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Two Major Divergences Should Put Investors on Guard

Technical weaknesses alert us to possibility of pending market reversal


Stocks traded in a tight range Tuesday with just 76 Dow points separating the top from the bottom. The reason for such lethargy is investors’ caution prior to the results of the Fed’s policy statement today and Thursday’s European Central Bank (ECB) rate decision.

July ended on a down note despite an increase in personal income for June and a stronger-than-expected consumer confidence number. But trading was slow throughout the day with indices closing near their lows. The Dow Jones Industrial Average was off 64 points at 13,009, the S&P 500 fell 6 points to 1,379, and the Nasdaq was off 6 points to close at 2,940. The NSYE traded 887 million shares and the Nasdaq crossed 494 million. Decliners were ahead of advancers by 1.4-to-1 on both exchanges.

DJU Chart
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Trade of the Day Chart Key




The late July rally was led by defensive sectors: utilities, consumer staples and health care. Each hit new all-time highs last week, and that is uncharacteristic of a stock market that is about to spring to new highs on a broad front.

SPX Chart

The S&P 500 represents the broad market, and on the surface, the chart looks strong. Its bull channel (not shown here) has driven the index through its intermediate resistance line (downward red-dash line), and the MACD internal indicator is on a buy signal. The first support is at 1,362, which is both the June high and the former resistance line.

But a close look at the MACD reveals an unusual pattern: Each peak of the MACD is lower than the prior high, while each high of the index is higher than the prior high. This is called a “non-confirmation” or “divergence” and is usually interpreted as a sign of a technically weak market. This pattern also exists on chart of the Dow Jones Industrial Average.

Conclusion: Two major divergences exist. The first is the failure of the Dow Jones Transportation Average to confirm the uptrend of the Dow Jones Industrial Average, which we discussed on Monday.

According to Edward and Magee’s The Technical Analysis of Stock Trends, “The fact is that, in Dow Theory, the refusal of one average to confirm the other can never produce a positive signal of any sort.”

The second is the divergence of the MACD to confirm the advance of the S&P 500 index. These technically weak conditions coupled with the leadership of defensive groups should alert us to the possibility of a pending market reversal despite the efforts of governments to shore up their economies. Until these conflicting technical factors are resolved, it is best to sell into strength and accumulate cash.

Today’s Trading Landscape

To see a list of the companies reporting earnings today, click here.

For a list of this week’s economic reports due out, click here.

Article printed from InvestorPlace Media,

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