- Breakaway momentum occurs when the ratio of advancing to declining stocks exceeds 1.97 over ten days.
- This breadth thrust measure is uncommon, only occurring 25 times since 1949, including yesterday.
- The S&P 500 has posted positive full-year returns in 23 of 24 past occurrences.
In yesterday's Smarts, I discussed how we were on the cusp of achieving a breakaway momentum breadth thrust characterized by an abnormally large ratio of advancing to declining stocks. Specifically, when the ratio of advancing to declining stocks on the New York Stock Exchange exceeds 1.97 over ten days, it has an uncanny knack for signaling robust market returns over the next quarter, six months, and one year.
Fortunately for bulls, the year-to-date rally in stocks continued yesterday, resulting in the 10-day ratio of 2.16, signaling breakaway momentum for only the 25th time since 1949.
Here's what you need to know about returns following breakaway momentum, including the risk of a sell-off and historical returns over time.
What is breakaway momentum?
Breakaway momentum is a term coined by long-term technical investor Walter Deemer. He cut his teeth in the 1960s under legendary technical analyst Bob Farrell at Merrill Lynch. Deemer served as the technician at Putnam, one of the country’s largest investment managers, in the 70s, before starting his research firm in 1980. Over his career (he retired in 2016), he amassed 52 years of tape-tracking experience. In short, saying he’s been there and done that is an understatement.
Here's how Deemer explains breakaway momentum. He writes: “Downside momentum usually peaks at the end of a decline, as prices cascade into a primary low. On the upside, though, momentum peaks at the beginning of an advance, then gradually dissipates as the advance goes on, and the more powerful the momentum at the move's beginning, the stronger the overall move; REALLY strong momentum is found only at the beginning of a REALLY strong move: a new bull market or a new intermediate upleg within a bull market. We coined the term "breakaway momentum" in the 1970s to describe this REALLY powerful upside momentum [emphasis added].”
Breakaway momentum isn’t achieved easily. Not only does it require a significant difference between advancing and declining stocks early on, but it also requires very few declining stocks on the inevitable down days within the 10-day calculation period.
Back to Deemer:
“The real trick in generating breakaway momentum? It's not a lot of advances; it's a lack of declines. If the market stages a strong two-day advance, for example, it MUST maintain very positive breadth days for a couple of days afterward (Days Three-Four and Nine-Ten) to keep the ten-day declines to a minimum. Also, declines MUST be kept to a minimum during the "normal" correction in the middle of the ten-day period; declines can exceed advances during those two days, but not by much or it will be impossible for the market to generate the two advances needed to offset every decline.”
How predictive is breakaway momentum?
Two ways to determine breakaway momentum’s success are win rate and returns. Breakaway momentum’s predictive potential is arguably remarkable on both fronts.
In Martin Zweig’s 1997 edition of "Winning on Wall Street", he includes data showing returns in the months following a 10-day advance-decline ratio above 2.0. Between 1953 and 1996, the ratio exceeded 2.0 only 11 times. The S&P 500 was higher every time three and six months after the signal, returning an average of 7.5% and 15.2%, respectively. Therefore, the success ratio for those 43 years was a remarkable 100%, with annualized returns far exceeding the normal average annual returns for the market.
Returns were even better using Zweig’s Unweighted Price Index or ZUPI (the S&P 500 is weighted heavily toward the largest-cap stocks). Zweig wrote:
“The S&P 500 and the ZUPI were up at least 10% six months later in virtually every case. You would have more than quadrupled your money in the S&P and sextupled it on the ZUPI…Those returns are extraordinarily high in the stock market.”
Walter Deemer shares a more updated table online showing results following breakaway momentum since 1949. The results offer a similarly compelling snapshot of the signal’s effectiveness.
Overall, the S&P was down just two times after three months across 24 breakaway momentum occurrences, resulting in a 92% win rate. The win rate for six and 12-month gains is 96% (23 of 24 were positive). On average, the average six and 12-month return was 14% and 20.7%, handsomely higher than the 6% historical average annualized return over rolling 10-year periods over the past 100 years, according to CFRA.
What could go wrong?
