Bearish Divergences Abound

By Frank Barbera CMT. July 24, 2007

Something is very wrong on Wall Street. As we have pointed out these late eight weeks, the bulk of the global stock market rally has slowly been coming to an end. How do large and elongated stock market rallies terminate? The answer is they always end up with a wide variety of bearish divergences. Divergences occur as a market moves higher, and slowly but surely takes fewer and fewer sectors and individual stocks with it. The process is like a large number of people stepping into an elevator that goes up a very tall building. Along the way, people start to get off the elevator. A few at first, and then as the elevator continues to move higher, only a few people remain aboard. By the time the elevator is hitting the highest floors, only a few passengers remain.

In the stock market, the process of individual stocks rolling over and starting to move down leaves the work of holding up the indices to an even fewer number of issues, which in order to compensate for the increasing number of stocks going down, actually have to move up an ever increasing rate. One by one, these last few stocks find the torrid pace of appreciation unsustainable and begin to decline. One by one, leadership is exhausted. For the broad market, the Daily Advance-Decline Line is one method of measuring overall participation and is computed by simply accumulating the NET number of advancers less decliners each day. When the figure is positive, the cumulative total rises; when the number is negative, the cumulative total declines. Last year, during the summer months, the S&P 500 continued to move ever higher, but as it did so, fewer and fewer stocks were able to keep up the pace and the A/D Line began to lag behind. Eventually, the S&P rolled over and succumbed to a nearly 8% decline.

Flash-forward to 2007, and we see the same type of phenomenon unfolding at the present time, with the Daily A/D Ratio peaking on June 4th and the indicator unable to best those levels ever since. Just recently, on July 12th and 13th, when the S&P roared to new all time highs, the A/D Line failed to make higher highs producing a bearish divergence. Since then, the A/D Line has slipped backward and is now below both the 20-day and 50-day moving averages.

Above: S&P 500 with Cumulative Daily Advance-Decline Ratio

Another gauge of market breadth is the 20-day Advance-Decline Oscillator. Again, a fairly simple gauge to compute, the 20-day Oscillator is calculated by taking a 20-day moving average of each day's ‘net’ differential between Advances and Declines. In my work, I have developed my own database which tracks 1500 common stocks, all of which are operating companies. Leaving out the plethora of ETF’s, Muni-Bond Funds, Country Funds, and Preferred Stocks eliminates a lot of technical noise, leaving us with a good image of the ‘real stock market.’ Using this data series, we note that over the last eight weeks, as the market has been constructing its top, the A/D Oscillator has made a long string of lower highs versus higher highs on the S&P. Most recently, with the S&P at new all time highs on July 12th and 13th, the A/D Oscillator peaked at a meager reading of +80.72, well below its peak for the post-mid-March rally which was seen at a value of +165.52 on April 18th. Since the failure in mid-July, the oscillator has moved quickly back into negative territory below zero, with a reading of -28.80 on Monday night.

Above: the S&P 500 with 20-day Advance-Decline Oscillator 1500 Operating Companies.

In addition to the 20-day A/D Oscillator that we maintain in house, any number of other breadth series also show the ‘thinning’ condition of the broad stock market. Among the most widely watched of the broad market breadth indicators is the Percentage of Stocks above their 200-day Moving Averages. As can be seen on the next chart, notice that as the market has flattened out its price advance since mid-May, more and more stocks are falling below their 200-day moving averages, meaning a growing number of stocks is already in a bear market.

Above: S&P 500 with NYSE % of Stocks Above the 200 day MA.

Above: S&P 500 and 100 day Ratio of Up-to-Down Volume

Yet another technical gauge which offers even more ‘cause for pause’ is the Medium Term Up-to-Down Volume Ratio. Another one of our ‘in-house’ gauges, here again, we see an indicator which has been consistently lagging behind the S&P for some time. Looking back, we find that this gauge peaked this cycle all the way back on November 15, 2006 with a peak value of 1.2047, with the S&P at 1399.75. Since then, the S&P has made higher highs on these dates with sequentially lower peaks on the Up-to-Down Volume Ratio as follows: May 9, 2007 1.1884 SPX 1512.60, May 18, 2007 1.1828 SPX 1525.10, June 1, 2007 1.1803 SPX 1539.20, and June 14, 2007 1.1419 SPX 1532.90. Most recently, with the S&P at a further higher high of 1552.50, the Up-to-Down Volume Ratio peaked at an even weaker value of 1.1160. Since then, the Ratio has reversed to the downside ending Monday at 1.0631, within about one good down day from reaching a four month low. This is not healthy action in the stock market and combined with what we see taking place on the breadth gauges is a clear-cut warning of a developing major market peak.

