Week in Review: Correlated Divergence Leads to Big Bounce

Two separate markets which have a high negative correlation gave off strong technical “buy” and “sell” signals after the close of trading on Oct.27; the S&P 500 and the Volatility Index (the VIX).

Many chart technicians use indicators like Stochastic and MACD to spot what is called divergence, which is seen when a market’s price and the indicator(s) move in opposite directions. This often precedes a reversal of a trend, at least in the short term. In this case, it preceded the biggest weekly rally the S&P has seen since 1974.

Below is a 6-month chart of closing values on the S&P 500. While the S&P makes a new closing low between Oct. 10 and 27 (lower low), stochastic and the MACD are making higher lows. This is what’s known as bullish divergence, which indicates a change from a down trending market to an up trending one.

On the 6-month VIX chart, we can see the exact opposite is happening. The VIX makes higher highs between Oct. 10 and 27 while stochastic and the MACD make lower highs. This is a bearish divergence. (We didn’t put a line on the MACD in the VIX chart because it was easier to see that way).

On the fundamental side, something else is happening which is also generally considered to be bullish; the market has rallied strongly even as the economic data has been very poor.

Tuesday:

The S&P/Case-Schiller 20-City Home Price Index fell for the 15th consecutive month in August and the index is now down a record 16.6% from a year earlier, an indication that no bottom exists for housing prices.

The Conference Board's U.S. consumer confidence index fell to an all-time low of 38.0 in October.

Wednesday:

Durable Goods orders for September surprised to the upside but spending on non-defense capital goods ex-aircraft, a barometer of business spending fell 1.4%. And as we have seen, the positive contribution from durables was not enough to prevent a contraction in Q3.

The FOMC strongly implied the economy is in a recession which is likely to worsen before it gets better citing weakening consumer expenditures, business equipment spending and industrial production while warning on exports, an important component which had prevented GDP from contracting in the first half of the year.  The committee completely abandoned its inflation bias, removing the language from September regarding its outlook as remaining “highly uncertain.”

The Fed has continued to quantitatively ease by expanding its balance sheet, taking the effective funds rate to 0.30% as of Thursday (latest data), and 70 basis points below the 1.00% target rate. The balance sheet expanded by $69.6 billion this past week, bringing the total expansion to $1.01 trillion from the week ending Oct. 31 2007.

Thursday:

GDP contracted 0.3% in the third quarter, less than anticipated, but the underlying numbers indicate a far worse situation. Disposable personal income fell 8.7% in Q3, the largest decrease since quarterly records began in 1947 and consumer spending fell 3.1%, the first cut in quarterly spending since the closing quarter of 1991 and the biggest since the second quarter of 1980. (All percentages are given on an annualized basis).

The 4-week moving average of continuing unemployment claims remained near a 5-year high.

Friday:

Personal spending fell 0.3% in September, marking the first time in two years that consumers have cut their spending. The Reuters/University of Michigan gauge of consumer sentiment dropped to 57.6 in October from 70.3 in September, its steepest drop on record.

On the plus side were the continuing (if slow) decline in Libor and the first expansion in the commercial paper market for seven weeks (due to the Fed’s new Commercial Paper Funding Facility).

Comments

[ESK:]

While house price indexes have reported a downward trend in most MSA's, a new house price index, IAS360 (iasreo.com/ias360updat...), I've been following has been reporting small gains at the neighborhood and county level. So far this is the only house price index I've seen analyze at the neighborhood level.

2008 Nov 14 12:04 PM