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Making Divergences Work For You


Opportunity lies in resisting emotion.

To borrow from a famous quote, "I'm scared as hell and I'm not going to take it anymore."

At the end of every major market move, an overshoot takes place – that is the point when greed (on the upside) and fear (on the downside) push markets to the extreme.

In truly extreme cases, greed morphs into a bubble while fear morphs into a panic. Both conditions result in a reversal of the existing trend and present investors with an opportunity to do what human nature wants to resist – sell into greed and buy into fear.

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But how is this done? What method can guide an investor to run against the herd?

One highly useful method is to identify when price is not matched action of other relevant indicators. When that occurs, you have what is known as a "divergence."

A divergence is a non-confirmation of the price action of a given index (such as the S&P 500) by either the price of another asset or by an internal measure of the index.

Let me show by example what I mean. The following two charts are current examples of a divergence – one that is obvious and one that appears to be on the verge.

The first chart shows the S&P 500 versus the S&P 600 Small Cap Index.

Click to enlarge

What this chart shows is that over the past three years every time the S&P 500 (SPX) made a new near term high or low, the S&P 600 (IJR) matched it. That is, until now. Note how SPX is right at its low of March of this year while IJR is a considerable distance from its March low. This is a bullish divergence for the market.

The second chart shows the SPX and measures its internal momentum (the rate of change or strength of the current move).

Click to enlarge

Note how the price action in March was not matched by momentum of that price action. What bears watching is if SPX makes a lower low right now while its momentum indicator does not confirm that low with a lower low of its own.

Investment Strategy Implications

Mohamed El-Erian, co-CEO of bond giant PIMCO, recently stated in an interview regarding commodities that, "We overshot on the way up and we will overshoot on the way down." This is the nature of investing and the extent to which cycles inevitably go to extremes.

Investors that can withstand the pressures of human emotion can find ways to exploit the nature of the crowd. Divergences are one very useful tool that can help put a dispassionate perspective on the markets at a time of great emotion.
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