Will These Divergences Matter?

by JC Parets  -  April 24, 2019

My colleague Tom Bruni recently pointed out some interesting price action in Indian stocks. He noted a lot of similarities between U.S. right now and where India was just a few weeks ago.

The NIFTY 50 Index is the National Stock Exchange of India’s equity market benchmark. Here’s a chart of the NIFTY 50 on April 10, consolidating tightly below all-time highs:

Eighteen-month history of the Nifty Fifty Index.

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At that level, the bearish momentum divergence was a concern, but it hadn’t been confirmed since prices were still above support at 11,555.

What isn’t seen on this chart is the deterioration in the market’s internals happening at the same time. Here’s a quick summary of what we were seeing:

  • momentum divergences across most of the major indexes and sectors;
  • small and mid-cap underperformance, signaling risk aversion;
  • fewer stocks in the major indexes hitting 52-week highs; and
  • fewer stocks in the major indexes getting overbought.

That brings us to today, two weeks later, when prices finally put in a failed breakout (via an “Island Reversal”) and confirmed the caution signals we were seeing build over the last month:

Eighteen-month history of the Nifty Fifty Index.

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Small-caps and mid-caps were hit hardest, closing at nearly four-week lows. The point is that despite our bullish intermediate-term outlook, we can’t be aggressively long stocks in the near term if prices in the NIFTY 50 are below their 2018 highs.

The risk has shifted to the downside, and we have to respect that.

So, the key question is, what does India have to do with the U.S. stock market?

Well, here’s the Dow Jones Industrial Average, or the Dow 30. It’s the U.S. equivalent of the NIFTY 50, and it’s sporting a similar bearish divergence as prices test their January 2018 highs:

Eighteen-month history of the Dow Jones Industrial Average, or the Dow 30.

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We’re also seeing some serious underperformance from small- and micro-cap stocks over the last year, particularly over the last two months.

Comparison of U.S. large-, small-, and micro-cap equity market index performance over the last 12 months.

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Looking at a broader measure of the U.S. stock market, we see the Russell 3000 Index’s recent highs not being confirmed by the number of new 52-week highs among its components:

Five-year history of the Russell 3000 Index.

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Nor are we seeing the number of its components getting overbought confirming price:

Five-year history of the Russell 3000 Index.

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Without the catalyst of price confirmation, these divergences aren’t yet actionable. But we’ll let you know when they are.

They can work themselves out through time or price. But, until they do, our thesis for continuing sideways chop in the short term before an upside resolution in the major indexes holds.

It took a month for them to begin unwinding in India… Who knows how long it will take in the U.S.

As always, we’re focusing on opportunities where our risk is well-defined and the reward-to-risk ratio is higher than at the index level.

There are times where we want to swing for the fences, and there are other times when we want to sit back and take some pitches.

Given the mixed signals we’re seeing in the short term, this is a time to be patient and to focus on hitting singles and doubles, not homeruns.

To wise investing,

J.C. Parets
Editor, Big Market Trends