Besides volume and chart patterns, the most important indicator is price. Of late, we have seen price hit new highs for the S&P 500, NASDAQ Composite, and the Dow Industrial indices. We’re missing new highs in the Dow Jones Transport index and in the Russell 2000 index, setting up a possible divergence. Despite how looming those two divergences appear, this market is still very healthy from a breadth, sector rotation, and trending view.
Let’s first define what divergence means. John Murphy calls it the opposite of confirmation. It is where different technical indicators fail to confirm one another and it acts as an early warning signal of a possible reversal.
Divergence All Aboard!
Looking at the two market divergences I mentioned in the introductory paragraph, let’s start with the transports. One of Charles Dow’s basic tenets of Dow Theory is the averages must confirm each other, which is a whole different matter from the technical term of divergence I mentioned above. We won’t get a new “Dow Signal” until either index reverses trend. At that point, both indexes must show the same reversal of trend to create confirmation. As far as the current trend is concerned, both made a higher low in November 2011, and both confirmed these lows with higher highs at the start of this year. Therefore, as far as Dow Theory is concerned, the last signal created was in January when both averages confirmed a positive trend reversal.
Now, let’s talk about how the two are diverging in price, which doesn’t have anything to do with Dow Theory confirmation except for one thing. While the two indexes are diverging, Charles Dow assumed that the prior trend was still maintained. Essentially, the transport index underwent a correction in February and March while the industrial average hit fresh highs. Coal shipments on rails have dropped and airlines are feeling the pinch on profits with higher oil prices. The divergence between the transports and industrials is an early warning that “something is not right” in equities.
Are the transports overly sensitive to high crude prices? If that was the case, we’d see the index show a negative correlation to oil, and we do not see that right now. Both are positively correlated to each other. The positive correlation suggests the two are more concerned about economic activity than inflation. As in today, if we get bad China numbers or bad Euro numbers, both crude and the transports are likely to correct.
The transport index is the only index between the two Dow indexes that has had a secondary correction since November. The correction was a one-month process after hitting a high on February 3rd of 5384 to the low on 3/6/2012 at 5029. If the transport index closes below the March 6th low, it will have created a double top reversal. The consolidation from February 3rd will continue until the price breaks either of these key levels. Obviously, we’ll need to see the industrials break trend as well to confirm the reversal.
So while the industrial average has diverged from the transports, there is still a lot that would need to develop before the current picture turns bearish. To sum up those points:
- The transports would need to reverse
- The industrial average would need to reverse at the same time or soon after
- This would create the necessary confirmation to satisfy a bearish Dow Theory reversal
Equity Index Harmony
When looking at the four major equity averages (NASDAQ, S&P 500, Dow Industrials, and Russell 2000), it’s important to see broad based advance in all four. When one index diverges from the group, technicians get concerned. The Russell closed at a new year high last Friday, but it has given that up, trading back below 834 resistance to close today at 821. The Russell 2000 is primarily filled with small domestic companies. So if concerns of late are about Eurozone and Chinese economic conditions, the Russell shouldn’t be struggling while the Dow Industrials hit new highs. The Dow Industrial contains huge multinationals with plenty of business in Europe and China.
Is the divergence a risk issue? If investors are concerned that the 2012 rally is overdone and in need of a correction or consolidation, they’re likely to get out of risky small-cap stocks and into large consumer staple stocks. That’s a possibility, yet technology and financial stocks continue to be the best performing sectors through February and March. So no, the risk off trade isn’t back.
When it comes down to it, it could just be a law of statistics working here – a reversion to the mean. Small-cap domestic stocks in the Russell 2000 outperformed on the U.S. jobs data in early February. It has since consolidated, but look at the rally in March this month. All four indexes are trading very similarly. The divergence in the Russell can be merely a consolidation or reversion to the mean of sorts and not a bearish signal.
While the Dow Transports and the Russell 2000 have shown some divergence of late as their peers reach new highs, the picture has not been painted bearishly yet. While the warnings are apparent, we would still need both the Transport and the Industrials to reverse trend and the Russell 2000 to break below the March 6th low to hint at anything more than just a season of consolidation after the markets have had such a stellar run since the October 4th bottom.
Other technical indicators like the percentage of stocks above the 200-day moving average (80% with fresh highs mid-March) and sector outperformance in early cyclical stocks (technology, consumer discretion, financials, and industrials) continue to suggest that the health of this rally is strong despite the divergences noted here. Confirmation is about looking at all of the technical indicators to ensure they’re all pointing in the same direction. The market has risen almost straight up since the November correction. It’s not surprising after four months to see some consolidation in niche areas of the market, but as the trend and other breadth indicators suggest, this bullish trend is healthy. I expect the current divergences to eventually get worked off.