Breakaway momentum’s track record includes some very tough periods, including the Korean War, Cuban Missile Crisis, Vietnam War, runaway inflation, a massively hawkish Fed under Volcker, the S&L crisis, September 11th, the Great Recession, and a pandemic.
For the most part, the signal stands the test of time, but that doesn’t make it infallible.
As we witnessed last year, unprecedented doesn’t mean impossible. There are years in the dataset that weren’t very good. For example, returns were mostly negative in 1962 until six months and entirely negative in 1992 until the 1-year mark.
Real Money Pro’s Doug Kass reminded investors that stocks might struggle – even if only short term – despite a high advance-decline line reading. He writes:
“Sentiment is moving to a more extreme optimistic condition - that's a "negative" for the markets - just as we are seeing constructive breadth thrusts this week. Who wins? Wally [Walter Deemer and Doug worked together at Putnam] thinks price action but I am less sanguine than my dear old friend! This week we are seeing, first hand, a tug of war between a developing market overbought and an impressive breadth thrust.
On one hand - since "price has a way of changing sentiment" (hat tip to The Divine Ms. M [Top Stocks’ Helene Meisler]) - investors are getting bulled up in the recent rally. As an example, as mentioned last night and this morning in my Diary, the S&P Oscillator has moved from very negative (-5.35% on December 28, 2022) to quite positive 9.46% last night. That transition from bearishness to bullishness is eye-opening.
On the other hand, according to my buddy/pal/friend, Wally Deemer, the positive and powerful breadth thrust has been impressive. Wally also highlighted on Twitter that we witnessed a Whaley Breadth Thrust on Thursday. (Here is a description of such a breadth thrust).”
The overbought condition highlighted by Kass aligns with cautious comments this week from Meisler and Real Money’s Guy Ortmann. Meisler wrote today that her short-term oscillator measuring advancing stocks to declining stocks is flashing overbought. That tool has been quite effective, helping Meisler tilt bullish in October and bearish in early December.
Meanwhile, a review of key indicators, including the McClellan Oscillator (another advance-decline line indicator), has Ortmann cautious.
In “Don't Chase Prices Now: Market Data Say to Wait,” he writes, “While the charts ascend and lack sell signals, the data is flashing some red warning lights that, in our opinion, increase the near-term probability of some weakness and consolidation if the recent sizable market gains. So, while sell signals have yet to appear on the charts, we remain of the opinion, as we said here Thursday, that some caution is warranted. The data suggests not chasing prices at these levels while waiting for better buying opportunities.”
The Smart Play
Performance following past breadth thrusts is impressive. However, that doesn’t mean a switch flips, eliminating all risks to stocks. Stocks never go up or down in a straight line, regardless of any signal flashing.
For example, the last breakaway momentum signal happened on June 3, 2020. The returns in the above table suggest it was clear sailing the whole year, but that’s not true. Shortly after the breakaway signal, stocks sold off sharply before quickly rebounding. Many likely cursed the breakaway momentum signal for a few days in mid-June before they were cheering later on. You can see how this played out in the following chart, showing the price action of the S&P 500 ETF SPY in 2020. The drop following breakaway momentum is highlighted.
Depending on the time frame, buyers and sellers can be right. For instance, we experienced rallies within the primary bear market downtrend in 2022, and we will similarly experience selloffs in a primary bull market trend.
For perspective, Walter Deemer provided insight into post-signal sell-offs following the breakaway momentum signal in 2016. He noted that 75% of the biggest pullbacks following a signal within the first six weeks following a signal exceeded 3%. Furthermore, he found 45% of the biggest pullbacks during the first three months were above 5%. That led him to conclude that pullbacks following signals are to be expected and a "decline of more than 5% would not be a deal breaker."
Deemer offered up additional thoughts today, Tweeting that the massive bullish breadth required for breakaway momentum, by definition, means it occurs coincident with overbought signals.
Given his point, don’t be too shocked if stocks digest recent gains over the next week or two. Ultimately, the breadth thrust’s track record suggests the path of least resistance is shifting from bears to bulls, so buying weakness makes sense. For this reason, build your watch list now so you’re ready to strike when stocks retreat. It may take time for buys to pan out, but history suggests you’ll be rewarded.