How Market Internals Can Improve Your Trading
If you trade stocks and you don’t follow market internals, also known as market breadth, then you’re missing out on a lot of valuable information.
Like any other study or indicator, market internals aren’t guaranteed to get it right all of the time, but when they do begin to diverge or exhibit some out of the ordinary behavior, it always gets my full attention.
Throughout this article, we’re going to define what market breadth is, lay out why we should care, and then focus on individual market internal indicators to explain how they can help us make better trading decisions.
I’ve recorded a video covering everything below, so if you’d rather just sit back and watch, click the video; otherwise, read on.
What are market internals? What is market breadth?
These two terms are often used synonymously.
Market breadth seeks to measure the quality of the market environment using the total number of individual stocks participating in a move.
Market internals are simply measurements of the “internals” of the market, which represent exactly that of market breadth.
The rationale is to look beyond price, and the headlines of what the major averages are doing, and analyze exactly how many individual stocks are participating in a move (or acting in a certain behavior).
Why should we care about market internals?
It’s easy to just look at the return of the SPY ETF and assume that’s what’s happening with every stock in the market, but that would be lazy and inaccurate.
One major flaw with that approach is the fact that the S&P500, is a market cap weighted index. That means the larger the company is (based on capitalization) the more of an effect it has on the returns of an index.
If Apple, Microsoft, Amazon, ExxonMobil are all having good days, it’s going to be really hard for the S&P500 to be negative, regardless of how many other stocks might be down on the day.
Measuring market breadth solves this, gives us added context about the environment, and ultimately gives a more accurate read on the true health of the market.
How can market internals help us trade?
Most of the time, market internals should (and do) align with what the major averages are telling us. But it’s when there is disagreement between what market internals are telling us, and what price is showing us, where things get interesting.
Divergence is one of the most powerful pieces of information market internals can show us, and used properly, can save (or make) us a lot of money.
Beyond divergences, market internals also serve as great market regime filters, solutions for confirming price action, and even more tactical applications that we’ll get into below.
Now let’s get into some specific indicators and discuss how they can be used.
Market internals – Advance-Decline Line
The Advance–Decline (AD) Line is a stock market technical indicator used to measure the number of individual stocks participating in a market rise or fall.
It is the king of all market internal indicators and it’s the most commonly cited measure of market breadth you’ll find.
Here’s what the day to day AD looks like for the full year of 2016 (click to enlarge):
How does it work? It’s really quite simple.
- Count up all the stocks up on the day.
- Count up all the stocks down on the day.
- Take the difference, and there’s your AD line.
The universe of stocks used in this calculation can be anything, but most commonly the AD line is measuring the NYSE (displayed above).
Pro Tip: you can create your own calculations using different exchanges, individual sectors, even your own favorite personal watch-list or group of stocks.
Tips for using the Advance-Decline Line
In general, you want to see day to day price movement (consistently) confirmed by the AD line just as you would analyze volume on an individual stock.
That means ideally stronger advances during up days, and lighter declines on pullbacks (if you’re bullish).
There are also some other important numeric thresholds worth keeping in the back of your mind if you’re using the AD line on the NYSE.
The NYSE has approximately 2800 stocks so anytime you see sessions exceeding +/- 1000, that is generally seen as a strong accumulation or distribution day.
That means roughly 65% of stocks are moving in the same direction, which suggests it’s more than just you and I out there buying and selling stocks; those are the big institutions at work.
In summary, the AD Line is one of the purest measures of how our market of stocks performed on a given day and provides reliable institutional footprints.
Market internals – McClellan Oscillator
The McClellan Oscillator is a market breadth indicator that is based on the difference between the number of advancing and declining issues on the NYSE (the AD Line we just discussed).
Here’s what the McClellan Oscillator looks like for the full year of 2016:
You can see this representation is much cleaner looking than our above AD Line, even though it represents the same underlying dataset.
The values are calculated by plotting the difference between a 19-period and 39-period EMA of the Advance-Decline Line.
I like to think of the McClellan Oscillator as a MACD on the advance-decline.
Tips for using the McClellan Oscillator
- Above or below the zero line is a very classic bull/bear line in the sand. Above zero, and breadth is seen as bullish, below and it’s bearish.
