Relative Strength and Breadth

Relative strength: strength only exists against something

A relative strength line is the price of one instrument divided by the price of another — a stock against its sector, a sector against the index, an index against cash. Everything interesting about the measure follows from that division. The line rises when the numerator outperforms and falls when it lags, so a stock can rise in absolute terms every day for a year while the line falls, which is precisely the information an absolute chart cannot give you: the stock is going up, and it is going up less than the thing you could own instead. In practice the ratio is plotted against its own moving average, and the useful readings are the same three the moving average lesson established — above or below, rising or falling, and whether the recent window has turned relative to the older one. The reason to care is opportunity cost rather than prediction. Every dollar in a lagging name is a dollar not in a leading one, and the observation that relative strength tends to persist over intermediate horizons — the momentum effect that Fundamentals F17 covers from the factor side — makes the comparison a source of information rather than a curiosity. The context in which it is applied matters too: at a market turning point, relative strength is one of the few measures that still discriminates, because everything is falling and the question becomes what is falling less. That is why sector rotation is usually described through the ratio rather than through absolute prices: a rotation is visible as the leading sector’s line flattening while the laggard’s turns up, often before either price changes direction. The honest limits are three. A ratio is not a level, so it says nothing about where either instrument will stop. It is amplified by the pair you choose — a small-cap against a narrow mega-cap index will produce dramatic swings that are partly a size effect rather than a signal about the business. And it says nothing about valuation, which is the factor lesson’s point: a stock can be strong and expensive, and the two facts are not in conflict. Relative strength answers “which of these two is being preferred”, and nothing else. The same 12% quarter, three ways — Absolute return: +12% — a number without a comparison · Against its sector, +20%: The ratio fell: it was preferred less than its peers ← · Against the index, +14%: Still lagging, though less than its sector — which is a clue about the sector rather than the stock · Opportunity cost: The dollar sat in the laggard while the leading alternative compounded A ratio is a relationship rather than a level, so it can rise while both instruments fall — a defensive name in a declining market is relative strength, and that is the sense in which the measure is most useful at turning points.

Breadth: how the market is being carried

Breadth measures count members rather than weight them. The advance–decline line adds a point for every member that rises and subtracts one for every member that falls, cumulatively, so it describes the typical member’s experience. The percentage of members above their own 200-day average describes how many are in their own uptrends. And the cleanest of all is the comparison between an index and its equal-weighted twin: the cap-weighted index gives the largest companies the largest influence, while the equal-weighted version gives every member the same, so the gap between the two is a direct measurement of how much of the return came from the few. Worked on the table above: the index is up 4.59% while its equal-weighted version is up 1.2%, so 26.1% of the headline was earned by the average member and 3.4 points came from the largest names. The value of these measures is that they are computed from the same universe on the same days, so they answer a question the index level cannot. An index can make a new high while most of its members are in downtrends, and that combination has different risk properties from a broad advance. Three properties in particular. Fragility: the failure of two or three dominant names is enough to turn the headline. Correlation: the same small group drives every index, so portfolios built on index exposure carry more single-name risk than their stated diversification suggests. And distribution: the forward range of outcomes is wider, which is an argument about size rather than direction. None of that predicts a decline; it prices one differently. The two ways breadth misleads are worth naming. First, treating a breadth divergence as a sell signal: breadth has been deteriorating for months at a time while indices advanced further, because concentration can persist and because the largest companies grow their earnings fastest while they are growing fastest. Second, reading breadth as if it were stationary across eras: the number of listed companies, the share of assets in index funds, and the composition of the index itself all change the readings, so a level that meant one thing in one decade means something else in another. As with every measure in this subject, the comparison that carries information is the reading against its own recent range rather than against a constant. • Advance–decline line: cumulative net advancers, describing the typical member. • Percentage above the 200-day average: how many members are in their own uptrends. • Cap-weighted versus equal-weighted: the cleanest measure of how much of the return came from the few. • Narrow breadth means fragility, correlated drawdowns and a wider forward distribution — not a forecast. • Breadth levels are not comparable across eras; compare a reading with its own recent range. The most common expensive use of breadth is as a timing signal: “the divergence will resolve, so I will be early.” Concentration can persist for quarters, and being early with a sized position is indistinguishable from being wrong. The defensible response to narrowing breadth is to reduce correlated exposure and to prefer the leaders the index is actually being carried by — which is the same conclusion relative strength gives, arriving through participation rather than through price.

