Over the past couple of weeks, there has been a lot of discussion on RealMoney about the many negative divergences between market movement and this or that indicator or data point. While negative divergences tend to show up late in a market run, let me state right up front: The data show that divergences have no predictive value.
The presence of a negative divergence does not mean that the market is putting in a top; in fact, my analysis shows that the market is just as likely to move higher as it is lower following a negative divergence. Negative divergences are likely to be seen at market tops, just like excessive bullish sentiment. However, the presence of a divergence can also lead to an accelerated move higher.
For a good example of how the market can move higher despite negative divergences, look at a weekly chart of the Nasdaq and the number of stocks making new highs. There's a negative divergence between the Nasdaq's level and another data set, the new highs. The Nasdaq has been making higher highs for two years now (points 1 through 4) despite the number of new highs having made successively lower highs (points A through B) -- a negative divergence -- during the same period.
Another type of negative divergence is when the market moves higher and an oscillator (used to measure momentum, such as stochastics) moves lower, as I've shown on the weekly chart of the Nasdaq below. The indicator that I'm using in this example is proprietary, one I developed to help me program my strategies, but the results are no different than they'd be if I had used any of several popular indicators, such as MACD (moving average convergence/divergence) or RSI (relative strength index).
Another Negative Divergence The Nasdaq vs. an oscillator
On the chart, I've indicated negative divergence with a pink marker over the Nasdaq's bar. Working right to left, the most recent negative divergence occurred in early December (point 1), after which the Nasdaq stayed in a range, so it hasn't really resolved that divergence yet. There were three negative divergences between the Nasdaq and the oscillator that led up to the May 2006 top (point 2). The negative divergence precisely defined the August 2005 top (point 3).
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Guy Lerner is an anesthesiologist and freelance writer who trades for his own account. He blends technical and fundamental analysis to find factors that lead to sustainable moves in the markets. Lerner's approach is research-driven and focuses on supply-demand issues, investor sentiment, intermarket relationships and monetary liquidity. He is a member of the Market Technicians Association and is the founder of TheTechnicalTake.com, a Web site that offers content, commentary and strategies for investors and traders. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. He appreciates your feedback and invites you to send your comments by clicking here.
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