Breakdown in sideways market marked by repeated distribution.|
|ResistReversal||Index breaks resistance, but failed to follow-through with accumulation.|
Some Technical Detail to Obtain Market Breadth Data.
I first scan my universe of stocks, perform data cleansing to detect and adjust erroneous data, and select 3000 most liquid common stocks. This is an important first step, because garbage in, garbage out.
Then, I monitor and categorize them into three main categories: up trending stocks, down trending stocks, and consolidation stocks within one month time frame. Next, I look at last day price action to see whether the stock rise significantly on high volume (accumulated), fell significantly on high volume (distributed), or did not move much but still have high volume nevertheless.
Everyday I collected the number of stocks which satisfy the above eight conditions as shown in the following chart.
What Make a Strong, Weak, or Sideways Market
The broad market state is changed to Strong if there are:
Once the market is considered Strong, it will remain so until there are
If we take Long position every time the market is Strong, then we will be in for most of major up trend. There will be some whipsaws but they are modest.
The broad market state is changed to Weak if:
Once the market is considered Weak, it will remain so until
If we take Short position every time the market is Weak, then we will be in for most of major down trend. There will be some whipsaws but they are modest.
Long, Short, or Exit Signals in the Market Timing System.
Bullish Patterns (To Enter Long)
End of Bearish Pattern (To Exit Short or Enter Long with Tight Stop if You are Advanterous)
Bearish Patterns (To Enter Short)
End of Bullish Pattern (To Exit Long or Enter Short if Market fall significantly soon after)
Change of Platform to NinjaTrader
Update 19 Jan 2012: I have now switched back to using NeoTicker to display the market breadth pattern analysis.
Recently I changed the platform to display my market timing system to NinjaTrader. Previously I used NeoTicker to generate and display the system. The following graph shows what each part of the section means in the new display.
You notice that the MarketPosition row does not match exactly what you read in forward testing track record displayed on daily market analysis. This happens because from time to time I slightly modify the logic or add new patterns but did not change the forward testing output. Otherwise, it becomes backtesting again.
Historical Back-testing Performance
The following historical charts show occurrences of the various patterns described above. The Bearish and End of Bullish Patterns are drawn as filled Down triangles just right below the Market State. The Bullish and End of Bearish Patterns are drawn as filled Up triangles further down. Market position if you have followed the patterns is shown the first row after SPX chart. Forward-looking track record of the system is included in each daily market analysis.