The index is not the market

The S&P 500 is capitalisation-weighted, which means its return is dominated by its largest members. When a handful of companies grow to a large share of the index’s total value, the index can rise handsomely while the median constituent falls — and that is not a glitch, it is arithmetic. In recent years the largest names reached a share of index value high enough that their moves accounted for the majority of the index’s return on many days, which is why tape-watchers learned to talk about “the market” and “the average stock” as two different things. Two tools expose the gap. The **equal-weighted** version of an index holds each member at the same weight, so it answers “how did the typical company do?” rather than “how did the biggest ones do?”. **Breadth measures** — the share of members above their 200-day average, the advance-decline line, the ratio of new highs to new lows — answer the same question from the other direction. When they diverge from the cap-weighted index, the divergence is the information: a rally carried by a shrinking set of names is a different market from one carried by most of them. The lesson is not that cap-weighting is broken. It is that you must know which question a number answers. “The index is up 1%” and “the average stock is down” can both be true in the same session, and a portfolio of individual names will feel like the second one while the headline reports the first. Same day, three readings — Cap-weighted index: +1.0% · Equal-weighted index: −0.4% · Members advancing: 196 of 500 ← · What a diversified portfolio felt like: the average stock, not the headline This is why index-level “market breadth” and your own account can disagree for weeks without either being wrong. They are measuring different populations.

The weighting is a decision, and the equal-weighted twin is also a strategy

Four indices can hold the same five hundred companies and behave differently, because a weighting scheme is a rule for deciding who gets the largest position. Cap-weighting gives the largest companies the largest weight, so the index follows the market’s own valuation of size. Equal-weighting assigns each member the same weight and rebalances back to equality on a schedule, so it mechanically trims whatever has run and adds to whatever has lagged. Fundamental weighting uses revenues, earnings, book value or dividends instead of market value, which tilts toward cheaper, larger-in-sales businesses. Each answers a different question, and none is the neutral one: the choice is an active bet on concentration, on size, and on the persistence of price moves, made by whoever built the index rather than by whoever buys it. That matters for reading breadth, because the gap between a cap-weighted index and its equal-weighted twin is not a pure measure of concentration. The equal-weighted version’s scheduled rebalancing is itself a small, systematic reversal strategy — it sells strength and buys weakness every quarter — and the academic literature on weighting schemes finds that some of the long-run equal-weight advantage comes from that rebalancing behaviour and its tilt toward smaller, cheaper companies rather than from concentration alone. So when the index is up 4.6% and its equal-weighted twin is up 1.2%, the honest reading has two parts: a large share of the headline was earned by the biggest names, and some of the twin’s own return was manufactured by the fact that it keeps rebalancing. The direction of the message survives; the size of it is soft, and quoting the gap as if it measured concentration and nothing else overstates what has been measured. The second consequence is that a weighting can be changed from outside the market, so a breadth series is not stationary. Providers adjust free float, add and remove members, decide how to treat multiple share classes, and change the number of holdings — Standard and Poor’s moved from a committee-managed list of six hundred names toward a larger, more mechanical set, and the index’s concentration has climbed for reasons that are partly arithmetic. On top of that, an equal-weighted fund has to trade its rebalance and has capacity limits in the smallest names, which is one reason the largest indices are structurally more concentrated than a market-wide equal-dollar portfolio would be: the vehicles that carry the most money cannot hold the market evenly. So when you quote a breadth number, quote the weighting with it, compare like with like across periods, and remember that the cleanest measurement tool in this lesson is also a position someone could own — with its own costs, its own turnover and its own tilt. Four weightings, four questions — Cap-weighted: How did the market value the whole market? Follows the largest names · Equal-weighted: How did the typical member do? Rebalances, tilts small and cheap ← · Fundamental-weighted: How does size look measured in sales or earnings rather than price? · GDP- or region-weighted: How did the world’s economies do rather than its listed market caps? ← The gap between the two twins is still the best single concentration read available, because both are computed from the same universe on the same days. It is a measurement with a known bias rather than a contaminated one: the bias has a sign and a rough size, which is more than can be said for a level read in isolation.

Sources

• Relative strength lines and sector rotationMurphy, “Intermarket Analysis” and “Technical Analysis of the Financial Markets”
• Breadth measures: advance–decline, percentage above the 200-dayStandard breadth literature and index-provider methodology
• Equal-weighted versus cap-weighted indices and concentrationIndex-provider methodology documentation (S&P Dow Jones Indices)