In the last few weeks, our outlook for the Nigerian Stock Market has been “net” bearish. The primary reason for the bearish bias has been premised on a weakening market breadth. Today, we will be allowing you to peek under the hood, so you can understand our methodology and reasoning for the bearish bias.
If you recall, from our introductory stock market outlook, we emphasized the need to create an outlook that was based on a methodic approach, not just subjective opinions. We call our approach a “data perspective” to the market outlook. This approach, at its core, is built around the relationship of the all-share index to its market breadth. So, what is the market breadth?
The big picture.
For most self-directed (retail) speculators, understanding what’s up with individual securities (GTBANK, ZENITHBANK, DANGCEM) is where their analysis ends.
Professional speculators, though, understand that individual securities do not trade in isolation. There is a presiding tempo that is set by the general market which determines how individual securities will perform. If the general market is strong, the likelihood of individual stocks performing well increases and vice versa.
For this reason, professional speculators know that analyzing individual securities alone does not give the full picture of what to expect in the market. If you trade stocks and are not aware of the general market conditions, you’re missing out on a lot of valuable information.
What is market breadth?
In very simple terms, market breadth is a term used to describe the strength of the general market environment (in this case, the Nigerian Stock Exchange). This is achieved by evaluating the population of the market that is participating in the market’s current move. Let’s explain this with an illustration.
Imagine that a stock market index has 200 constituent stocks. At the end of a trading day, 150 of the 200 stocks registered positive price gains, and the value of the index itself closed higher. The breadth of this illustrative market, for this particular day, can be said to have been positive because a majority of the constituents participated in moving the value of the index higher.
Focusing on the value of the Nigerian all-share index alone will not tell the full story of what’s going on in the market. You may be wondering why this is so.
The all-share index is a value-weighted index. This implies that companies with larger valuations (capitalization) will have a disproportionately larger influence on the returns on the all-share index than companies with smaller valuations.
If MTNN, DANGCEM, BUACEMENT, NESTLE, GUARANTY, and ZENITHBANK are all having a great day, it’s quite unlikely that the all-share index will close the day negative, irrespective of how many other stocks might close the trading day lower.
Examining the market breadth gives speculators added context about the environment, and ultimately gives a more accurate read on the true health of the market.
How to use market breadth.
It is widely expected that the market breadth of the index should align with its general trend. If the index value is rising, it is expected that the breadth should agree, by rising with the value. This expectation, though, is not always the case.
There will be times that the breadth of the index does not align with its direction (trend). This disagreement between market direction and market breadth is known as a divergence between breadth and trend. When this happens, professional speculators have learned to take note. By studying market breadth, speculators can confirm price action and identify trend reversals.
Now that we have explained what the market breadth is and how it can help speculators, let us look at some of the popular market breadth indicators.
The Advance–Decline (AD) Line is one of the most popular market breadth indicators. It measures the number of individual stocks that are participating in a market’s rise or fall.
The AD indicator is derived by:
Adding all the stocks that closed higher on the trading day.
As done above, summing all the stocks that closed lower on the trading day.
The AD line is simply the difference between steps 1 and 2 above.
The image below is the AD indicator for the Nigerian Stock Exchange all-share index from January to December 2018 (powered by the Investor Hangout).
A quick glance at the chart will show that the AD line was at the highest in Q1 2018 and descended shortly after. The rest of the year experienced market breadths near or below zero (an indication of weak market conditions). Remember 2018?
Other important market breadth indicators include:
How can studying market breadth improve trading performance?
By following the activities that are happening in the entire market, the market breadth:
Gives the speculator some perspective about the environment they are speculating in,
Helps the speculator identify significant divergences, and
Allows the speculator to be more efficient in their asset allocation.
Institutional investors are the major stakeholders that determine which way the market moves. Studying the market breadth is one of the clearest ways to track that institutional activity.
By tracking such activities and identifying when institutional money is moving into and out of the market, speculators can increase their chances of being on the right side of the market.
Now that we have explained the concept of market breadth, let us look at how Investor Hangout applies it to its market outlook projections.
Stock Market Breadth Cycles
We understand that there are several indicators for measuring market breadth. With choice, often comes confusion. The investor Hangout, therefore, created a market breadth cycle, a model, which combines the most important market breadth indicators. This model gives a much clearer picture than any single indicator could do on its own.
The Investor Hangout market breadth cycle is an effective way of measuring the health of the Nigerian stock market based exclusively on market breadth data.
The breadth cycles are broken into three categories:
Green – for positive market breadth (strong, upward market),
Yellow – for neutral market breadth (sideways, ranging market) and
Red – for negative market breadth, (weak, downward market).
The following chart shows the breadth cycle overlaid on the NSE ASI in 2018 (for illustration only).
The image above shows how well the breadth cycle was able to recognize the weakening market conditions that preceded the decline from the end of May 2018 to January 2019. It also captured the improvement in market strength by turning yellow in January 2019 and then green by March 2019.
Speculating with the breadth cycles.
The market breadth cycles help the user to understand, quickly, the current conditions of the general market.
They provide the speculator with an assurance of what the current market trend is – bullish, bearish, or ranging, helping to establish an efficient asset allocation framework.
When the breadth cycles indicated divergence between the market breadth and trend, it accurately informed of the divergences at key market tops and bottoms, creating great risk to reward opportunities.
Where is the breadth cycle today?
At the beginning of this blog post, we mentioned how our outlook for the all-share index has been net bearish and this opinion was premised on a weakening market breadth. We also discussed our desire to create an outlook that was based on a data perspective.
The market breadth cycle is a key component of the framework for our stock market outlook as it provides a quantifiable and measurable method for identifying the current market conditions.
The chart above is the breadth cycle of the all-share index for the last 12 months to March 21, 2021. It tells a story of how the negative breadth from 2020 became neutral (yellow) at the end of May 2020 and then, consistently positive in October 2020.
A look at the end of February 2021 shows that the breadth cycle turned neutral (yellow) and, for the first time in almost one year, it turned negative (red). This, right here, explains our bearish bias for the stock market. If we, subsequently, notice any change, for the better, we will adjust our opinion appropriately.
The market breadth cycles are a component of our stock market outlook dashboard and report. While we have run consistent backtests that show positive results, it should not be taken as investment advice.
The breadth cycles and the outlook dashboard should not be considered as independent trading systems and should, also, not be solely relied upon for timing the market.
If, having acknowledged our disclaimer, you would like to get access to the outlook dashboard and track the market breadth cycles, then subscribe to our newsletter below, so you do not miss potential market turning points before they run out of steam.
Taiwo Megbope is the Co-founder and Chief Growth Officer at Investor Hangout.
He is tasked with ensuring and managing the growth of the Investor Hangout project. His responsibilities include creating and implementing the project's vision as well as executing growth-generating strategies.
Taiwo is an avid researcher and autodidact. In his spare time, he enjoys spending time with his family and friends.