A divergence too big to ignore

As I said, it is difficult to be bearish these days or in the 12 weeks since New Year. The market has become increasingly bull-driven and virtually a straight line up non-stop. “Who cares what bears are thinking; as long as it is going up, we should feel happy!” I have got this feeling shared by many people out there and they keep chasing highs with rather euphoric mood. Indeed they got the right to be elated as the market had kept going highs. While I have been more like a crying wolf for weeks, I just feel increasingly worried for those joyful folks. I think they are just taking too many pain inducing tablets now that may trigger a great deal of pain to them if they don’t know what they are doing and what is lying ahead. There have been many warning signs showing up along with the resilient uptrend in the past weeks. Let me share with you another grave warning sign that not many people notice or are bothered with even if they are seeing it. But for savvy traders, I think you should pay attention to it as it may be signaling something big to the downsize maybe for a few months ahead. It is the gigantic divergence of the price actions between big cap stocks (S&P 500) vs small cap stocks (Russell 2000). If you really understand the dynamics of the stock market, you should be aware of a well-established phenomenon that the small cap stocks are usually the leading indicator for the health of the stock market. If an uptrend is really sustainable, usually you should see a strong uptrend with small caps as well. But if there is significant divergence, in this case, a strong uptrend with general stocks but failing down for small stocks, you really should think twice if you want to chase stocks here. I don’t think you need to know much about TA to detect the divergence on the charts below, right? I’m using the typical intermittent term trend line, the 50 DMA as a gauge to define the trend. For S&P, it has been well above the trend line suggesting a bullish uptrend. But for Russell, it just cannot go over the line and is now turning down as we speak. It suggests the current uptrend is not sustainable regardless how strong it may feel like. Together with many other TA indicators, I have a strong feeling that we may see some sharp lower days ahead. And more worrisome is that this is the weekly chart, meaning the underlying next move (the downtrend in this case) may materialize in a few months time, i.e. this is not just a very short direction change in days or a few weeks. If I’m right (but I could be wrong of course), we may see very challenging days with high volatility in the next few months through the summer time, a typical weak season for stocks in general. How low it can go is anyone’s guess at the moment but I won’t be surprised to see a low testing to the Dec lows during the period.

 

 

If this is not enough, let me throw in another one, the DOW transportation index weekly chart. Heard about the famous Dow Theory? In essence, if the stock market is healthy for a sustainable uptrend, it should be supported by the transportation sector, moving in the same direction. If not, a big question about the health of the market. 

Well, both small caps and transportation index are having a trouble to challenge their 50 DMA and is heading down right now while the general stocks are comfortably above the 50 DMA and seemingly resilient by refusing to head down. While you always should take the TA with a grain of salt, I do believe it is the time for big caution and not the time for blindly following the herd!

Just a quick clarification about my writing here when talking about a general direction or trend. People are often mistaken by thinking that I would just stay bearish or shorting all the time when I’m feeling bearish. Not at all. As I said many times, I don’t believe straight line of anything, either up or down or sideways. Within a big trend, there will be many swings in the course and such big swings can create many trading opportunities for nimble traders. E.g even if I think the S&P will go down significantly in the next few months, I may still go long S&P from time to time to bet for a quick swing up when it is too oversold at a given point of time. The key is to know what you are doing and with what timeframe. For most people who are not traders at all and they are generally in for longer period time, it could be very risky and painful to simply chase highs or lows for FOMO. That’s the purpose of my writing here to give a general trending projection and hopefully can help those less savvy investors to avoid painful mistakes.  Same principle for me for any individual stocks when I’m doing trading (not long term investment that I usually keep “forever” if no fundamentals changed).
Also be crystal clear,   I don’t believe the 10 year long bull market has ended by now, likely not in this year anyway. While I’m bearish for the next few months, I think the chance is still high for new highs towards the later part of the year. This is my trading thesis for the year.