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Are Divergences A Problem?

Daily State of the Markets
Tuesday, August 21, 2012

Publishing Note: With vacation season in full swing on Wall Street, Daily State reports will be published on an as needed basis between now and Labor Day.

Good morning. Even the most enthusiastic bear will likely admit that their opponents have been firmly in charge of the market action over the past twelve sessions. And with the exception of a brief pullback seen at the end of July, the bulls have actually had things going almost exclusively their way for the better part of the past month. The primary driver of the action has been pretty easy to identify as expectations for additional stimulative measures from the central bankers of the Eurozone, China, and the good ol' USofA have pushed the DJIA up more than 650 points since July 25th.

It is also worth noting that the dip buyers have once again become very active during the bulls' latest joyride to the upside. Over the past two and one-half weeks, the S&P has been finished higher nearly every single day as all pullbacks have been met with buying on an intraday basis. Perhaps it is the expectations for more QE that is causing what appears to be a return of the "Tepper Trade." (If you will recall, it was during the economic soft patch in 2010 that hedge fund manager David Tepper told CNBC that "everything was a buy" due to the expectations that the Fed would initiate another round of quantitative easing. Tepper opined that if the economy got better stocks were a buy because profits would improve and that stocks were also a buy if the economy weakened due to the anticipated action by the Fed.)

In any event, the market has enjoyed a stellar run lately as the DJIA and S&P 500 have moved to fresh new highs for the current bull market cycle that began on March 9, 2009. With the major indices all sitting above their short-, intermediate-, and long-term moving averages and those moving averages themselves all moving upwardly, it is hard to argue against the idea that the trend is up.

But (you knew that was coming, right?) the bears are refusing to give up the ghost here. Not only is the glass-is-half-empty crowd still expecting the current run for the roses to end badly, they are now providing evidence suggesting that there may be some serious cracks in the foundation of the rally.

When stocks make a major move, market technicians like to check the internals of the market for confirmation of the move. In short, a strong move to the upside should be accompanied by indications that the troops are following the generals higher and that there is sufficient "oomph" behind the move to ensure that the rally is sustainable. And it is on this note that the bears are making a lot of noise right now.

The bottom line is that while the Dow and S&P 500 (aka the market's "generals") are currently perched near fresh new highs for the cycle, "the troops" (the broader indices such as the NASDAQ Composite, the Russell 2000, smallcaps, etc) have not followed suit. Take a look at the weekly charts of the S&P versus the Russel 2000 indices below and you'll see what I mean.

S&P 500 Index - Weekly

Russell 200 Index - Weekly

Unfortunately for the bull camp, the same type of non-confirmations (aka "technical divergences") can be seen when looking at charts of the stock-only Advance/Decline lines of the S&P 500 and Small Cap indices. In short, the A/D lines are nowhere near the new highs being made by the price indices. The same can be said for the action seen in the charts of the global markets. And similar divergent patterns can be seen when looking at charts of New Highs and New Lows as well as our industry strength model, which charts the technical health of more than 100 industry groups. The key here is that all of these indicators have failed to confirm the Dow and S&P's new highs by making new highs themselves.

While technical divergences are not traditionally signs of imminent danger for the bulls, it is important to note that nearly every single major stock market decline I've seen over the past 32 years has been accompanied by the type of divergences now taking place. Put another way, divergences in and of themselves don't cause corrections or bear markets. However, major divergences occur before the start of most bear markets. And while there is still time for these divergences to be reconciled in a good way, if they continue to persist, the bears may have a case before too much longer.

Turning to this morning... European markets are moving up nicely this morning on further reports that Germany will not oppose the ECB's plans to buy sovereign debt. Chinese stocks moved up a bit on reports that more stimulus is coming to cities. In response, the U.S. futures are pointing to a slightly higher open at this time.

On the Economic front... There is no economic data scheduled to be released before the bell this morning.

Thought for the day... Why not do something nice for someone today for no reason at all...

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

  • Major Foreign Markets:
    • Australia: +1.10%
    • Shanghai: +0.54%
    • Hong Kong: -0.02%
    • Japan: -0.16%
    • France: +0.59%
    • Germany: +0.47%
    • Italy: +1.68%
    • Spain: +0.01%
    • London: +0.31%
  • Crude Oil Futures: +$0.77 to $96.74
  • Gold: +$6.00 to $1629.00
  • Dollar: lower against the yen, euro and pound
  • 10-Year Bond Yield: Currently trading at 1.844%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: +2.07
    • Dow Jones Industrial Average: +8
    • NASDAQ Composite: +4.32

Positions in stocks mentioned: none

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