Start to Watch for Divergence

Was it just nine months ago that Blackstone (BX - commentary - Cramer's Take) went public in a much-ballyhooed IPO? Does that mean that it was less than a year ago that the market was still so enamored with buyouts and deals and takeovers? You might recall that everything had a takeover premium in it. You surely couldn't be short this or that, because you ran the risk of a deal being done overnight.

And now we have deal after deal collapsing in front of our very eyes. And the same folks who insisted there was no private-equity bubble now insist the bottom of the market is in!

All rallies start with short-covering. That is stating the obvious. But after the short-covering we need to see buying -- real buying -- come in. Real buying means volume increasing, not decreasing as it has been the past two days. Real buying means new highs expanding, not contracting as they have the past few days. (Yes, even Nasdaq with its big up move yesterday had fewer new highs than the day before.)

The same way we look for positive divergences on the downside when we're looking for a low, we pay attention to negative divergences on the upside when looking for a high.

Let's look at the Oscillator for Nasdaq, a momentum indicator, to explain this visually.

Point A is mid-October, when Nasdaq had a high, as did the Oscillator. We then corrected and then Nasdaq went on to a higher high, yet the Oscillator went to a lower high. That was a negative divergence in momentum.

Point C is the high off the November low in early December. We then corrected and rallied again to point D. Note that point D on the Oscillator chart is a lower high. Once again a negative divergence.

Now notice the move the Oscillator has made now -- it's quite sharp to the upside. When I discuss that the window for the rally is open for three to six weeks, that is what I'm looking at. The initial two weeks are typically when we see that big rise in the Oscillator. We then typically get some sort of pullback or correction, followed by another rally. If that rally finds the Oscillator (and other indicators as well) making higher highs, then we know the rally has staying power; if it makes a lower high, we start to put up caution flags.

I expect the market to reach a maximum overbought reading next week, which conveniently turns out to be just after the end of the quarter and the beginning of the new quarter. A correction from that point would then set us up for yet another rally in mid- to late April. And it is that secondary rally where we will be on the lookout for divergences, such as a lower high in the Oscillator.

For now, we haven't even had the first correction, so the same theme we've had for two weeks now is still in place: We continue to have a rally window open.

---

At the time of publication, Meisler had no positions in the stocks mentioned, although holdings can change at any time.

Helene Meisler writes a daily technical analysis column and TheStreet.com Top Stocks. For more information, click here. Meisler trained at several Wall Street firms, including Goldman Sachs and SG Cowen, and has worked with the equity trading department at Cargill. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. She appreciates your feedback; click here to send her an email.