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What is the Breadth-Of-Market Theory?

Jim B.
Jim B.

The breadth-of-market theory is a technical stock market theory that states that the market's strength depends upon the entirety of the market as opposed to a few big players. This theory attempts to spot trends in the market by analyzing the market as a whole. One key statistic used to aid the breadth-of-market theory is the advance-decline index, which measures the amount of rising stocks against the amount that are falling. Although the theory is a strong indicator of overall market strength or weakness, it isn't equipped to deal with sudden jolts to the market.

Many investors look at the market as a big-picture scenario and analyze large groups of stocks and their trends before they take a look at an individual stock. Yet it makes sense that a majority of stocks on the rise likely means that the market is in good shape. In contrast, if most of the stocks available are on the drop, then it's very possible the market is suffering. The breadth-of-market theory takes this simple point of view and strengthens it with statistical information to analyze how the market is doing.

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Man climbing a rope

Those who subscribe to the breadth-of-market theory will likely point to the advance-decline line as a prime indicator of market strength. The advance-decline line takes the number of stocks that closed higher than their price of the previous day and compares them to the number of stocks that closed lower. Taking these results and studying them over a period of time can distinguish market trends that are usually in coordination with other market indicators.

In addition, the advance-decline line is a good way of measuring when other market averages intended to indicate strength may be misleading. For example, a few large stocks may be in decline, weighing down the averages for the whole market. If the advance-decline line were positive at the time, savvy investors might be able to realize that those big stocks were actually throwing off false signals. The breadth-of-market theory believes the stock market is a sum of equal parts, with no one part being more important than another.

As with any method of technical analysis, the breadth-of-market theory cannot promise flawless results. For instance, sudden real-world events can take place that could jolt markets out of conjunction with any prevailing trends, even those associated with market breadth. While market breadth may give an accurate snapshot of how the market is performing, it can't exactly say why it's performing in that way, which ultimately is the most pressing question for investors.

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