Thursday, May 16, 2013

Divergences: Stock Market Advance Not Being Confirmed

As I've mentioned here before, I expected the S&P 500 to undergo more of a meaningful correction about 80 points ago -- obviously, I've been incorrect about a correction. 

It's not unusual for me to be early (vs. late) as I do typically err on the side of caution when $$$ are involved, and I prefer to be prudent rather than gutsy. That said I'm always closely tracking the charts/indicators I've grown to value and trust over time as I am vigilant about not committing the behavioral sin of getting overly-attached to an investment stance. Pay heed to your process, stay disciplined, but also remain flexible and always look for reasons why you could be wrong this time. It's a tricky balance (and why this business ain't easy).

After reviewing several such charts and indicators, I do still see some lasting divergences that are concerning, one being small-cap performance versus larger-caps.

 Source: Stockcharts.com

The chart above shows the relative return of the Russell 2000 Index (IWM) versus the S&P 500 (SPY), plotted with the S&P 500 in the background (green line). Note that despite the new all-time highs in the S&P 500, IWM performance has lagged SPY performance with a red line identifying the bearish divergence. I would also point out that the RSI of the IWM:SPY ratio exhibits a bearish divergence, and that the Aroon Oscillator of the ratio remains repressed -- further non-confirming signs of the market's latest advance.

In addition, below I present two more relative return charts, the first showing high-yield (junk) bonds (HYG) versus T-bonds (TLT) and the second chart showing cyclical stocks ($CYC, Morgan Stanley Cyclical Index) versus staples (XLP). Both have the S&P 500 (green line) in the background.



Source: Stockcharts.com

The HYG:TLT ratio has been heading in the right direction (up), however it needs to surpass its prior high set in March to confirm the S&P 500's new highs. Likewise, in the second chart, the $CYC:XLP ratio has been heading in the right direction but it appears to be rolling over at the key 100-day moving average (I've discussed this indicator in the past). Also, note the developing bearish divergence of the $CYC:XLP ratio as it looks to be making a lower high for the third time -- as it did in February-April of last year. 

I will be the first to state that by definition, divergences lag and they can eventually disappear, i.e. finally confirming a move. However, in my experience, as they develop and remain in place one would be wise not to ignore the potential implications. All in all, I continue to be wary of this recent rally in the market.

5 comments:

  1. I will be the first to state that by definition, divergences lag and they can eventually disappear, i.e. finally confirming a move. However, in my experience, as they develop and remain in place one would be wise not to ignore the potential implications. All in all, I continue to be wary of this recent rally in the market....how to invest in stocks

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