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Is Bad Breadth Killing Your Portfolio?

By Linda McDonough on August 22, 2017

Despite the fact that the S&P 500 is up 8% year to date and the Nasdaq up 15%, beneath the headlines a gaggle of stocks is falling. Most investors shoot a cursory look at the major averages to make sure their portfolio is in good shape, but when the change in your balance doesn’t match the headlines, it’s time for a deeper dive.

Much has been written describing the support that FANG stocks have had in supporting the overall market. Strength in Facebook, Apple, Netflix and Google (renamed Alphabet in 2015) have masked a flock of wilting smaller stocks.

As a market weighted index, the S&P 500 puts more weight on larger stocks. This method begets a winner’s bias because stocks that are moving up see their market caps increase. These rising stocks then gain more influence on the S&P 500’s performance.

The poor Russell 2000, whose smaller cap stocks are equally weighted, is up just a hair year to date and has tripped into negative territory on a few days. Depending on how your portfolio is allocated, you might see your highest balance on or about July 25th, the day the Russell 2000 was up 6% and at its highest level of the year.

I like to keep on eye on the Arm’s Index, affectionately known as TRIN, an acronym for (TRading INdex) to get a clearer picture of the market’s health that measures the breadth of stocks increasing.

It’s an index formulated in 1967 by Richard Arms. TRIN is a ratio that measures the number of increasing stocks on any given day and the trading volume of those increasing stocks versus the number of declining stocks on that same day and the volume of those stocks.

While a simple advance/decline line on the market shows you a 100-foot view of how healthy the market is on any given day, TRIN shows you how exuberant investors are about the stocks they are buying or selling. Heavier trading volume in either camp gives that group more weight in the calculation.

I won’t bore you with the algebra, but a measure of TRIN less than one is considered bullish. This is when the number of up stocks (and their accompanying trading volume) is higher than those in the declining group.

A TRIN higher than one is considered bearish. While no technical indicator is a perfect predictor of market behavior, TRIN is pretty good at picking a turn in the market. Based on the super bearish action that I’ve seen recently in many stocks reporting decent news, my guess is that a market turn is in sight.

In fact, the TRIN measured a 52-week high of 5.4 last fall, right before the election. The almost microscopic reading of .08 occurred right at the election and then slowly climbed up to above 2 in April. Since then it’s been bouncing up and down between 1.5 and 2.

You’ll notice that TRIN has little correlation the S&P 500. Part of that is due to the market weighting discussed above that influences the calculation of the S&P’s average. Part is because TRIN is based on NYSE traded stocks, a smaller subset of S&P 500 stocks.

Based on the bearish trading I’ve witnessed in many stocks that have reported good earnings, I think the market is due for a move to the upside. It will be easier to distinguish that turn because TRIN will start moving down as investors become more bullish. It is impossible to catch the top or bottom tick in the market or any particular stock, but when a disconnect exists between stock prices and fundamentals, values can be found.

In my Profit Catalyst Alert service, I’ll be using long term puts and calls for some of the stocks that I feel are over or undervalued at this point in the market and wading into new buys slowly. I always recommend that subscribers dollar cost average into new stock positions as a way to get the best entry price. In most “normal” markets, averaging in over a week or two works well. However, with the market throwing tantrums over any sign of weakness, I’d recommend stretching that out to a month.

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