More Than One Outcome from a Divergence

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  • on April 29th, 2011

I’ve mentioned this week how wide the performance gap has been between what I call Leaders vs. the S&P 500.  In most cases, this results in a price or time correction to bring these highly correlated groups back into balance.  There is a major lesson to be learned, however, when the split persists.

Divergences can basically have the following outcomes:

1) Convergence- what we generally expect; lagging breadth drags the index down to its level(or leading breadth pulls the index up)

2) Divergence- the apparent extreme becomes even more extreme(see PALM/COMS or Volkswagen/Porsche); death sentence for leveraged types like the Nobel Prize winners at LTCM

3) Maintenance- the spread persists without widening or balancing; a deeper movement is at work

On Tuesday and Wednesday, I thought we might experience #1…the selling in a cross-section of favored names would drag the index into at least a pause in the rally.  The deeper I looked, the more I began to question that outlook.  The market of today’s era is filled with smart folks, and the window to spot an edge before it closes is pretty small, hours at most.  The fact that the index continued to rise in the face of weakness in leaders meant I needed a new question…am I looking at the right list of leaders?

For the most part, the answer is yes, but the stocks capable of tipping the market’s hand are in constant rotation.  If a stock carves out its own path, it’s no longer relevant in my effort to identify useful divergences.  If new stocks emerge to carry the torch, I need to give them a place on the list.  So the “problem” wasn’t a stupid market ignoring its impending doom; it was a stupid operator using the wrong basket of stocks to track the relationship.  I’ve tweaked my list towards blue chips to make it more reflective of the shifting themes:

In the past week, we’ve seen total duds like $JNJ and $INTC explode from sleep while volatile names like $NFLX and $RIG have suffered.  I think this is a major shift from highflying mid-caps to boring large-caps, led by healthcare and consumer staples at the expense of energy and materials.  It makes no sense in the face of rising input costs, but a change in investor preferences doesn’t always have to make sense.

The most powerful sign of longer timeframe participation is when shorter timeframe extremes don’t fix themselves.  I believe we’re in that phase now, with money coming out of last year’s winners and being immediately moved into dividend growers that the boomer generation recognizes.  These stocks trade much differently than the recent leaders, as the billions of share outstanding slow the momentum when the stocks surge.  That said, the emergence of megacaps that have done nothing for a decade may be just the kicker needed to keep this doubted bull alive.

 

Disclosure:  Long $DIA, Short $IWM

 

 

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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