Why do we care about breadth in the first place? Read trading books from 20 years ago, 50 years ago, or 100 years ago, and they all mention breadth. And for good reason. Market breadth is important because index price action can be deceiving. Since the index price is only one price, it leaves out important information. So it often misleads, and misleads, and misleads, until the market has already turned and you’re caught offsides.
Following market breadth gives you additional information about whether investors as a whole are adding or pulling money from the stock market overall. Though there are many ways to assess breadth, I want to introduce one simple metric here. It’s a comparison of the SPY (the market-cap weighted S&P 500 ETF) vs. RSP (the equal-weighted S&P 500 ETF). When market breadth is strong, RSP is usually outperforming SPY, as many stocks participate in the rally, whereas when market breadth is weak, RSP is usually underperforming SPY, as only a few stocks are participating in a rally. Here’s the 5-year chart of the ratio of RSP / SPY:
Most notably, the ratio actually bottomed in late 2008, and even though SPY made a new low in March 2009, the ratio was making a higher low, indicating improving market breadth, and a bullish sign at the time. More recently, the ratio actually topped out in spring 2011, and even though the SPY made a new high in the spring of 2012, the ratio made a lower high, and has actually trended lower ever since February of this year. It is basically on its lows of the year, even with the recent rally, and it’s another indication to me that money is coming out of the stock market even though the major stock indices seem to show resilient price action.
Along with the relative strength of the defensive sectors that I mentioned this morning, this is another strong sign to me that the internals of the market are indicating potential future weakness even though the market is up 6% on the year. Buying stocks here feels to me like believing the used car salesman on his sales pitch without checking under the hood for yourself.