A Critical Look At Market Divergences

Over the past month, many technical analysts have increasingly focused on the stock market divergences that in many past instances have resulted in meaningful stock market declines. For a technical analyst divergence is a key method of identifying both stock market tops and bottoms.

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The divergences have been discussed in several past contributions to Forbes.com. On September 30, 2018, just before what turned out to be one of the sharpest quarterly declines in many years, I featured the chart above which revealed that as the NYSE Composite was making new highs in August and September, line a, the NYSE All Advance/Decline Line was forming lower highs, line b, as it was diverging from prices. The NYSE Stocks Only A/D did not diverge as it made higher highs, line d. By the December low, the NYSE was down over 18%.

Divergences can be observed in many different technical indicators that in my experience have a varied degree of relevance and importance. Of course, multiple indicator divergences will increase the probability that the stock market trend is changing

In the last few months of 2021, only 119 stocks in the Nasdaq Composite stocks made New Highs as they had peaked at 519 early in the year. The warning for this divergence came from the increase in the stocks making New Lows as I discussed in Get Consistent Warnings Before The Market Declines.

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The Spyder Trust (SPY) made a high Thursday of $550.12 but then closed at $544.09 just 1.3% above its rising 20-day EMA at $536.93. On May 17^th, line 1, the S&P 500 Advance/Decline line made its high as the SPY closed at $529.45. SPY did correct by the end of the month as it had a low of $518.36 on May 31^st . After reaching its starc- band it turned higher.

By last week SPY had moved sharply higher but the S&P 500 A/D was below its WMA for most of the time and was still below the high from May 17^th. The A/D line shows a clear pattern of lower high identifying the negative or bearish divergence.

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The picture is much different when you look at the S&P 500 A/D line which is equally weighted versus the S&P 500 Equal Weight ($SPXNEW). This average has been flat in June as it has traded just above and just below the pivot at 6673. It has not rallied like SPY which has a 40% weighting in just MSFT, AAPL, NVDA, and AMZN.

As of Friday’s close, the S&P 500 A/D line was just above its EMA but is still below the high from May 15^th. The downtrend, line a, is not a divergence as $SPXEW has also made lower highs. The NYSE All A/D Line is still below its EMA and has resistance to watch at line b.

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Those market averages with the largest number of holdings are the most important in my view as the NYSE Composite has over 2000 stocks. It therefore has a more important influence on the market’s trend than the Dow Jones Industrial Average which has 30 stocks. The length of the data is also important as the longer the data the more important the divergence will be for the market’s direction. As a result, divergences in the weekly and monthly data are more important than the daily divergences.

This weekly chart of the NYSE Composite shows that it was up 1% last week after first dropping to the rising 20-week EMA at 17,725. The NYSE formed higher highs in May with important support now at 17,736, line a. This support is 3.6% below Friday’s close.

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The weekly NYSE Stocks Only Advance/Decline Line formed higher highs in May, line 2, confirming the price action in the NYSE Composite. Last week it moved back above its EMA and has important support at line 3. The NYSE All Advance/Decline Line has held even further above its EMA and is even more positive. It has support at line 4. Positive A/D numbers this week will support the bullish interpretation.

Based on the weekly analysis of the major averages, the recent negative divergences in some of the technical studies, including the advance/decline lines, do not indicate that a major top is in place. If negative divergences are evident in the weekly A/D lines on a move above the May highs it would be a different story.

Last week’s sharp reversal in the VanEck Semiconductor ETF (SMH) and market-leading NVIDIA Corp (NVDA) also got the market’s attention last week. Both SMH and NVDA exceeded their weekly starc+ bands on Tuesday which put them in a high-risk buy area. NVDA had been above its weekly starc+ band for five weeks in a row which is always a sign of an overbought extreme.

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Interest rates were a bit higher last week and despite the negative MACD readings, a bounce cannot be ruled out. This week we get Consumer Confidence, GDP and the key PCE inflation report on Friday. Look for updates during the week on X.