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The Importance of Good Breadth

The Dow Jones Industrial Average and the S&P 500 aren’t the only measures of a bull market, Cramer said during Wednesday's Mad Money. In fact, investors should look for more metrics than just those. Breadth is important if they want an accurate picture of stocks at any given moment.

“As much as we like to cling to that totem,” Cramer said of the Dow and S&P, “it doesn’t necessarily capture the truth about the state of the market. Breadth can tell us much, much more.”

Breadth is a measure of the number of stocks going up versus those that are going down. Good breadth means there are many stocks in many different sectors moving higher. Bad breadth, of course, is the opposite: More stocks are declining, and few sectors are rallying.

Now averages can move higher even on narrow breadth, which means, “Your bull is weaker than it might appear,” Cramer said. At the same time, averages can decline despite having good breadth, because of a larger percentage decline in one or two key areas. So you can see why investors shouldn’t rely on the averages themselves to gauge a rally. They should look to breadth instead, which is a truth test of sorts. The more breadth there is, the more legitimate the bull market.

The Dow often lags behind changes in the US economy, Cramer said, so breadth can be a much more reliable indicator. When Lehman Brothers collapsed in September 2008, AIG , Alcoa , Citigroup and General Motors were still leading components of the index. But the government ended up bailing out AIG, Citi and GM, and Alcoa was heavily in debt, making these stocks a terrible measure of the market. So if the Dow is headed higher regardless, then investors need to be cautious.

Also, remember the rally of 2007, the one just before the housing and financial crises rocked the market? That rally, led by just fertilizer, natural gas and minerals stocks, was driven by high commodity prices. Few other sectors enjoyed the move, making for some pretty narrow breadth. When the economy faltered, those commodity prices came right back down, taking the stocks with them and reclaiming much of the gains investors had made.

Admittedly, thin breadth isn’t always a bad thing. New bull markets usually start out that way. But the first leading sectors and stocks eventually take others with them, and that’s confirmation of the rally. This expansion isn’t always detectable in the averages.

Cramer’s bottom line? Breadth indicates whether a move is a “bona-fide bull” or just “money rotating from one group of sectors into another.” Investors should pay attention to it just as much as they do the Dow’s closing number.

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