- Extreme readings are also interesting to pay attention to. This is an oscillator after all, which means we are bounded on either end, and we can look back historically to measure levels at which the oscillator tends to revert back to the mean. The specific numeric level will differ depending on how your charting software calculates its values.
- Sharp moves are interesting regardless of the direction and positioning. Whenever we see a sudden move in the McClellan Oscillator it’s worth paying attention to for further signs of follow through and/or change in behavior.
- Divergences between what the McClellan is doing and what price is doing is also very helpful. For example, if price action continues to make higher highs, meanwhile our oscillator slugs around reluctantly near the zero line, it may be time to re-think the bull case.
Market internals – net new 52-week highs/lows
Net new 52-week highs and lows is another very popular market breadth indicator to help determine the underlying strength in stocks.
Here’s what the Net New 52-Week Highs/Lows looks like for the full year of 2016:
The Calculation for this indicator is straightforward:
- Count up all the stocks making new 52-week highs.
- Count up all the stocks making new 52-week lows.
- Take the difference, and that is your net 52-week high/low list.
Some may prefer to view new highs and lows separately, but I prefer to combine the data sets and look only at the net number.
Tips for using net 52-week highs/lows
- Similar to how we analyze the AD line, we can use the net 52-week high/low indicator for confirmation in what price is doing. On up days, we prefer to see more followthrough in new highs, and during price pullbacks, we prefer there is no major drop off or expansion in lows (if you’re bullish).
- Like with most market internal indicators, divergence is once again a key behavior to look out for. When price is making higher highs and you’re not seeing it confirmed by expanding new highs (or worse, new lows) then it’s time to get suspicious in the rally.
- Based on my experience this is a better intermediate to longer-term indicator of market health. Divergences can occur weeks and even months before the market eventually catches up.
Market internals – cumulative AD line
The cumulative Advance-Decline line is simply the advance-decline line discussed above, displayed as one long summation from one day to the next.
Here’s what the Cumulative AD Line looks like for the full year of 2016:
Because this is just another view of the AD line, we’re looking at the same information, but this view can provide some easier to spot divergences and patterns.
You can also more easily apply some technical studies like moving averages or MACD and start to analyze the behavior of the AD line, just as you would your favorite stock.
This, again, can surface some interesting divergences when you begin comparing the behavior of the cumulative AD Line to the SPY for example.
Market internals – stocks above a moving average
Calculating the percentage of stocks above a moving average is another great way to gain insight into the behavior of individual stocks.
Here’s what the Stocks Above 10SMA Oscillator from IndexIndicators looks like for the full year of 2016.
You can use any period moving average you want, the shorter the moving average, the more oscillations you’re going to see, and more short-term in nature the indicator will represent.
I am partial to using a fast period, the 10SMA, for spotting short-term multi-day oversold and overbought points.
A great benefit of the charts from Index Indicators is that they give you the relative standard deviation zones to know when you’ve reached those extreme overbought and oversold areas.
Tips for using stocks above a moving average
- Similar to our McClellan Oscillator, above or below the midpoint, which in this case will be roughly the 50% mark (not the zero line), will give you the general indication of who is in control, the buyers or sellers.
- The 1 and 2 standard deviation markers will give you good insight into where the relative overbought and oversold levels are. The oscillators can remain in the overbought and oversold levels for a number of days, so don’t try and immediately use them as a buy/sell signal, rather it should be used in context with the environment you’re in (trending, rangebound, etc).
- I personally don’t use this indicator for divergences between price, but others have found success with that.
How market internals can improve your trading
By tracking what’s going on under the hood of the market indices we gain more context about the environment we’re trading in, identify powerful divergences, and allow us to be more selective with our trades.
We know that institutions move markets, and monitoring market internals are one of the clearest ways to track their activity.
There are many other market internal indicators out there to explore, but we’ve touched upon some of the most popular throughout this article.
Keep in mind all of the tips and suggestions that we discussed are simply my findings and interpretations of these indicators, and should not be assumed to be the only way or even “the right” way to use them.
Have a favorite market breadth indicator that we didn’t mention? Leave a comment below and share!
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