An important divergence that has previously signaled an impending market top is worth monitoring right now. I mentioned it when writing about the technical overview of the market at the end of January.
The pattern comes about when a breadth measure such as the bullish percent index or the percentage of index components above their long term moving average can not accompany their underlying index as it makes new highs. The simple explanation underlying the usefulness of such a divergence is that while everyone is watching the index assault new heights, the underlying components start to act weak.
Historically, a market top occurs when fewer and fewer constituents of an index manage to keep up, leaving the heavy lifting to fewer and fewer issues. Within a short time, the index can not sustain its rise on such dwindling constituency and eventually succumbs to the same forces that had been pushing down the growing majority of its components.
My previous commentary contained a note of caution:
So while the market is hovering very near its 52 week highs, the underlying issues are trading a bit heavy as not as many stocks rallied this time above their 50 day moving averages. Finally, other sectors of the market such as the small caps are also showing weakness, not keeping up with the large caps. The transportation sector, as measured by the Dow Jones Transportation index, is also declining in contrast to the robustness of the Dow Jones Industrial index itself and the S&P 500 index. This makes me cautious as I believe that the market continues to trade within a high risk zone making it prone to a short term decline.
The market managed to crawl higher for a few more weeks but it soon topped out in February and fell below the levels we had seen when I wrote the above negative remarks. Right now, as the S&P 500 approaches the February levels again and begins to trade lethargically, my concern is that this same phenomena is returning.
The recovery from the March lows has been quick and relatively easy with the market rising consistently. But if we look beyond the index there are signs that the component issues are not keeping up.
The number of new highs relative to new lows is showing a divergence as we are seeing fewer new 52-week highs relative to new 52-week lows in Nasdaq component stocks. We saw a similar divergence occur during the topping pattern in 2007.
The bullish percent index for the S&P 500 is showing a divergence with the underlying index. While the S&P 500 index tested 1340 a few times – but never closed above them – the bullish percent index was significantly below the level it was in February 2011:
We can see the same divergence in the percentage of stocks above their long term moving average. Accompanying the February top, appx. 94% of S&P 500 issues traded above their 150 moving average. Recently, with the S&P 500 scraping by the same levels, there were only 89%.
Don’t get me wrong, at this point I don’t see enough signs of an impending top to warrant serious alarm. If this is a top, then what I’m describing above may be the first signs of breadth breakdown that is characteristic of such tops. Without further confirmation, it would be mere speculation to say that this is definitively a top. So while this may sound a bit wishy-washy, I hope that you’ll realize I’m trying my best to do a reasonable analysis with the given indicators without overstepping.
One final thing to consider is that several sentiment measures that have provided very good guidance in the past are either returning to extremes or are at new extremes (in the example of the Investors Intelligence survey).