Primary Breadth Trend analysis is the second 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.
The Dow Theory stated that there are primary trend, secondary trend, and minor trend in the stock market. Once a trend is in place, it tends to continue until evidence to the contrary is established. Thus, we are advised to go with the trend.
We can analyze stock market trend by looking at price indexes, such as SP500, which are usually constructed as capitalization-weighted average of a group of stocks. Thus, these indexes are disproportionately affected by high cap stocks. For the purpose of identifying primary trend, price indexes are highly noisy since any small changes in their constituent stock prices affect the index.
In view of these two limitations, I prefer to look at longer term market breadth statistics, such as new 52 weeks highs and new 52 weeks lows to assess direction of primary trend in the stock market in general. By looking at market breadth statistics, all stocks are treated equally. This is desirable because in major bull run, all stocks should participate. When confidence is high and cash is plentiful, investors are adventurous enough to invest in even non-blue-chip stocks. By looking at new highs and new lows, we only count significant movement in stock prices. Noise in stock prices get filtered out. As a result, we will get a less-biased and less-noisy statistic to assess primary trend in the stock market.
The main objective of reading primary trend is so that we can be aligned with them.
Primary Market Breadth Analysis
The second chart below shows cumulative sum of 52 weeks new high minus 52 weeks new low of Nasdaq composite stocks. We call this statistic NAHL. I used Nasdaq stocks because they are generally more speculative, less dependant on basic resources companies, and less dependant on interest sensitive companies such as utilities. When confidence in the stock market is running high and cash is plentiful, we expect the more speculative stocks to run to the sky, making new highs along the way. On the other hand, when confidence is low or cash is scarce, we expect the more speculative stocks to tumble, making new lows along the way.
The NAHL is overlaid by its 20 days moving average. This line is used to detect change in direction.
The third chart shows the difference between NAHL and its moving average. Positive value indicates that NAHL is still above its moving average. Thus primary trend is bullish. Negative value indicates that NAHL is below its moving average. Thus primary trend is bearish.
A simple study to assess the usefulness of identifying primary trend this way is to Long SP500 index whenever the difference is positive and Short SP500 index whenever the difference is negative.
The following chart shows that this very simple approach indeed align ourselves to major trend in the SP500 index. My historical data for NAHL only started in late 2002. However, I strongly believe that similar approach would have alligned us into bull market trend in 1990s and subsequent bear market in early 2000s.
Of course, it is not sufficient to just identify primary trend for the purpose of swing trading. To do that, I looked at short-term market breadth patterns to identify shorter term continuation, exhaustion, and reversal in the broad market.