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Is it Time to Worry About the Divergences? image

There has been an awful lot of discussion lately about the existence of "technical divergences" in the current market. In English, a "divergence" occurs on the charts when the major indices and/or sectors are not all dancing to the beat of the same drum. In short, in a strong market, "the generals" (the Dow Jones Industrial Average, S&P 500, and NASDAQ) tend to lead the market and "the troops" (the Midcaps and Smallcaps) follow along.

To be clear, this really isn't about which index is outperforming or underperforming. No, this is about "confirmation." In other words, if the Dow and S&P are at new highs, the rest of the major indices should also be movin' on up into their respective Promised Lands.

So let's get started. The biggest divergence at the present time can be seen in the Russell 2000 Smallcap index. This spring's "momentum meltdown" created a significant beating in the smallcaps, which has caused the Russell to lag the blue chip indices. As such, the bulls can argue that this "divergence" is easily explained. However, other divergences have been cropping up lately that are worthy of attention.

Why Should We Care?

The problem here is quite simple. You see, history shows that the combination of narrow leadership and technical divergences between "the generals" and "the troops" has been present during the vast majority of market tops. And as the saying goes, those ignore history are doomed to repeat it.

Everyone knows that the current bull run has been one for the record books. And everyone knows that it has been an inordinate length of time since the market experienced a meaningful correction. Remember, this is the 4th longest period in the last 85 years without a -10 percent correction and the 3rd longest stretch without a -20 percent drop.

Because of this, anyone who has been at this game a while is watching this "divergence" situation like a hawk. So, in an effort to be of service, we thought it would be a good idea take a look at a bunch of charts to see if these divergences should be a reason to worry.

In Search of the So-Called "Divergences"

The first chart to review is the ultimate "General" of the market, the Dow Jones Industrial Average, which hit another new all-time high on Friday.

Dow Jones Industrial Average - Daily

There is really nothing to complain about here. The index is at a new high. The index is above both its short- and long-term moving averages, which themselves, are moving up. And then there is a nice uptrend line on the chart dating back to February. As such, the trend clearly favors the bulls here.

However, a perfect example of a technical divergence occurred on Friday. The Dow finished in the green while all the other major indexes closed in the red - with the Smallcaps losing more than 1.25 percent on the session. This is the type of action that keeps drawing attention to the "divergence" issue.

Next up, is the S&P 500, which is also a key "General" in the market.

S&P 500 Index - Daily

While the Dow appears to be marching merrily higher at the present time, there is less cheer in the S&P 500 index. Exhibit A here is the fact that the recent breakout to fresh all-time highs has been less than convincing. One colleague described the gains in the S&P lately as "begrudging." And on Friday, the red finish puts the validity of the breakout in question.

The bottom line here is that the bears will score a major victory if they can push the S&P back into the recent trading range. Therefore, 2005 is a key technical level in the coming days.

Next is the NASDAQ Composite, which up until just recently has been a clear leader and is up +9.65 percent on the year.

NASDAQ Composite Index - Daily

The tech-heavy NASDAQ Composite did most of the heavy lifting in terms of leadership in the recent rebound. The NASDAQ led the way in breaking to new high ground in mid-August and appeared to be the clear leader. However, more recently the league-leading NASDAQ has not confirmed the Dow and S&P's move to new high ground and appears to have lost momentum.

One easy explanation for the near-term divergence is the Alibaba (NYSE: BABA) IPO. The biggest IPO in U.S. history required those buying BABA to raise a monstrous amount of cash. Thus, the thinking is that investors likely rotated out of existing technology holdings and into BABA.

While the divergence in the NASDAQ is clearly only a short-term issue at this point and could easily be corrected, this remains something to watch.

Next let's check in on the Russell 2000 Smallcap index.

Russell 2000 Smallcap - Daily

If one compares the chart of the Russell 2000 to those of the S&P 500 and DJIA, a classic technical divergence is easily seen. While the Dow and S&P are hitting new highs, the Russell is in both a short- and intermediate-term downtrends - and is stuck in a broad range that has been in place since January.

While the divergence can be explained by the "momo meltdown," the key is to understand that "it is what it is" in the world of technical analysis and no explanations are considered. As such, this is a whopper of a divergence and is unlikely to be rectified in the near-term.

Next, although not nearly as severe, a similar problem exists in the S&P 400 Midcap index.

S&P 400 Midcap Index - Daily

There are two problems with the chart above. First, is the fact that the Middies have not confirmed the Dow and S&P's new high. And second, not only did the Midcap index fail to move to new highs, the index is actually in a short-term downtrend. This is another classic divergence - at least from a near-term perspective.

But, it is important to recognize that this divergence could be rectified with as little as a 2 percent advance. Therefore, this remains a yellow flag situation as opposed to a reason to run for cover.

Let's Review

So let's review. The Dow is in good shape. The S&P 500 confirmed the Dow's move, but just barely. The NASDAQ has diverged in the near-term. The Russell is still suffering from the "momo meltdown" and presents a classic, important divergence. And the Midcaps are also diverging, but not nearly to the same degree as the Smallcaps. Therefore, one can conclude that there are reasons to be nervous about the technical divergences among the major indices at this stage.

However, the question, of course, is whether or not they can be placed in the "bull killer" category.

Tomorrow, we will dig into the sectors to see if we can get some answers.

Turning To This Morning

The markets this morning are all about the outlook for central bank stimulus measures. Over the weekend, Chinese Finance Minister Lou Jiwei said the country will not meaningfully alter its economic policy because of any one indicator. This is being viewed as a push back against calls for further stimulus measures. Recall that the People's Bank of China had injected liquidity into the country's 5 biggest banks last week after weak economic numbers - a move that was the equivalent of the PBoC cutting rates by 0.50%. Thus, it appears that traders are voting with their feet on China's publicly stated policy and Chinese stocks suffered overnight. Next up, the ECB’s Noyer told a German magazine that the central bank is not currently considering widening its asset purchase program. As a result, European bourses are mostly lower and U.S. stock futures are pointing to a weak open on Wall Street. The only real positive coming into today's session is that both bond yields and the dollar are trading lower in the early going.

Pre-Game Indicators

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

Major Foreign Markets:
    Japan: -0.71%
    Hong Kong: -1.44%
    Shanghai: -1.69%
    London: -0.67%
    Germany: +0.10%
    France: -0.09%
    Italy: -0.77%
    Spain: -0.08%

Crude Oil Futures: +$0.05 to $92.46

Gold: -$1.80 at $1213.90

Dollar: lower against the yen, euro, and pound.

10-Year Bond Yield: Currently trading at 2.570%

Stock Indices in U.S. (relative to fair value):
    S&P 500: -4.45
    Dow Jones Industrial Average: -27
    NASDAQ Composite: -12.39

Thought For The Day:

Better three hours too soon than a minute too late. - William Shakespeare

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Positions in securities mentioned: None

Wishing you green screens and all the best for a great day,

David D. Moenning
President, Chief Investment Officer
Heritage Capital Research
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