Strong breadth readings are generally bullish for the markets. The more stocks that are participating the better. There was a massive breadth thrust around the U.S. election in November and following the announcements of the rollout of a number of COVID-19 vaccines near the end of 2020.

This week as part of my PRO-II series, I’m looking at one of the best indicators of 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.

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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 one-month price only return is 0.51 per cent. When the index is in the top deciles, the average return tends to be above normal. Thus, the thrust of breadth leads to more momentum buying. The risks come mostly as the index comes off the high-breadth readings and momentum wanes. This is known as a divergence.

The above chart shows four examples of divergence 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.

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 stocks (relative to the decliners) is when caution is most warranted. The indicator also has more efficacy when combined with several of the others in our PRO-II series discussed over the past few months. If the Democrats take both seats in the Georgia Senate runoff election this week, the market could get excited over the prospect 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 ETF) versus a traditional market cap weighted exposure (SPY ETF), as the average stock should do better than the larger stocks. I made this shift in many of my investment portfolios. This theme makes sense for 2021 as the world hopes to put COVID risks in the rear-view mirror. However, the next few months will likely be a challenge and investors should expect some increased volatility in equities.

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

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