From time to time, you may have heard the word divergence used to describe an issue with a market index or individual stock. It is a simple concept, but one that is sometimes misconstrued. Understood correctly, divergences are insightful and useful tools when looking for bottoms and tops.

This is not the Holy Grail. It is a device to keep in an investor's quiver to help alert him to impending changes. Divergences can occur in all types of markets and in almost any type of momentum indicator, in indices and individual stocks alike. They can be both positive and negative, and alert investors to bullish as well as bearish changes in the chart.

Technicians often use the word divergence when identifying a deteriorating technical environment. The basic premise is when stock prices and internal indicators, such as momentum, are moving in opposite directions, it is typically an indication of a change in the bullish or bearish "energy" in the chart.

Divergences are an early indicator that the rally is maturing and upside (or downside) momentum is waning. We like to view them as a precursor condition to changes in trends and find them very effective in alerting us to those changes. While not all signals eventually lead to declines or rallies, they very often suggest that a period of relative underperformance, at best, is beginning.

The one thing to remember with divergences is that the timing of when the effect occurs is not that easily determined. It is better to use these signals as guide posts to impending changes and wait for the price action to confirm the divergence.

40-Day SARSI Indicator

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In the following example, we are using the Utilities sector as a group that was showing a momentum divergence just prior to the recent weakness. Our internal SARSI indicators (Self Adjusting Relative Strength Indicator), which track the number of stocks participating in the advance, peaked and started heading lower, while the price of the utility index was still moving higher. That indicated there were fewer stocks advancing in that group even though the index was still making new highs.

The divergence in bullish participation was an indication that the sector was narrowing to fewer and fewer bullish stocks in the group, which made the sector vulnerable to a bearish catalyst. The recent spike in rates provided the bearish catalyst, and the utility stocks rolled over into a corrective phase.

American Electric Power

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American Electric Power

(AEP) - Get Report

is a good example of a bearish momentum divergence and corrective decline in an individual stock. AEP formed a bearish divergence in the price rate-of-change indicator, which peaked in late March, while the stock's price action continued higher and didn't peak until late-April.

The divergence between the momentum indicator and the price action was a leading signal of problems on the way in AEP. As we can see, the stock has since rolled over and corrected significantly from the highs.

AEP and the rest of the utility sector remain vulnerable to further corrective action, especially if rates continue to push higher. Steer clear of the group until a deep oversold reading is reached.

At the time of publication, John Hughes had no positions in the stock mentioned.

Hughes began his career at the NYSE in 1989 followed by twelve years running the technical analysis department and co-managing a hedge fund for a New York based brokerage firm. In 2001, John Hughes co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indexes and sectors. Mr. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion.