Charting Stocks

Charting Stocks Weekly Update

Negative divergence has been present in the major average for the past couple of months. Meaning that while the price action of the major averages have been moving higher, some of their respective indicators have been moving in the opposite direction (lower). In a true uptrend, you’d like to see the indicators move higher in parity with the price. The negative divergence between the indicators and the price caused us to conclude that this rally may be running out of steam.

Let’s examine a few short term charts of the major averages (Dow Industrials, S&P 500, NASDAQ and the Russell 2000).

Below is a chart of the Dow Jones Industrial Average. Here we can see a good example of the indicators moving in opposite directions of the price. Notice the uptrend in price, while the indicators were experiencing a downtrend. The Dow has now violated that uptrend which began in the summer 2006 rally. Though this is only a slight trend violation, it needs to be watched carefully.

Now let’s look at the S&P 500 Index. Here we see a more serious trend break coming off 2 months of negative divergence.

NASDAQ Composite Index has also broken the uptrend line. This appears to be a serious violation with an awful lot of sellers at the 2450 level. I should point out, however, that the MACD indicator (bottom lines), appear to be turning up. No signal has been given yet, but a strong rally in the coming week can trigger a MACD buy signal. I think the probability is relatively low of that happening, given the broad based weakness across all the major averages. We’ll have to wait and see.

Here is the Russell 2000 Small Cap Index which was one of the leading averages over the past 6 years. The picture looks similar. Negative divergence for a couple of months and an uptrend violation. The RSI Indicator failed to hold a support level and has dipped below 50 (which is generally bearish)

Divergence doesn’t just occur between price and indicator. They can be used among various indices, sectors, etc. The relationship between the Dow Jones Industrial Average and the Dow Jones Transportation Average is one that I closely follow. Notice on the chart below, that the two sister averages tend to move in the same direction. We began to see them diverge recently and this gave cause for concern. This relationship is based on Dow Theory, which is one of the oldest concepts in technical analysis. If this was a true bull market, we’d expected that the makers of the goods (the industrials) to be making new highs along with the movers/shipper of the goods (the transports). The new highs on the industrials were not confirmed by the transports.

Now let’s look at some of the market internals, or breadth charts.

Here is a chart of the NYSE Advance Decline line. This is just the number of stocks going up minus the number of stocks going down. We can see a very strong uptrend line which began in July 2006. We can also see that the uptrend line was violated last week while the MACD indicator appears to be rolling over.

Below we see the Advance-Decline line of the NASDAQ Index. This trend was broken in December and has been trending downward since.

Here is a chart which shows the relationship between Volatility (As measured by the VIX) and the Stock Market (As measured by the S&P500) Notice that when the purple line (The VIX) breaks a down trend it usually coincides with a MACD (Top lines) buy signal. These “buy signals” give an indication of an increase in Volatility ahead. Notice that an increase in the VIX usually translates into a decline in the S&P 500 (Green line). We recently experienced a “buy signal” on the VIX which should translate into weakness for the stock market.

Commodities suffered another violent sell-off. Here we see that the CRB index has not only, broken down but failed to hold a key support level.

In my report titled “The Coming Stock Market Crash of 2007,” I spoke of the importance of Copper as a gauge of economic health. I mentioned that if copper could not hold its support level, it would have the implication of a coming recession. Last week Copper suffered a sharp sell-off and seems to be free falling. This doesn’t make me feel warm and fuzzy about the economy.

Brazil was one of the countries to get hit the hardest last week. It makes sense since its economy is based largely on Commodities. We see price and RSI breakdown on heavy volume.

It seems that the probability of a decline over the next few weeks far outweighs the probability of another sharp advancement. The major averages, as well as the market internals, are signaling a correction in the coming weeks to months.

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