Market Divergence?

• Posted by Derek
• on February 16th, 2013

No, I’m not shifting into grizzly mode and positioning for an imminent decline. But with a real squint, I can look at this 3rd week of February and see the first notable loss of breadth momentum in 2013. How does that fit into my tactics in the coming days and weeks?

To me, when breadth fails to keep up with the S&P it triggers the following two mental shifts:

1) Reduce the number/beta of equity holdings because new cash is getting more selective

2) Believe in a sustained move in the opposite direction IF the indices start to fall

Here’s the squintable update of my breadth worksheet:

A slight falloff in some breadth measures at a time when the S&P made a slight new high. I said “slight” twice because this is not a situation that I think requires drastic action(AKA getting heavily short). For now, the simple act of letting longs get stopped out, and having less urgency to replace them with new longs, is enough to prepare us both financially and mentally for a better opportunity.

Like everyone else, I worry about all kinds of headwinds for the market…valuation, sequestration, Europe, too much bullishness. But I track my stats constantly, and only feel a need to act when they send me a message. Right now, the only message they’re sending me is “be selective”; as long as green remains the home of my stats I don’t worry about a sustained decline.

The resolution of a divergence is not locked into only one outcome. Remember techs historically lagging megacap growth in late 1994? The fix was that techs caught the index, not the other way around. How about just about everything diverging from sizzling tech in 1999? When I look at the following range charts across sectors, the dominant theme is still strength, not weakness(just note MDY or RSP if you don’t like my breadth grid):

Each day gives us a chance to take the pulse of both the advertised market(indices) and the actual market(underlying stocks). Sometimes, a divergence plays out perfectly, like in Spring of 2012 when leaders stopped leading and by May the whole market was caught in a correction. In 2007, financials tipped their hand in with early summer weakness, but it wasn’t until October that the S&P peaked. It’s different every time, but the process of tracking the market of stocks remains the same.

For me, the benefit is in marking the status of my key momentum measures, over and over again and across Intraday, Daily, and Weekly timeframes. They will always keep me at least coincident with fresh strength or weakness in the market, and sometimes they’ll even give me an early set of clues. I’m not in love with the opportunity set at this flattened phase of the trend, but tightening the portfolio on subtle price evidence is my way of staying on the offensive for the next phase.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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