The much-feared start of the normalization of US monetary policy (“taper”) has thus far proven a “paper tiger” and stock markets remain buoyant. How sustainable are these rallies? A closer look into the markets’ internal constitution shows...
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Mikio Kumada, Global Strategist at LGT Capital Management
that price trends are being confirmed by market breadth in the West and Japan, implying that these bull markets will remain intact. That is not yet the case in the emerging world, however, and thus some caution remains advisable in that space for the time being.
Market breadth clues for the underlying state of a market
Market breadth indices (also known as advance-decline lines) offer insights into the internal constitution of a market and provide early warning of potential market tops or bottoms. In this approach, the price trend of an index is viewed against the background of an indicator of the number of shares that is actually moving in the same direction. When index price and breadth diverge, we have a warning that a (bullish or bearish) trend is about to reverse in the near future. When they move in the same direction or converge, we have confirmation that an existing market regime remains unbroken. The key constellations are the following:
1) Negative Divergence: rising stock index, combined with stagnant or declining market breadth
This constellation is typical for an aging bull market – it characterizes a market in the final stages of a boom. The stock market index continues to rise, but a rising number of stocks is no longer participating in that rally. Eventually, only a minority of shares, often those that are represented in the major indexes, continues to rise, while most shares in the market are actually trending lower. The continued rise in the index only creates the false impression of an intact bull market.
In the short-term view (since end-June), Hong Kong fits that pattern at present (see chart, page 2 in the PDF). However, there is no divergence in the medium-term trend – i.e. the Hang Seng is trading lower today than at the start of the year, and market breadth has been declining as well, confirming the existing sideways/bearish regime. Thus, it is too early to expect a bottoming in the larger trend. It is also worth noting that US breadth indices that include US-listed foreign shares are also diverging from US price indices (S&P 500, etc.). However, that warning is overruled by the pure US breadth indices (tracking only US companies), which aren’t diverging.
2) Positive Divergence: Falling stock index, combined with stabilizing or improving market breadth
This pattern characterizes the final stage of a bear market – i.e. the exact opposite of the above case. The falling stock market index falsely implies an intact bear market, but a growing number of shares – many of which are not represented in the index – has already started to trend higher. If we look at recent short-term trends, Brazil fits that pattern: market breadth began to rise in early June, but the stock index continued to fall through mid-July (see p.2 in the PDF). However, this is not yet the case in the medium-term view (year-to-date) for Brazil either. Still, if the short-term trend continues, this might lead to the first signal of a bottoming in the emerging markets.
3) Price and breadth move in the same direction or converge
This pattern confirms a pre-existing stock market trend. It applies to the larger overall picture as well as to the occasional corrections/consolidations within the regime framework. Bull market highs are more or less simultaneously confirmed by new highs in market breadth. Of course, corrections and consolidations take place in every bull/bear market – but they are not threatening the underlying trend as long as the price and breadth indices rise or fall in sync, without first going through a phase of divergence. Current examples are the US (excluding US-listed foreign company shares), Europe and Japan. There is no divergence between price and breath in these markets in either the short or medium term view.
Overall, despite the fact that the bull market has “aged” somewhat, we do not yet see conclusive signs of a possible market top (rather, we might eventually see a bottom in the emerging markets). At the same time, after four-and-a-half years of rising stock prices, it is advisable to keep a closer watch on market breadth, both at a global and regional level.
Source: ETFWorld – LGT Capital Management
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