Strong Breadth Suggests More Upside Likely

Strong breadth readings are generally bullish for the markets. The more stocks that are participating the better. We saw a massive breadth thrust around the US election and following the announcements of high efficacy on the vaccines. This week as part of our PRO-EYEs series, we are looking at one of the best indicators for looking at overall participation. The McClellan Summation Index was developed by Sherman and Marian McClellan in the 1960s and is one of the best estimates of the average number of stocks advancing and declining. It looks at the average number of stocks rising and falling over multiple timeframes and acts like and overbought/oversold oscillator.

S&P 500 vs. McClellan Summation Index

Like many indicators, the efficacy at low points is much better than at high points. Markets tend to bottom much more acutely while tops tend to form over longer periods. Unlike most indicators, a stronger overbought reading is a positive. Since 1997, the average daily 1-month price only return is 0.51%. You can see when the index is in the top deciles, the average return tends to be above normal. Thus, the thrust of breadth begets more momentum buying. The risks come mostly as we come off the high breadth readings and momentum wains. This is known as a divergence. We have highlighted 4 of them over the past few years. They typically lead to a correction, but we never know how deep they will be. We are on the lookout for a similar pattern in the coming weeks.

Decile 1M Avg Return
100% 1.51%
90% 0.58%
80% 0.84%
70% 0.09%
60% 0.52%
50% -0.12%
40% -0.06%
30% 0.22%
20% 0.37%
10% 0.25%
0% 3.54%
Average 0.51%

This suggests that divergences are a more powerful signal than absolute level of the index. A push to new highs in an index like we are seeing now combined with weaker momentum in the advancing versus declining stocks is when caution is most warranted. The indicator also has more efficacy when combined with several of the others in our PRO-EYEs series we have discussed over the past few months. If the Democrats take both seats in the Georgia Senate runoff this week, we could see some excitement of larger stimulus. A divergence would develop if investors use the potential market strength to take some money off the table.

From an investment perspective, stronger breadth readings favour an equal weight exposure to the S&P 500 (RSP) versus a traditional market cap weighted exposure (SPY), as the average stock should do better than the larger stocks. We made this shift in many of our portfolios. This theme makes sense for 2021 as we (hope) to put COVID risks in the rear-view mirror. Until then, the next few months will likely be a challenge and investors should expect some increased volatility in equities.

Look for more in the coming weeks from our new Berman’s Call Probable Return on Investment Index, PRO-II (pronounced Pro Eyes) Indicator. We will be launching the new website this month so that BNN viewers can follow along with the various risk and opportunity factors we follow.

Happy New Year. It may not be a better year for markets, but I expect it will be for wellbeing.

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