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By Costas Bocelli - Creator: Channel Trading Secrets
The bulls have had plenty to celebrate as they closed out a very memorable first quarter.The Dow Jones Industrial Average gained 11.2% and finished at an all-time high. It was also the best quarterly start in fifteen years.
The S&P 500 gained 10% and made history on the very last trading day of the quarter, finally eclipsing the previous all-time closing high made in October of 2007.
It was indeed the perfect ending that played out like a Hollywood script.
Now that we got the storybook ending, will the next chapter play out more like a low budget horror flick?
It’s a little too early to make such a rash call, but there is no doubt that the second quarter has kicked off with a pretty bad hangover.
Whether it’s the poor ISM data, weaker than expected ADP payrolls, Italian political gridlock or the heightened tensions on the Korean peninsula, markets have come under pressure since the start to the week.
Maybe it’s simply the fact that the previous three years have started off in similar fashion -- i.e. with strong gains leading to springtime corrections.
It’s happened three times in a row. What’s to stop the continuation of this seasonal trend?
The conditions are definitely ripe... the indexes are overextended and near all-time highs.
But what’s even more ominous is that several technical factors are flashing big warning signs right now.
So let’s forget about all the headline risk, economic data, or even the spring swoon seasonal trend, and let's focus solely on what’s developing in the financial markets.
In a sense, we’re going to peel back the outside layers and look into what’s making the market tick. And what we’re about to find are several negative divergences that have recently materialized over the past three weeks which may infer that this rally could soon run into trouble.
Price action is diverging from technical momentum indicators
As the Dow and the S&P 500 have been hitting all-time highs, the Relative Strength Index (RSI) has been making lower lows. The RSI is a momentum oscillator that measures the strength and magnitude of price movements.
And when prices are moving higher while the RSI is trending lower, it creates a confirmation failure which suggests that less conviction is behind the forces that are pushing prices higher, suggesting a possible reversal in trend. This is what’s called a negative or bearish divergence.
Dow Transports and Russell 2000 have given up the lead
As the Dow Industrials and the S&P 500 have been powering to new highs, it’s been the Transports and the cyclically sensitive Small-Caps that have been leading the way.
But over the past three weeks, they’ve made a notable shift and the leadership reins have been lost. In fact, they are now leading with weakness instead of strength.
As a result, negative divergences have materialized, which is yet another signal that spells trouble for the rally.
The following chart is the Dow Industrials measured against the relative strength of the Dow Transports. According to the tenets of Dow Theory, the two indexes should confirm one another or move together in tandem as a validation of the trend. When they diverge, it becomes a warning sign that an impending change may be coming.
The next chart is the S&P 500 measured against the relative strength of the Russell 2000, which is an index comprised of companies with small market capitalizations.
Small-cap stocks tend to lead the larger-cap stocks, as they are more sensitive to cyclical shifts in economic activity. And they’ve been leading large-cap stocks to new highs.
But again, we’re now seeing a notable shift over the past three weeks, and small-caps are now diverging and exhibiting relative weakness. If this persists, the rally could be in trouble as the S&P 500 would likely roll over.
The rally has been buoyed by safety
The market's final push over the past three weeks, vaulting the Dow and the S&P 500 to record highs, has come from sectors that tend to be defensive in nature.
Health care, utilities and consumer staples have been leaders. But growth sensitive sectors such as materials and technology have been laggards. This is somewhat of a disconnect -- a clear sign that investors lack strong conviction and are wary of risk assets which are needed to sustain the animal spirits of a rally.
The following chart clearly shows where investors have been putting their cash. It overlays the S&P 500 index with the relative performance of the five sectors mentioned.
What’s most telling is that the relative performances over the past three weeks coincide with the other divergences that we’ve discussed.
Consumer staples (XLP), Utilities (XLU), Materials (XLB), Technology (XLK)...
The bulls have maintained firm control of the market and sustained the rally with uncanny resiliency. Since the beginning of the year, pullbacks have been brief with very few instances of even back-to-back declines.
But how will the market behave in the coming weeks -- or the entire second quarter for that matter?
Unless these divergences reverse and realign with the current bullish trend, we could finally be on the cusp of a meaningful pullback that has been so elusive since the start of the year.
This could be your signal to take profits and reduce risk. Hedge long market positions with options while premiums are still very low. Or, simply reinforce your psyche that remaining patient right now is the best course of action, knowing that there’s a good chance that opportunities to buy at lower prices may soon be on the horizon.
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Costas began his trading career in 1998, at Gateway Partners, an Equity Options Trading Specialist Unit on the Philadelphia Stock Exchange (PHLX). During his successful tenure, and though unprecedentedly volatile trading levels, Costas boldly and adroitly navigated the global "financial meltdown" that saw the downfall of the hedge fund and of Long Term Capital, and the Russian Currency Crisis. Having achieved the coveted Senior Equity Options Market Maker position for his firm, Costas eventually left to join a proprietary trading desk, where he successfully makes markets for large customer and institutional orders. In addition to his more than 7 years of experience as an options market maker, Costas has also trained and educated many junior traders on option theory, risk analysis, and strategy. His passion is helping self-directed investors achieve all of their financial goals through a clear, practical understanding of the power of options and of the many benefits of trading in a proven systematic way. |
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