I thought the rising support pattern provided by the 20 period moving average was interesting and wanted to show the diagram.

I’m showing the DIA (Dow Jones ETF) on the 15-minute chart with a 20 and 50 period exponential moving average.

While I often trade off the 5-minute chart, I view the structure of the higher time frames (yes, a 15-minute chart is a slightly higher time frame for me!). Higher time frames can develop biases or expectations for you, and can also provide risk management points and trade entry points.

The typical interpretation is to identify the trend structure on the higher time frame and then time your entries and exits (targets too) on lower time frames.

For example, if a 30 minute chart shows a resistance level just ahead, and your 5-minute chart gives you a buy signal, you may use the resistance level on the 30-minute chart as a target for when the market might reverse.

Anyway, let’s look at the above chart.

Notice how price is supported as it trends higher by the 20 period moving average. As price gaps higher and forms a U-Turn sell (or rounded top), retracements (pullbacks) are deeper but still are supported by the rising 50 period average.

Trend reversals are often preceded by such ‘loss of momentum’ situations where price retraces deeper and deeper before ‘rolling over.’

Nevertheless, I thought this was an interesting example for you to review.

I use momentum divergences as a large part of my trading, and I thought I’d take you inside a momentum divergence so you could understand the concept better.

First, let’s start with a definition.

Price can be defined as the aggregate value of all participants in a market as they express their hopes, desires, fears, and other considerations as they establish positions (whether as hedged positions or outright directional positions).

Momentum can be defined as the speed or force of prices traveling in a given direction.

Thus, price may be moving higher, but doing so at decreased speed or decreased force (or urgency). If this situation develops, we would consider this to be a ‘momentum divergence,’ in that momentum is registering an opposite reading to price direction.

One may also think of it as throwing a ball into the air. As the ball reaches the apex (the highest point), the ball slows down its speed accordingly before stopping and then reversing… slowly traveling down at first but then gathering speed as it heads closer to the ground.

In this example, I am showing a positive momentum divergence via Harley Davidson (HOG) at the beginning of 2007. Notice that price is trending lower, and we can see this through a series of lower lows and lower highs. It’s best to view momentum divergences in comparison with swing highs and swing lows in price, combined with the overall direction.

Notice on March 12^th how price makes a lower low on a pronounced and strong price swing down, which registers in our momentum oscillators as making a lower low as well. For this example, I’m demonstrating the 3/10 Oscillator, ROC (Rate of Change), and MACD Histogram.

A counterswing up occurs until around March 19^th, and then a new downward impulse occurs. However, this particular downward impulse – although it took prices lower – failed to do so with the strength (or magnitude or length) of the previous price swing.

I drew two hashed lines to show the length of the downward price swing and how it set-up the classic divergence. With price making a lower low, but doing so on less speed or force than the prior price low, a positive momentum divergence forms, which is picked up by our oscillators.

Each of the oscillators (and there are more we could use) makes a higher low while price makes a lower swing low. This warns us that the sellers are losing force (or ‘power,’ conviction, momentum, etc) and that a reversal in price may be setting up. If anything, divergences warn us to take profits if we have them in a position.

It is important to note that divergences alone do not signify trend reversals – they merely indicate a weakening posture of the dominant force (be it buyers or sellers) and that the next counterswing could be stronger than prior counterswings. Sometimes divergences do indeed precede trend reversals, but it’s best to use them as warning signs and allow price to complete a reversal before repositioning.

I’ll be discussing how to use divergences in more detail in future posts. Be sure to check back for more information.

Barry Ritholtz at the Big Picture recently asked the question: “Are Markets a Leading or Lagging Indicator” which addressed the commonly held notion that markets lead economics (or financial conditions as they develop).

Barry states, “There are so many varied inputs into equity markets — sentiment, trend, liquidity, momentum, valuation — anyone of which can be dominant at any given moment.  Merely assuming markets are giving you a 6 month heads up into the future, based on recent action, is often unwarranted.”

He further addresses data from the housing market (and ‘credit crunch’) market declines and takes us back to 2000 when the market rallied into a recession and then bottomed near the start of the economic recovery.

Ritholtz concludes that markets can both lead and lag, which challenges conventional wisdom. “But getting the correct interpretation involves careful review of the charts, sentiment reads, liquidity, momentum, market internals, and other data.”

In other words, it’s not as simple as reading a stock market peak and declaring “the economy is about to decline” or observing a potential market bottom and declaring “the worst is over.”

Markets are increasingly affected by globalization and do appear to becoming more correlated as information reaches so many trading desks across the world simultaneously.

Also, with the proliferation of hedge funds as well as computerized algorithmic trading, the classic ‘purpose’ for investment (or trading) has deteriorated from what it was 20 or 30 years ago.

While funds do still invest on their belief about the future prices of equities, computerized trading programs and the open access to more market participants distorts these views.

Also, with the acceptance and rise in popularity of technical analysis methods, more traders are analyzing prices strictly due to mathematical indicators and visual chart patterns which seek to exploit certain aspects of market psychology of participants. Such trading creates unexpected and often unintended price movements which have very little to do with equity valuation or fundamental analysis. This further removes the link between the stock market and the economy.

This is a fascinating concept and I am glad Barry is addressing the point and sharing a few of his views.

As with most things in the stock market, nothing is as simple as it seems at first glance.

In the previous post, I specifically mentioned the Technology sectors as being one of the worst performers year-to-date, and the Industrial sector as being one of the best. Let’s take a look at those in a little more detail to see if we can gather a few clues:

The Technology Sector, supported by similar patterns and excellent performance by Apple (AAPL), Google (GOOG), and others, appears to be on its way to complete a ’rounded bottom’ or perhaps ’saucer bottom’ and the likely pathway could lead to higher prices yet to come.

Notice the near-symmetrical rounded shape of the price action combined with a positive momentum divergence that has been developing since the beginning of the year. The key reversal day of January 22^nd helped quite a bit as well.

Longer term, the picture is similar to the major US Indexes:

Also, I mentioned the Industrial Materials Sector as surprising me to have the best performance year-to-date. Let’s look:

The Industrial Materials (XLB) has made new highs, in part thanks to strength from commodities and world-wide demand. Nevertheless, volume is declining on the recent march to new highs which serves as a temporary non-confirmation.

The daily chart shows a classic bull flag completing its measured move:

Keep an eye on these sectors to see where strong (and weak) stocks within them might trade to give you fresh, potentially unseen opportunities for profit.

Let’s take a quick look at what the sector analysis is saying.

First, let’s look at year-to-day (76 days) returns for the nine major SPRD sectors according to StockCharts.com:

The Materials (up 6.5%) and Energy (up 5.6%) sectors have outperformed all others, while the Health Care (down 10%) and Technology (down 10.5%).

While the Sector Rotation Model would expect Technology stocks to be down in a defensive (or down) overall market, it is surprising to me to see Health Care stocks (which typically are used as a defensive posture and/or don’t follow normal sector rotation patterns) to be down just as much. This development bucks the expected direction.

Now, let’s look at the Sector performance relative to the S&P 500 Index:

Again, we would expect Energy stocks to do well going into a defensive market, as this sector tends to ‘top out’ as the economy tops out due to the increased spending cuts that consumers and businesses take due to higher fuel costs (and transportation costs).

It’s also a little surprising to see Materials stocks – which often do well in mid to late economic expansions – performing higher than energy stocks.

These developments warrant further investigation in my opinion.

Sector Rotation analysis can give you a ‘heads up’ about where the larger money could be flowing as the economy (and stock market cycle) progresses from one stage to the next.