A Lesson in Divergence
10th May 2009
Bob makes an excellent point in his sarcastic remarks about the euphoria in the financial markets. Just because the pace at which the economy is getting worse is “slowing down” is not an indication that it is getting any better. Why do all the talking heads seem so happy?
While this situation is a perfect real world example of what technical analysts call a divergence, you can not trade on a this alone. We have seen a divergence between the stock market prices and momentum indicators several times in the past year. The problem with a divergence is the fact that a market can stay over bought or over sold for a long time.
The lesson here is that you need some type of confirmation that a market that is losing momentum has actually started to move in the opposite direction. To illustrate my point, let’s review a couple of my comments over the last couple of months.
On March 8th, I pointed out that the falling market was losing momentum based on a divergence with the momentum indicator. While the brave could have bought the next day because the market had been over sold for a few weeks, it would have been safer to wait until you had confirmation that the down trend had been broken.
On the other hand, let’s go back to my comment on April 5th. At that time, I pointed out that the market rebound was losing momentum. It is now a month later and the stock market is still over bought. These extremes can run for quite a while, as you might recall from the market’s recent fall.
The lesson here is simple, don’t jump the gun! Anticipating that a market is going to turn around will work some times, but there are many times when that turn around will be a long time coming. Wait for confirmation before placing a trade.
The current market rally will subside eventually, so if you have been along for the ride on this bounce be ready to take your profits. If on the other hand you agree with Bob and I that this market is likely to go back and test the March lows, do not place a trade and then hold your breath waiting for that to happen. Let the market tell you when it is time to take action.
JD
