Stock Market Analysis – Negative Divergences

Dear Traders

It was a tough day on the US Markets yesterday and as I write this most of the major indices futures are negative.  This could be a continuation of the correction that began on the 22nd of February 2011.

Taking a look at the chart of the S&P 500 we see there are a number of technical factors that support the assumption that the market will continue the short term downtrend is has just begun.

Click to Enlarge - SP500 Negative divergences of RSI and MACD - Chart Courtesy of Worden Brother Inc.
  • Since December 2011 the market embarked on a strong bull run, yet RSI 14, 2 has formed a long negative divergence.
  • In my last post on January 22nd I warned of a negative divergence forming – the market has continued to move up but is now looking significantly weaker.
  • Since February 22nd, RSI has seen a strong drop and MACD’s charachter has changed from positive to negative.
  • We have seen a volume surge as prices have moved down since February 22nd, which is usually a bearish sign.

What is a Positive or Negative Divergence in the Stock Market Chart?

A Divergence is a way for us to compare the direction of an indicator with the direction of price.  When the indicators start to move in the opposite direction to price this is known as a divergence. Positive Divergences refer to when an indicator starts to move up as price is moving down.  A Negative Divergence is when an indicator moves down when prices continued to move up.

Ben Bernanke suggested yesterday that a continued rise in fuel prices would negatively impact the US economic recovery.  That is not rocket science, is is simple economics.  We may see as fuel prices are continuing to rise that this will affect the stock market directly.

Is the Market already overpriced?

The US economy is in a fragile state and the debt burden it bears is absolutely incredible.  Trying to support that debt burden in combination with high unemployment and the Obamacare costs will be tough.  Having a fiscally weak president is also not helping the matter.  The US is a fantastic and dynamic place to do business, but at some point it’s leaders will need to start to manage Fiscal and Monetary Policy responsibly.  It can of course inflate its way out of its debt situation.  But as we know strong deflation or strong inflation can be catastrophic for the stock market.

Historic PE Ratio of the SP-500 Index Source:

The above chart shows the PE Ratio of the S&P 500 historically (blue line), you can see how overpriced the stock market was at each of the major Busts;1929 and 2000 specifically.  Today we are at a PE of circa 22, which by any stretch of the imagination is not cheap.  One could say given the state of the US economy and the challenges it has ahead, it may be overpriced.


In summary, we may be looking at a short term trend change to the down side.  Will it turn into a medium or long term negative trend?  Only time will tell.  But if inflation increases significantly or energy prices continue to surge then I suggest it will.  Keep this in the back of your mind as you place your trades.


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