By Corey Rosenbloom, CMT, Afraid To Trade.com | 12 October 2010
Anyone who knows me knows how big a fan I am of "Market Internal" divergences (or momentum divergences as well). They're one of my favorite methods of market analysis, as they seek to reveal the health— or weakness— of a trend in progress. Divergences often appear ahead of big turns in price, and the last few months have certainly been no exception of that rule. Let's take a look back at the prior two major Breadth divergences (and subsequent reversals) and then look at what breadth says right now.
Click Here, or on the image, to see a larger, undistorted image.
First, let me explain the indicators. Instead of showing actual Breadth ($ADD) or Volume Difference (of Breadth)— $VOLD, what I've done on the daily frame is smooth them both out with a 20 period simple moving average. You can use a 10 day SMA— same logic— but the point is to smooth out the volatility and arrive at a clearer picture of what's going on under the market's hood.
Let's start with prior divergences.
1. April/May Death Rally
Ok, I'm sensationalizing the terminology, but that's really what it was to those trading it. It was a situation where Breadth, Volume, and Momentum declined almost every day as the market rose every single day. You couldn't really get short, as there was no trigger (you can't trade short off a divergence— you need price to break a trendline for entry), and you really couldn't get long because at any day, the market could 'fall apart' due to the lengthy non-confirmation— which was exactly what happened.
Anyway, this was a great lesson in how divergences undercut a rally in progress, but just because divergences exist does not mean the market will collapse the very next day. Price often rallies longer than most people think it will. The main idea is that trading long in an environment of lengthy, massive divergences (such as April/May) is extremely risky and similar to playing Musical Chairs where the music will stop— those caught without a chair will suffer.
It's also like walking farther out into a frozen lake where the ice is becoming weaker under your feet— the longer you walk and ignore the danger of the ice cracking under your feet, the more danger you're in. Anyway— the April/May divergence period was one of the worst I can remember seeing— and it ended appropriately and exactly as expected— with a Crash, not a thud. We now call this the "Flash Crash" but divergences suggested at the potential of a devastating crash the longer the market rose on daily declining 'internals.'
2. July Positive Divergence At Lows
Markets are more likely to "Crash" down than they are to "crash" up, particularly when forming a bottom (in other words, you're more likely to see huge, single down days than you are to see huge single up-days). As the S&P 500 pushed to new 2010 lows at the 1,010 level in July, internals (Breadth and Momentum particularly) showed POSITIVE divergences. Price formed a key (visible) LOWER low while internals (and momentum) formed a HIGHER indicator low— locking in a positive divergence.
The positive divergence preceded a short-term reversal that took the market back to 1,130 where a negative divergence (not really captured by the smoothed 20 day average) sent the market back down.
3. September/October Rally
That brings us to the present, where the situation is looking similar to the April/May period, but if that's the case, we're somewhere in the late-middle period of a grossly overextended rally that is showing consistently weaker momentum and internal support. In the charts above, I highlighted areas where Breadth peaked and then— in the case of April/May— labeled the resulting higher price action as "Dead Air" which is a good way to visualize it. It's like a tree that looks strong from the outside, but internally is decaying.
And if we take the recent past and apply it to the present, we can suspect that price CAN continue rising higher and higher, but the longer it does so WITHOUT the support of momentum and internals actually increases the probability of a severe pullback/reversal— as opposed to a gentle retracement. What's remarkable is that just before the actual May Flash Crash (May 6th), the 20 day SMA of Breadth almost turned negative (ie, it almost reached the zero-line). We're seeing the current 20 day SMA of breadth once again nearing the zero-line as price pushes higher and higher.
I won't extrapolate any more beyond that, but it goes without saying that you should probably be more cautious to the long-side, even though we could certainly see higher prices yet to come— especially if the market breaks above 1,170 and travels back to the 1,200/1,220 region. If volume, momentum, and breadth do NOT increase as price subsequently rises look out for a much sharper correction to come that would correspond with the Bullish "Music" stopping.
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