Above: S&P 500 (top) Cap Weighted and Below: S&P 500 Equal Weighted

Still more negative divergences can be found by simply comparing a number of important indices. Take the S&P 500, which is traditionally computed and reported as a Market Cap Weighted Index. On the chart above, we show the conventional S&P on the top clip and the Equally Weighted S&P in the lower clip. Notice that on July 12th and 13th, as the crowd was getting whipped into a bullish frenzy by the new all time highs in the DJIA, and conventional S&P, that the equally weighted S&P Index barely made a new high. Since then, the index has quickly slumped right back into the same trading range leaving a potentially bearish double top. Unimportant, you say? Well, it has been this observer's experience that these are precisely the kind of signals the stock market gives off just prior to starting major declines. (Note: Due to my travel schedule this week, a good portion of this article is being penned on Monday evening, July 23rd.)

Yet, all of the divergences we have addressed so far don’t really convey the full gravity of the current condition. As we have noted on many occasions over the last few months, for the last few years, courtesy of Alan Greenspan and Ben Bernanke, the US Economy has been one gigantic credit bubble. Last week, Bear Stearns announced that two if its mortgage CDO Hedge Funds were broke, busted, toast! Less then $.10 on the Dollar if that! Holy Bad Credit Markets, Batman!

The implications of the collapse of the Bear Stearns funds should have any sane investor running for cover. Oh yes, we know the bulls are out there saying it’s all ‘contained,’ that there will be no ‘contagion,’ but that is pure bull. Most of this paper isn’t even being priced -- that’s why its being ‘contained’ because it isn’t being marked-to-market, or at least no one was brave/foolish enough to try until recently. Now the proverbial Jeannie is out of the bottle, and investors can be sure that where bad CDO credits are concerned, the collateral damage will not be ‘isolated’ to Bear Stearns, and that the next leg of the Sub-Prime and Alt-A fiasco is sure to arrive any day.

Want some additional proof? OK, let’s look at the action of the big Broker-Dealers, the big hitters on Wall Street. When things are good, truly good, these stocks always move WITH the stock market. So what’s happening with the shares of big brokers these days? If you guessed ‘another bearish divergence,’ you guessed correctly. Just look at the chart below which compares the S&P 500 and the AMEX Broker-Dealer Index (the XBD). Notice how the XBD did NOT move to higher highs with the SPX, and how since rolling over, the XBD is threatening to break down to multi-week new lows.

In fact, not only is the XBD breaking down, but the price action of the last few weeks shows a small, but potentially very powerful Head and Shoulder Top just now in the act of breaking the neckline and in close proximity to breaking the longer range 200-day moving average. Anyone really believe this is a sign of a “healthy’ market environment? Dream on…

Above: the Relative Strength Ratio of Broker-Dealers versus the S&P 500.

Taking a somewhat longer view, we find that the Broker-Dealer stocks have also just recently experienced a serious break down on the Relative Strength Ratio versus the S&P. Over the last two weeks, the Ratio has broken below an 18-month rising trendline, with the 50-day average now crossing down and through the flat to declining 200-day average, the so-called ‘Golden Cross-Over’ on the downside. This is a sign that there is an excellent chance we will see more bombshells impacting Wall Street and the mortgage market in the weeks directly ahead. Dovetailing with the steep decline in Relative Strength for the Brokerage stocks is a longer range Elliott Pattern showing the completion of a five-wave advancing sequence dating back to the late 1970’s.

The implications behind the completion of this long-term advance suggest that the downside action in large cap brokers could be far more dramatic than most would expect. In addition to the Broker-Dealers, we also see terrible price action in the Financials, which after a very brief rally attempt, are uniformly once again making new lows for the last few weeks. In the chart below, we show the Philly Bank Index and the NASDAQ Small Cap Regional Bank Index which has been in an unrelenting decline. Again, is this a good omen for the stock market?

Finally, we also note the recent sharp decline in high yield municipal bond indices as measured by the Nuveen Closed End Index. Another sign of distress creeping into the Credit Markets? You bet, with the Nuveen Index often turning down several weeks before the S&P. Going forward, we continue to watch key support levels such as 1520 and 1490 on the S&P with the expectation that prices are close to the start of a major stock market decline.

Above: S&P 500 with Nuveen High Yield Closed End Index

Markets ended down Tuesday with the S&P 500 closing lower by 30.53 to end the day at a reading of 1511.04, the DJIA down 226.47 closing at 13716.95, and the NASDAQ lower by 50.72 to close at 2639.86. The Ten Year Bond ended down .033 yielding 4.92%.

That’s all for now,

Frank Barbera

Contact Information

Frank Barbera CMT
Editor, Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
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