For the past several weeks, I've been making the bifurcated earnings season argument for third-quarter 2009 results. I've also tied the earnings results to the price action of the key market cap sectors (mega, large, mid, small, and micro) in an attempt to identify whether a market divergence will occur, thereby producing a near-term market-top sell signal (see Sustainability Should Top the Economy's To-Do List). Additionally, I've pointed to the emerging divergence between the global markets and China.

What I'd like to now add to the potential market-top equation are the momentum readings that have proved to be a most reliable indicator of deteriorating (or improving) internal market strength.

In the accompanying chart, I've noted the following key factors:

1. The first arrow shows that the mega trend (price, moving averages, and the relationship between and among them) has moved into bullish territory. This is supportive of higher highs, although not necessarily without there being intermediate pullbacks from time to time.

2. The second and third arrows paint a much different picture. While the price action exhibits solid readings, the two indicators aren't supportive of the upside moves. The recent flat to down trend in the two indicators -- Momentum and MACD -- are producing a momentum divergence that, should it not get resolved soon, strongly suggests that price (in the form of higher highs) may be running out of internal momentum strength. And it's the internal momentum strength (or weakness) that sustains all market moves, both up and down.

3. The very short term Slow Stochastics indicator is approaching an overbought level (>80). An overbought reading is often indicative of potential sustained strength at the start of an upside move, not after months of higher highs, which is where we are now.


Click to enlarge

A picture may be worth a thousand words, but when it comes to market-timing-related matters, it's also always good to try and be as precise as possible. Therefore, to help crystallize how a near-term market top may occur in the coming weeks from a divergences perspective, let’s put a little tabular meat on the chart bones.

Taking yesterday’s closing price and going on the assumption that the failing rally scenario (the intra-day high for the S&P 500 needs to move above its recent bounceback high of 1060.62 reached on September 29) will be removed from the equation, the following table highlights that the gap needed to be closed for the major market-cap sectors (with China thrown in for good measure) to make a higher high. Should the large-cap S&P 500 rise above 1080 courtesy of above-consensus earnings results while the smaller cap sectors don't confirm that move, a major divergence will occur, adding more support to the market top argument.



Now, let me refer back to the divergences part of this market-top story and how the bifurcated earnings season factors in.

As I've noted many times before, the most powerful market combination occurs when fundamentals and technicals come into alignment on the same side of a point of view. At such times, the odds increase exponentially that the outcome predicted (in this case, a market top) will occur.

Investment Strategy Implications

Stocks appear poised to produce a major non-confirmation divergence supported by fundamentals that will be revealed in the coming weeks as earnings season unfolds. Should the generals (large and mega cap) move out and the infantry (mid, small, and micro cap) not follow for the fundamental reasons noted above, the stage will be set for the long-publicized (and I'd add, healthy) market correction to finally arrive.