Commentary for November 17, 2004

| November 17, 2004

Yesterday we discussed Technical Analysis (TA) and briefly described three of the indicators that we use here at PMI: Chaikin Money Flow (CMF), Moving Average Convergence Divergence (MACD), and the oscillator Relative Strength Index (RSI). At the end of our discussion we posed a question: Given that TA indicators each describe some aspect of current price movement state, how are they useful as predictors of future behavior? Today we will answer that question.

Below is a daily chart of the NASDAQ Composite index from late March, 2000; you may recognize this as the very top of the secular bull market that ended that year, with this particular average reaching the 5,000 level:

As usual, the top portion of the chart displays the actual price movement itself, while the three technical indicators displayed below it are CMF, MACD, and RSI, respectively. This particular chart is a textbook example of a negative divergence, which is a bearish warning sign that–in this particular instance–accurately predicted the beginning of the great “crash” to come. Divergences are one of the most reliable indicators of potential trend changes, and–as such–we make extensive use of them as part of our statistical analysis. So, what precisely is a divergence?

First, examine the price movement during the month of March. The short-term uptrend that began at the end of January terminated on March 10th just over 5,000. It was then followed by a short-term downtrend to about 4,600, and another short-term uptrend to just under 5,000. In qualitative terms, the long-term uptrend attempted and failed to move above 5,000 twice before turning lower a second time. This is not unusual, as prices will oftentimes require multiple attempts before they are able to break above important resistance levels. So, then, what makes this particular instance of two failed attempts bearish in character?

Now take a look at each of the three technical indicators displayed above. Notice their values during the first attempt to move above 5,000, and then take note of the their values during the second attempt. How did they change? In each instance they moved significantly lower, and that is what is characterized as a negative divergence. You see, when a trend is healthy, technical indicators will confirm price movements by moving to extremes as prices do the same. When technical indicators move in the opposite direction of price, as they did above in March, that is often an indication of a weakening trend, as well as a warning that the trend is vulnerable to a meaningful change in direction.

Of course, just because a negative divergence has developed, that is certainly no guarantee that a trend change will always occur moving forward. If you analyze the month of January on the chart above, you should notice yet another negative divergence between price action and all of the displayed technical indicators. However, this one did not lead to a new downtrend, reinforcing the fact that anything can–and often does–happen in the stock market. Wondering what happened to the NASDAQ immediately following the negative divergence in March? Have a look:

As you can see, this particular negative divergence was right on target, as they often are. The recognition and characterization of divergences is an important part of TA, and an invaluable part of our analysis here at PMI.

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Category: Commentary, Market Update

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